Legal Definitions - market-making

Market-making is a financial practice where a firm, often called a market maker, stands ready to buy and sell specific financial instruments, such as stocks or bonds, using its own capital. By continuously quoting both a "bid" price (the price at which they are willing to buy) and an "ask" price (the price at which they are willing to sell), market makers ensure there is always a counterparty for investors who want to trade. This activity provides liquidity to the market, making it easier for others to buy or sell, and helps in the continuous discovery of prices for these instruments.

Here are some examples to illustrate market-making:

• Example 1: Trading a Less Common Stock
  Imagine an individual investor wants to sell shares of a small biotechnology company that is traded "over-the-counter" rather than on a major stock exchange. Because this stock is not widely traded, there might not be an immediate buyer readily available. A market maker specializing in these types of securities will step in, offering to buy the investor's shares at their quoted "bid" price. Simultaneously, the market maker will offer to sell those same shares (or others they hold) to another interested party at a slightly higher "ask" price. This ensures the investor can sell their shares without delay, even if there isn't another public buyer immediately present, thereby providing essential liquidity to the market for that specific stock.

• Example 2: Facilitating Corporate Bond Transactions
  A large institutional investor, like a mutual fund, needs to sell a substantial block of corporate bonds from a particular company to rebalance its portfolio. Corporate bonds are often traded directly between financial institutions rather than on an exchange. A market maker specializing in corporate bonds will provide a two-way quote: a price at which they are willing to purchase these bonds from the mutual fund (their bid price) and a price at which they would sell similar bonds to another client (their ask price). By doing so, the market maker absorbs the bonds into its own inventory, allowing the mutual fund to execute its large sale quickly and efficiently, and ensuring continuous trading in the corporate bond market.

• Example 3: Pricing Municipal Bonds
  A pension fund is looking to invest in municipal bonds issued by a specific city to fund a new public transit system. These bonds are often traded over-the-counter and can have varying levels of liquidity. A market maker specializing in municipal bonds will provide a firm quote, indicating the price at which they are willing to sell that particular bond to the pension fund (their ask price) and the price at which they would buy it back if the fund decided to sell later (their bid price). This service allows the pension fund to acquire the desired bond without having to search for an individual seller, and it helps establish a transparent and fair market price for these less frequently traded government securities.