The Role of Market Makers and Wholesalers

What Market Makers and Wholesalers Do

Market makers are firms that continuously post bid and ask prices for securities, standing ready to buy from sellers and sell to buyers. In US equity markets, approximately 50-55% of all trading volume flows through market makers rather than directly between investors. The NYSE and Nasdaq together list over 6,000 securities, and market makers provide liquidity for thousands of these stocks simultaneously.

Wholesalers are a specific type of market maker that purchases retail order flow from brokerages. When you place a market order through Fidelity, Schwab, or Robinhood, that order typically routes to a wholesaler rather than a public exchange. In 2023, the four largest wholesalers (Citadel Securities, Virtu Financial, G1X, and UBS) executed over 90% of all retail marketable orders in US equities.

How Market Making Works in Practice

Market makers profit from the bid-ask spread while managing inventory risk. Here is the core mechanic:

Bid-ask spread example:

• Market maker posts bid: $49.95 (willing to buy)
• Market maker posts ask: $50.05 (willing to sell)
• Spread: $0.10 per share

If the market maker buys 1,000 shares at $49.95 and sells 1,000 shares at $50.05, gross profit equals $100 before costs. However, the market maker now holds no inventory and faces no directional risk.

The risk: If a market maker buys 5,000 shares at $49.95 but the stock drops to $49.50 before selling, the unrealized loss is $2,250. Market makers use sophisticated algorithms to adjust quotes continuously based on order flow, volatility, and inventory levels.

Designated Market Makers (DMMs) on the NYSE:

The NYSE assigns one DMM to each listed stock. DMMs have obligations that regular market makers lack:

• Must maintain continuous two-sided quotes
• Must provide price improvement on at least 15% of orders
• Must participate in openings and closings
• Cannot step away during volatility

In exchange, DMMs receive certain informational advantages about order flow that other market participants lack.

How Retail Order Flow Reaches Wholesalers

When retail investors place orders, the order routing process follows a specific path:

Step 1: You submit a market order for 100 shares of Apple through your brokerage app.

Step 2: Your broker's smart order router evaluates destinations. For retail orders, this typically means comparing wholesaler prices.

Step 3: The order routes to a wholesaler (often Citadel Securities or Virtu), not the NYSE or Nasdaq.

Step 4: The wholesaler fills your order from its own inventory, usually at or slightly better than the National Best Bid and Offer (NBBO).

Why brokers route to wholesalers:

• Wholesalers pay brokers for order flow (payment for order flow, or PFOF)
• Wholesalers typically offer price improvement over exchange prices
• Execution speeds average 0.01-0.03 seconds versus 0.1+ seconds on exchanges

PFOF economics: In Q3 2023, Robinhood received approximately $0.002 per share for equity orders routed to market makers. On 100 shares of a $50 stock, that equals $0.20 paid by the wholesaler to the broker.

Price Improvement Mechanics

Wholesalers attract retail order flow partly by offering price improvement over the NBBO. Here is how this works:

Example with NBBO of $50.00 bid / $50.10 ask:

You place a market order to buy 100 shares. On a public exchange, you would pay $50.10 (the ask price).

The wholesaler fills your order at $50.08, providing $0.02 per share price improvement. Your total savings: $2.00 on the 100-share order.

Aggregate price improvement data:

According to SEC Rule 605 reports, wholesalers provide price improvement on approximately 88% of marketable retail orders. The average price improvement in 2023 was approximately $0.016 per share for S&P 500 stocks.

On a $10,000 portfolio with 50 trades per year averaging 100 shares each, cumulative price improvement equals roughly $80 annually.

Worked Example: Market Maker Profit and Loss

Consider a market maker quoting a mid-cap stock:

Initial position:

• Bid: $25.45 (1,000 shares)
• Ask: $25.55 (1,000 shares)
• Spread: $0.10
• Inventory: 0 shares

Transaction sequence:

Final calculation:

• Total cash received: $7,665 + $15,210 + $10,160 = $33,035
• Total cash paid: $12,725 + $20,352 = $33,077
• Net loss: -$42

Despite earning the bid-ask spread on individual transactions, the market maker lost money because inventory accumulated before a price decline. This illustrates why market making requires sophisticated risk management, not just spread capture.

Regulatory Framework

Market makers and wholesalers operate under specific SEC and FINRA rules:

Regulation NMS (National Market System):

• Prohibits trade-throughs (executing at prices worse than the NBBO)
• Requires brokers to seek best execution
• Mandates consolidated quote display

Regulation SHO:

• Governs short selling by market makers
• Provides limited exemptions for bona fide market making
• Requires locate requirements before short sales

SEC Rule 605 and 606:

• Rule 605: Requires disclosure of execution quality statistics
• Rule 606: Requires disclosure of order routing practices and PFOF arrangements

2023 SEC proposals under review:

• Auction mechanism for retail orders before wholesaler internalization
• Enhanced disclosure of execution quality
• Potential restrictions on PFOF

Common Misconceptions

Misconception 1: Market makers guarantee profits

Market making is a competitive, low-margin business. Virtu Financial reported operating margins of approximately 24% in 2023, but this requires billions in technology infrastructure and risk management. Individual market makers regularly lose money on specific stocks or trading days.

Misconception 2: Wholesalers always disadvantage retail investors

Studies show conflicting results. Retail investors typically receive better prices from wholesalers than they would on exchanges for small orders. However, the counterfactual is difficult to measure, as exchange spreads might tighten if retail orders returned to public markets.

Misconception 3: All order flow is equal

Wholesalers segment order flow by perceived information content. Orders from day traders face wider effective spreads than orders from buy-and-hold investors, because day traders are more likely to have short-term price information.

Practical Implications for Investors

Understanding market structure affects trading decisions in several ways:

Order size matters: Price improvement is most consistent for orders under 500 shares. Larger orders may receive partial fills at multiple prices.

Limit orders versus market orders: Market orders route to wholesalers more frequently. Limit orders may provide better execution on volatile stocks by accessing exchange liquidity directly.

Time of day: Spreads widen at market open (9:30-10:00 AM ET) and narrow during midday. Executing routine trades between 10:00 AM and 3:00 PM ET typically provides better fills.

Illiquid stocks: For stocks trading under 100,000 shares daily, wholesaler liquidity may be limited. Consider using limit orders rather than market orders.

Checklist: Navigating Market Maker Dynamics

Before placing your next trade, consider these factors:

• Check the bid-ask spread before submitting a market order (wide spreads indicate low liquidity)
• For orders over 500 shares, consider splitting into smaller pieces
• Review your broker's Rule 606 report to understand where your orders route
• Use limit orders for illiquid stocks or during volatile periods
• Execute routine trades during regular hours (10 AM - 3 PM ET) when spreads are typically tightest

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Source: SEC Rule 605 and 606 disclosure reports from major brokerages.

Source: FINRA Trade Reporting and Compliance Engine (TRACE) market structure data.

Source: Virtu Financial and Citadel Securities quarterly SEC filings.