Market making is carried out, under Osaka Exchange's Market Maker Program, for the account of a trading participant's proprietary trading division or an end customer, and by dealers in OTC markets. Both the spread revenue and the loss on price moves in inventory make up the profit or loss of the business. A firm that quotes as a primary market maker (PMM) at Osaka Exchange should note that whether it has met the conditions of the program also matters.

How a market maker keeps quoting buy and sell prices

A market maker keeps quoting the price at which it will buy (the bid) and the price at which it will sell (the ask), and at those prices it takes either side when others want to sell or buy. For example, in the JASDAQ market-making stocks analyzed in a 2003 paper from the Bank of Japan's Institute for Monetary and Economic Studies, market makers had two obligations. They had to keep showing bid and ask quotes with quantities, and they had to trade at least one unit at the quotes they showed1. In a market with several market makers, the highest bid is called the best bid and the lowest ask the best ask. The difference between them is the market's bid-ask spread2.

A market maker plays the role of a dealer, acting as the counterparty for its own account3. In OTC markets, dealers are the market makers4. The difference between dealers and brokers is covered in Dealers and Brokers.

Consider a hypothetical example in which J Securities quotes a bid of 9,990 yen and an ask of 10,010 yen per unit in a futures contract. The spread is 20 yen, and the price halfway between the two quotes (the mid price) is 10,000 yen. When a participant wants to sell, J Securities buys 1,000 units at 9,990 yen. When a participant wants to buy, it sells 1,000 units at 10,010 yen. If the purchases and sales match in quantity, J Securities keeps 20 yen × 1,000 units = 20,000 yen. A market maker's profit is locked in when a purchase and a sale are paired up in this way5.

The purpose of Osaka Exchange's Market Maker Program is to have market makers keep quoting sell and buy prices. This secures trading opportunities for investors, helps trades get done smoothly, and improves liquidity6. Even when sellers and buyers are not in the market at the same moment, the market maker stands between them, so trading is possible at any time7. In return, the market maker bears the risk of price moves while it holds inventory.

Sources of revenue and loss

A market maker's profit or loss is not decided by the spread alone. Using the J Securities example from the previous section, the sources of profit and loss are as follows.

Source Gain or loss J Securities example (1,000 units)
Difference between the bid and the ask A gain if purchases and sales match Buying at 9,990 yen and selling at 10,010 yen gives a gain of 20,000 yen
Price moves on inventory A gain or a loss depending on the direction of the move After buying at 9,990 yen, selling at 9,970 yen after a fall is a loss of 20,000 yen, and selling at 10,040 yen after a rise is a gain of 50,000 yen
Trades with better-informed counterparties Tend to be losses If a participant who knows about a price fall in advance sells at 9,990 yen, the result tends to be the price fall case above
Exchange fee discounts and similar incentives A gain if conditions are met Under Osaka Exchange's program, trading fee discounts and other incentives depend on how well the conditions are met

For example, if the mid price falls to 9,960 yen, the ask is 9,970 yen, and if it rises to 10,030 yen, the ask is 10,040 yen. Price moves on inventory become a problem when only sellers keep arriving. J Securities then holds the 1,000 units it bought at 9,990 yen and waits for the next buyer. If the price falls in the meantime, the loss can exceed the spread of 20 yen per unit, and if the price rises, it gains.

Trades with better-informed counterparties tend to lose money on average. A market maker bears adverse selection risk from trading with informed traders8. If the counterparty knows the direction of the price move in advance, the market maker ends up on the wrong side of the trade. In a market where it must trade at the quotes it shows, as in the JASDAQ example in the previous section, a market maker cannot choose its counterparties9.

What sets the width of the spread

The width of the spread reflects three things: the fixed costs of the business, the risk of holding inventory, and adverse selection risk. Early theoretical studies of market makers named fixed costs, such as staff and office costs, and the risk of holding inventory as the factors that set the spread. Adverse selection risk from trading with informed traders was added later, and studies have split observed spreads into three parts: fixed costs, inventory costs and adverse selection costs8.

The larger the adverse selection risk, the wider the spread. A market maker expects losses when it trades with informed traders and quotes a wider spread to cover them9. The paper takes the view that for stocks that trade rarely, and so offer few chances to earn the spread, the cost built into each trade to cover adverse selection is larger5.

The spread also widens when the cost of holding inventory on the balance sheet or the cost of trading with other dealers rises. A paper from the US Treasury's Office of Financial Research (OFR) analyzing the credit default swap (CDS) market shows this relationship with a model10.

How quotes depend on inventory

When a market maker's inventory is skewed to one side, it moves its quotes to bring the inventory back. Research on market structure looks at markets in which customers can choose a dealer at no cost and dealers compete on price. In such markets, a dealer with skewed inventory sets its bid and ask so as to attract customers who trade in the direction that restores its inventory11. The 1981 model of Ho and Stoll considers the risk of price moves on inventory and, unlike the OFR model discussed below, sets no limits on positions. In this model, the bid and the ask both move by an amount that depends on the risk of price moves and the size of the inventory, and the width of the spread does not change12.

Consider a hypothetical example in which J Securities lowers both quotes by 10 yen when it holds a long inventory of 1,000 units, and raises them by 10 yen when it holds a short inventory of 1,000 units. The spread stays at 20 yen.

Inventory (units) Mid price (yen) Bid (yen) Ask (yen)
1,000 (long) 9,990 9,980 10,000
0 10,000 9,990 10,010
−1,000 (short) 10,010 10,000 10,020

With a long inventory, J Securities lowers its ask to 10,000 yen to attract buyers and lowers its bid to 9,980 yen to discourage sellers. Shifting the quotes makes it more likely that the inventory will shrink, but the profit or loss from price moves until the inventory is reduced remains.

