Market Makers: Function, Compensation, and the Mechanics of the Spread

Abstract

Market makers are financial intermediaries who earn revenue by quoting both a bid price (willing to buy) and an ask price (willing to sell) for a security, contract, or other instrument, enabling other participants to trade immediately without waiting for a counterparty to appear. They are compensated principally through the bid-ask spread, the difference between these prices. The spread exists to remunerate market makers for three categories of risk: inventory risk from holding positions, adverse selection risk from trading with counterparties who may possess superior information, and the operating and capital costs required to provide continuous quotations.

Core Concept and Mechanical Function

A market maker stands ready to trade on both sides of the market simultaneously. If a trader wishes to sell, the market maker buys at the bid; if a trader wishes to buy, the market maker sells at the ask. By absorbing these one-sided flows, the market maker consolidates supply and demand, making immediate execution possible rather than requiring buyers to wait for sellers and vice versa. The difference between bid and ask is the market maker's gross profit on each round-trip trade (a matched buy and sell).

For example, if a market maker quotes $100.00 bid and $100.05 ask for a stock, any seller can immediately execute at $100.00 and any buyer at $100.05. The market maker earns the 5-cent spread if they buy at $100.00 and later sell at $100.05, or if they sell at $100.05 first and later buy at $100.00. The spread is the sole mechanism by which market makers are compensated; they do not receive fees or salaries from the exchange.

Sources of the Spread: Risk Compensation

Three principal risks justify the existence of the spread:

Inventory Risk

A market maker who buys must hold inventory until offsetting sell flow arrives. If the stock falls from $100.00 to $99.90, the market maker loses $0.10 per share on that holding. The spread must be wide enough that, across all trades, the market maker is compensated for the risk that prices move adversely while they hold inventory. The wider the expected time between offsetting trades, the wider the spread must be to justify the risk.

Adverse Selection Risk

Not all trading is motivated by liquidity demand alone; some traders possess information the market maker lacks. A trader submitting a large aggressive buy order may have completed due diligence or detected a forthcoming earnings surprise. The market maker, facing such an order, cannot distinguish the informed trader from an uninformed one. Glosten and Milgrom (1985) formalized this insight: market makers widen spreads when the probability of facing an informed trader increases ^[1]. The spread is a defensive mechanism: by pricing in a margin for uncertainty, the market maker ensures that on average, even trades with informed counterparties yield non-negative expected profit. The wider the spread, the higher the barrier for an informed trader to profitably exploit the market maker.

Operating and Capital Costs

Modern market making requires substantial infrastructure: electronic systems quoting thousands of prices per second, connectivity to exchanges and traders, monitoring of risk and position, and personnel. The bid-ask spread is the mechanism by which these costs are recovered. Also, capital tied up in inventory represents an opportunity cost: in a positive interest-rate environment, that capital could instead be deployed in short-term treasury securities. The spread compensates for this opportunity cost ^[2].

Worked Example: S&P 500 E-mini Futures

The CME Group E-mini S&P 500 contract (ES) illustrates market-maker economics in a large, liquid derivatives market. The ES contract has a minimum tick of 0.25 index points, equivalent to $12.50 per contract ^[3]. During normal trading hours with substantial volume, market makers typically quote spreads of 0.25 to 0.50 index points. If a market maker buys one ES contract at an index level of 5,000.00 and sells at 5,000.25, the profit is $12.50. To generate meaningful income, a market maker in ES must execute hundreds or thousands of these round-trips per day while actively managing inventory to remain neutral or near-neutral to directional risk.

The spread in ES widens predictably under stress. During the release of major economic data such as the non-farm payroll report, spreads widen to 1.0 to 2.0 index points because uncertainty spikes and adverse selection risk increases: traders executing at that moment are likely responding to new information. Similarly, spreads widen during off-peak hours (such as 4 a.m. EST) when volume is low and the probability of facing an informed trader rises. During high-volume periods such as the 9:30 a.m. EST open, spreads narrow to 0.25 points or less because volume provides continuous natural offsetting demand, reducing the time a market maker must carry inventory ^[3].

Why Markets Persist with Positive Spreads

If spreads were zero, market makers would earn no compensation for the risks they absorb. In a theoretical frictionless market, every participant could post unlimited bids and asks at the midpoint; in reality, someone must be willing to cross the spread by hitting an existing order. Without compensation for doing so, no one would choose to take that immediate adverse price. Spreads ensure that market makers, as a class, remain willing to compete to provide liquidity.

also, markets with narrow spreads signal that the probability of adverse selection is low and inventory holding periods are short. A 0.01-penny spread in a highly liquid stock like Apple reflects the fact that millions of shares trade daily and the adverse selection risk is minimal. A 2-percent spread in a thinly traded closed-end fund reflects high adverse selection risk and low order flow. Spreads adjust endogenously to equilibrate the supply and demand for liquidity.

