I was chatting with someone at a recent conference about how market makers make money, and said that they profit off the spread. I don't understand how this works. Example: Assume that the order book stands as follows. Bid/Ask spread stands at $14.78/$14.79; a 1 penny spread. If a market buy is placed for 1 contract, it will be matched with the standing ask available at $14.79. How does the market maker make money on the spread in this deal? Are posted prices marked down or up from the market maker's buy price? In this example, although the posted price is $14.78, the internal price of the asset was $14.76, and when match the order at $14.78, they make $0.02?
Sorry I have to ask: You are a vendor, your company is Richie Stock Exchange and you have to ask this question?
Market maker buys at the BID and sells at the ASK and makes a penny per share if that bid/ask stays as is, or more than a penny a share if not a highly liquid stock. Multiply by millions of shares a day plus other fees and you have almost free money (they have to balance their exposure).
It is nearly impossible to make any money in a penny wide market in reality. If you really mean penny wide the underlying is traded in multiple venues. The MM would only see really two sided markets if the if they bought flow and that would make it easier, but they would give up some of the spread. They are also paying exchange fees and all of their technology and regulatory costs. Huge volume would help, but it's still tough. Many of the penny wide markets you will see in underlyings like SPY or often coming from different MMs and the bid/offer aren't from the same MM and are living with some trade-thru rule where see order shipping away unless they match. So think about it as $1.00 on a hundred shares. Payment and fees can eat easily eat half of that. Technology costs are huge, but cheaper per share as your volume grows and the number of names you trade increases
Didn't any of the market makers mention rebates using the typical maker/taker model? Provide liquidity and get a rebate, take liquidity and pay the venue fees. You being the venue/exchange keep a piece of the fee regardless. If you really want to build some hype around your exchange then charge a cancel fee for anyone who cancels an order at any price level. This will cut down on spoofing. Instead of pocketing that fee give part of it to whoever is next in the que or who ever steps in at that price level with an order. Futures don't have rebates so I don't know how market maker makes money there. I know in some futures markets (30 Year and Eurodollar) the exchanges let people jump ahead in the que based on order size. Is your exchange focusing on equities or futures?