In the foreign exchange market, the three important categories of players are banks, non-banking financial institutions, and retail traders. Retail traders may not have adequate financial strength to participate directly in the interbank currency market. Still, currency trading is possible for retail traders through two means: market makers and electronic communication networks (ECN). So, let us study who these market makers are and their role in the decentralized over-the-counter Forex market.
A market maker is the one who continuously buys and sells a currency at an openly quoted price in the OTC market. By doing so, a market maker acts as a counter-party to most of the trades made by retail traders. To put it simpler, whenever a retail trader buys a currency, the market maker sells, and vice versa. Notably, a market maker invariably trades against the crowd. One of the primary functions of a market maker is to provide liquidity to any traded asset. For performing this function, a market maker gets compensated by a markup to the bid and ask price. The difference between the bid and ask price, known as spread, is the profit a market maker generates for his role in providing liquidity. The price quoted by a market maker is based purely on the demand and supply mechanism.
A market maker has no intention to predict the direction of price movement or push the market towards any particular direction through accumulation of positions. They just facilitate an instantaneous transaction at the quoted price, without the need to wait for a counter-party. By doing so, a market maker ensures a smooth flow of price movement.
In a range-bound market, a market maker will have plenty of time to cover his trades by passing on the risk to another trader who may have an opposite view about the trend. However, it will not be the case in a volatile market. Thus, to mitigate the risk, a market maker will employ several methods, including hedging with one or more tier 1 broker.
In case of a retail trader, a Forex broker will be the market maker. Unless a retail trader has opened an ECN account, a Forex broker will be the counter party to all the transactions.
When a trade takes place between two banks or a bank and a large financial institution, the market maker will be another bank or a financial institution. Due to a huge competition among banks and retail Forex brokers to acquire clients who trade large volumes, the spread is extremely low and does not affect the performance of a retail trader significantly. So, market makers play a vital role in providing liquidity and maintain competitive bid-ask rates in the Forex market. Ultimately, their objective is to provide liquidity and earn a profit through spread or commission.
The role of a market maker is often presented in a distorted manner due to incidents of sharp spikes, which remove stop-loss orders. A market maker is crucial for an efficient performance of financial markets, including the FX market.