Variation Across Market Types and Conditions

Electronic markets such as the NYSE and CME publish spreads transparently. Regulatory rules such as SEC Regulation SHO and exchange-operated limit-order books constrain spreads via tick-size minima: a dealer must improve a public quote or their order is not allowed to trade ^[4]. In contrast, over-the-counter markets such as US Treasuries or credit derivatives feature opaque, bilaterally negotiated spreads that can be substantially wider. During the 2008 financial crisis, spreads in many fixed-income markets widened 5-fold or more as counterparty risk surged and market makers reduced inventory in response to elevated adverse selection and inventory risk.

Limitations and Critiques

Spreads Exceed Risk-Based Justification in Concentrated Markets

While spreads are justified as compensation for measurable risks, in practice they often exceed what risk models predict, particularly in markets with few dominant dealers. A market maker with substantial market share can maintain wider spreads without losing order flow to competitors. This represents an exercise of market power rather than pure risk compensation. Retail investors paying spreads in less liquid securities may face prices that are wider than justified by the underlying risk.

Information Asymmetries Favor Sophisticated Traders

The adverse selection model assumes all market makers face uniform information disadvantage. In reality, high-frequency trading firms and sophisticated dealers exploit order-flow patterns and latency to detect informed order flow and adjust their quotes defensively within microseconds. Retail traders and less-sophisticated institutional traders, lacking this capability, effectively cross wider spreads to compensate for the information advantage held by sophisticated market makers. The spread captures not only pure inventory and adverse selection risk, but a technology rent extracted by faster participants.

Tick-Size Regulation Distorts Spreads

Regulatory-imposed minimum tick sizes (the smallest permissible price change) do not adjust continuously with volatility or order flow. In very calm periods, tick sizes may force spreads wider than economic fundamentals justify, inflating market-maker profits. Conversely, in volatile periods, tick sizes may prove too large, forcing discontinuous spread widening. The SEC has conducted tick-size pilot programs to study this tension, but optimal regulation remains debated ^[4].

Spreads Hide a Transaction Tax on Non-Market Makers

While the spread is presented as risk compensation, it functions as a tax on all non-market-making traders: every participant who buys must pay the ask and every participant who sells receives the bid, realizing the spread as a cost. In perfectly competitive markets, spreads approach the minimum economic cost of providing liquidity. In reality, market power, tick-size constraints, and asymmetric information often inflate spreads above that minimum.

Summary

Market makers are essential to modern financial markets, providing continuous liquidity by quoting and transacting on both sides of the market. The bid-ask spread is their sole source of income and serves as compensation for inventory risk, adverse selection risk, and the operating and capital costs of providing quotations. Spreads adjust dynamically with market conditions: they narrow during high-volume, low-volatility periods and widen during stress, illiquidity, or when adverse selection risk rises. While the spread is economically justified as payment for real risks, it also reflects market power, information asymmetry in favor of fast traders, and regulatory constraints on tick sizes. Spreads represent the fundamental mechanism by which liquidity is purchased in financial markets, but that mechanism can be abused in concentrated or illiquid markets.

Key Definitions

Bid-ask spread: The difference between the highest price a market maker will pay to buy (bid) and the lowest price at which they will sell (ask).

Inventory risk: The financial loss a market maker incurs if the market price moves against a position they are holding while waiting for offsetting trades.

Adverse selection risk: The loss a market maker faces from trading with a counterparty who possesses information superior to the market maker's, causing the trade to be unprofitable on expectation.

Tick size: The minimum permissible price increment for quoting or trading an instrument, set by exchange rules.

Round-trip: A matched sequence of trades in which a market maker buys and subsequently sells (or vice versa) the same quantity of an instrument.

Opportunity cost of capital: The return foregone by deploying capital in inventory rather than in alternative investments such as treasury securities.

Order flow: The stream of buy and sell orders submitted to a market, including their timing, size, and aggressiveness.

References

^[1] Glosten, L. R., and Milgrom, P. R., "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneous Informed Traders," Journal of Financial Economics, Vol. 14, No. 1 (1985), pp. 71-100.

^[2] Federal Reserve, Monetary Policy and the Distribution of Income and Wealth (Board of Governors, 2021). Https://www.federalreserve.gov/

^[3] CME Group, "E-mini S&P 500 Futures Contract Specifications," CME Group Education. Https://www.cmegroup.com/education

^[4] U.S. Securities and Exchange Commission, "Tick Size Pilot Program," SEC.gov, 2016. https://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000789019&type=&dateb=&owner=exclude&count=40

^[5] Investopedia, "Bid-Ask Spread Definition and Example," Investopedia LLC. Https://www.investopedia.com/terms/b/bid-askspread.asp

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Last reviewed by the PropLedger research pipeline: 2026-10-26. Educational research on historical data, not financial advice.