Market maker's Operating Model

Question

I got a question about the liquidity provider's operating model. Really hope if someone can take a look and share some thoughts!

Scenario: Say an ETF investor wants to offload a million ETF shares; the investor is seeking multiple market makers to offload the shares and compare the bid/ask price quotes; he/she will select the highest bid price so the investor can sell high. Now market makers got these shares and will try to offload;

Question 1: I know they should have already got the same ETF's underlying assets and some exposure to the same ETF shares. How exactly do they sell at the higher ask price? Why can't the investor do it themselves? What's the most sophisticated part of this process? I really want to understand the complete flow of their operations.

Question 2: I understand that they can make arbitrage profits by buying undervalued assets and overvalued ETFs. But how is this strategy involved in their liquidity service for investors?

Really appreciate if someone can correct my misunderstanding or shed some light on this. Thanks!

Answer 1

The market maker's operating model is simple - Buy at Bid, Sell at Ask. Bid is always less than Ask.

The Bid/Ask spread generates the profit, and market competition (i.e. presence of other market makers) causes this Bid/Ask spread to tighen (i.e. the spread becomes less as competition increases).

How exactly do they sell at the higher ask price?

Market Makers sell at Ask Price.

Investors sell at Bid Price. (i.e. Market makers buy at Bid Price).

Why can't the investor do it themselves?

Investor receives a Bid/Ask quote (from a Market maker).

Investor does not provide a Bid/Ask quote.

Quotes are provided over established platforms, such as Bloomberg (or a variety of other platforms). It is not worthwhile (or feasible) for the investor to establish himself / herself as market maker. A market maker must (i) provide a bid/ask quote at all times, usually with a cap on the bid/ask spread, (ii) have reputation and capital to deliver or settle the committed transactions etc. The business is financially infeasible at small transaction volumes and is a full time job.

Investor makes money by taking over market risk. Loss due to buying at Ask and selling at Bid is a second order factor. For example, he / she makes money by buying at a given Ask Price and selling a a "future Bid Price" which is potentially higher than the "prior Ask Price" where he bought.

Market maker makes money primarily on the bid/ask spread, with the market risk of carrying some inventory being an incidental second order risk. A market maker could lose money by buying at a given Bid Price, and end up selling at a "future Ask Price" which is potentially lower than the "prior Bid Price" where he bought.

Answer 2

They buy at a lower price compared to a measure of the prices in the recent past, say, traded VWAP in the last one week. Since they're buying at a discount, they can make a (small) profit and multiplied by the large quantities they deal in, they can come out ahead. An investor cant (or doesnt) do this by himself generally is because there are specialized algos that allow you to dump shares in the market (optimally) without affecting the prices too much, which is a measure of liquidity. If there was infinite liquidity, this presence of market maker in this regard would add little value. But since there is not, market maker adds value by holding inventory and dumping them in the market so as to reduce market impact.

This is not supposed to mean that the market maker carries no risk, he does. But the market maker with his investment in sophisticated algo/technology is better suited to do this than the investor whose source of profit is something else.