I've read this question and the other question you asked and I hope I can help.
The important thing to realize that in any market multiple market makers operate and they are all trying to optimize their risk adjusted return. A market maker earns a return buying low and selling high. Suppose you are the only market maker and you quote this spread:
1 | Bid 100 @ $99 | Ask 100 @ $101
the best thing that can happen is that a liquidity seeker sells $100 @ 99 (remember that $99 is the price for which the market maker is buying) and immediately can sell $100 @ 101 to another liquidity seeker. After this, you have no position and therefore no risk but more importantly: you paid $9900 and received 10100 netting you $200!
In this situation you would be taking some risk as the market can move and you can easily get into the situation where you bought 1000 of shares which are now worth significantly less. But suppose you manage your risks well and you make a nice profit every day. Such a nice profit will surely attract competition and they can make sure to get more business than you by simply quoting a more narrow spread.
2 | Bid 100 @ $99.50 | Ask 100 @ $100.50
whenever you quote
3 | Bid 100 @ $99.00 | Ask 100 @ $101.00
You could react by in response quote an even narrower spread:
4 | Bid 100 @ $99.75 | Ask 100 @ $100.25.
Of course, this narrowing of the spread can't continue very long. However, I hope it is now clear that
It is not from the benevolence of BBB Market Makers that we expect our narrow spreads, but from their regard to their own interest. -- With apologies to Adam Smith
which leads to competitive pressuresin market making.
The above also gives a hint on why these market making algorithms quote prices at multiple levels:
You would like to quote only the first spread and do lots of trades on both sides. Thanks to competition this will not happen, other market makers will quote slightly narrower spreads and they will make a lot of trades (earning less per round trip but making up in volume). Therefore, you also decide to narrow your spread reducing your own margin but hopefully also making up in volume. Now what do you do with your original quote? You could stop quoting it by why would you? You might just get lucky and a deep-pocketed liquidity seeker might trade against all better prices and yours. If this happens you get a better price than the situation you would just quote a narrow spread (and hope that the market hasn't moved against you permanently).
Attack86 mentions a number of scenario's where the market makers are incentivized by the exchanges or have other reasons:
- They get a profit share when they attain specific liquidity targets. In that case they might optimize for making the target instead of making a profit through trading (e.g. TP-ICAP's iSwap or Liffe's Ultra Long Gilt contract).
- Others just aim to provide liquidity to their customers but don't necessarily want to trade all the time, this is common in investment bank fixed income trading.
