How do Market Makers make money?

For those who don’t already know a Market Maker is a CFD brokership model where the brokerage takes the positions of those trading with them onto there own books, not necessarily placing a trade in the physical market for that particular instrument. It is often asked how a brokerage can make money from such a business model especially if they have a number of successful customers on their books. However a Market Maker has a number of different ways in which they can alleviate and control their internal risk. 

Firstly, a lot of the time a broker can offset different client positions against one another meaning that they profit the spread as commission. 

Client # Instrument Buy/Sell Lot Size
1 EUR/USD Buy 1 Lot
2 EUR/USD Sell 1 Lot


Suppose that there are two different clients who both simultaneously open positions in the EUR/USD. One Buys a Lot while the other sells a Lot, meaning that until one of the traders closes their position the brokerage is not exposed to any risk. As any profit made by Client #1 will be offset by the same loss in Client #2’s account, this remains true until the 2nd Client closes his position leaving the brokerage exposed to any continuing profits that the first client’s position makes. This may not be a major problem as by now a third client may have opened a position selling the EUR/USD therefore again covering the brokerage from any risk. 

The problem for Market Makers comes when there is a huge number taking on positions in one direction. But again there are still ways in which a Market Maker can deal with such risk, as explained in the following example.  

Client # Instrument Buy/Sell Lot Size
1 EUR/USD Buy 2 Lots
2 EUR/USD Buy 2 Lots
3 EUR/USD Buy 2 Lots
4 EUR/USD Buy 1 Lot
5 EUR/USD Sell 1 Lot

In the above example you can see that clients have opened 7 Buy Lots, while one other client has opened one Sell Lot. This means that the Market Maker is exposed to 6 Lots of risk, which presents them with a significant risk. Supposing these positions look like there going to be profitable due to some or other breaking news, the broker could either take the losses providing they had the required funds. Alternatively the brokerage could open positions in the underlying physical instrument to mirror that of its clients reducing its risk to zero, while there would be some costs in this by going into the markets with a physical brokerage the broker would get a much a lower spread than the broker offers to it’s clients. This allows them to make some limited profits. This is also the reason that brokerages widen their spreads during high volatility periods, the bigger the spread the more profit that can be potentially made. 

 
There are other more complicated ways that Market Makers can do to manage their risk. Due to the fact that they can see the Open Profit & Loss balances, they can offset profits being made by some traders against the losses being made by others. Normally this isn’t particularly problematic due to the fact that it is estimated that around 80-85% of retail Forex traders lose money. Meaning that a lot of the time the Market Maker doesn’t really need to be to concerned about risk management, often only having to take an active interest in risk management when large positions are taken out in one particular direction. Meaning that being a Market Maker can be a very profitable.

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