The model in the OFR paper sets limits on positions (an upper and a lower limit), and how quotes are set depends on the cost of trading with other dealers. When that cost is low, a dealer passes the part of a customer trade that goes beyond its limits on to other dealers. The spread then depends on the aggregate inventory of all dealers rather than on the dealer's own inventory. When that cost is high, the dealer does not trade with other dealers. The spread is then narrowest when the inventory is at the dealer's preferred level (the amount it wants to hold) and widens as the inventory approaches a limit13.

The paper shows that in the US single-name CDS market from 2010 to 2016, the prices of trades with customers came to depend more on individual dealers' inventories than on the aggregate inventory of all dealers. In terms of the OFR model, this is the picture when the cost of trading with other dealers is high. The paper says the result is consistent with the view that regulatory reforms after the 2007–2009 financial crisis raised the cost of holding inventory and the cost of trading between dealers14.

Among ways to hedge inventory, how to offset price moves on an inventory of options by trading the underlying is covered in Delta Hedging.

Quotes in OTC derivatives

In OTC derivatives, trading does not only take the form used on exchanges, where everyone sees the same list of orders. A participant may also ask several dealers for quotes, and those asked respond. In the United States, a Commodity Futures Trading Commission (CFTC) rule sets out, as one of the execution methods for swap execution facilities (SEFs), a system in which a participant requests a quote to sell or buy from three or more others (request for quote, RFQ)15. Japan also regulates electronic trading platforms for OTC derivatives, as mentioned in Exchange-Traded vs OTC Derivatives.

Osaka Exchange's Market Maker Program

Osaka Exchange's Market Maker Program has two kinds of market makers (under the rules effective August 3, 2026). A primary market maker (PMM) keeps quoting bids and asks in line with conditions set by the exchange. A liquidity provider (LP) places quotes within a range it judges appropriate and is not subject to conditions like those for PMMs16. As a rule, a firm can apply for only one of the two roles, PMM or LP, for the same product17.

The conditions for PMMs cover the hours for quoting, the range and number of contracts to quote, the maximum spread between the bid and the ask, and the minimum quantity of each quote, and they are set for each product18. For example, under the Type 1 conditions for Nikkei 225 mini, a PMM quotes bids and asks during the day session in the nearest monthly contract month. The maximum spread is 6 ticks (6 steps of the tick size, or 30 yen), and the minimum quantity is 10 units. The standard for receiving incentives is a condition fulfillment rate of 60% or more. Incentives are paid only if the PMM also meets the standard in other products it designates separately (such as DJIA Futures)19. When a request for quote is sent through the trading system (J-GATE), a PMM may choose whether to respond20.

The condition fulfillment rate is found for each trading day by dividing the time the market making conditions were met by the quoting hours, and the monthly average is then taken21. Consider a hypothetical example in which J Securities scores 80% on half of the trading days in a month and 50% on the other half. The monthly average is 65%, which meets the 60% standard. If it scored 50% every day, it would fall short.

PMMOsaka ExchangeQuotes underthe conditionseach trading dayDivides time metby quoting hoursfor the daily rateAverages the daily ratesso far, in mid-monthand at month endReceives noticeof that averageGives fee discounts andother incentivesbased on the monthly average
Figure 1From the condition fulfillment rate to the fee discount for a PMM
Figure description

Based on the quotes the PMM makes, Osaka Exchange finds the fulfillment rate for each trading day and the monthly average. The notice follows from the average as of mid-month and month end, and the discount follows from the monthly average.

A PMM can temporarily stop making markets because of market conditions, trading conditions or system issues. There is no direct penalty for failing to meet the conditions. However, incentives may be reduced, and the exchange may revoke the designation if it judges that the fulfillment rate is extremely low with no prospect of improvement22.

The incentives include trading fee discounts and fixed payments according to the average monthly condition fulfillment rate23. LPs receive trading fee discounts according to their monthly trading volume24.

Notes

  1. 宇野淳 et al., "JASDAQ市場のスプレッド比較 ―オーダー・ドリブン対マーケット・メイキング―" (Comparing spreads in the JASDAQ market: order-driven versus market making), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (June 2003), page 93, "３．（２）MM制度の概要" (3. (2) Overview of the market maker system), and page 100, "４．スプレッドの決定要因" (4. Determinants of the spread) (in Japanese). ↩

  2. The same document, page 100, "４．スプレッドの決定要因" (4. Determinants of the spread). ↩

  3. Osaka Exchange, "先物・オプション取引に係るマーケットメイカー制度の取扱い" (Handling of the market maker program for futures and options, in Japanese; amended June 30, 2026, effective August 3, 2026), page 1, the remarks column of II.1 "定義" (Definitions). Under Osaka Exchange's program, market making is done for the account of a trading participant's proprietary trading division or of an end customer. ↩

  4. Mark Paddrik and Stathis Tompaidis, "Market-Making Costs and Liquidity: Evidence from CDS Markets" (OFR Working Paper 19-01, March 2019), page 1, the first paragraph of "Introduction." ↩

  5. 宇野淳 et al., "JASDAQ市場のスプレッド比較 ―オーダー・ドリブン対マーケット・メイキング―" (in Japanese), page 108. ↩ ↩2

  6. Osaka Exchange, "先物・オプション取引に係るマーケットメイカー制度の取扱い" (in Japanese), page 1, I "目的" (Purpose). ↩

  7. 宇野淳 et al., "JASDAQ市場のスプレッド比較 ―オーダー・ドリブン対マーケット・メイキング―" (in Japanese), page 87, "要旨" (Abstract). ↩

  8. The same document, page 90, "２．先行研究" (2. Previous research). ↩ ↩2

  9. The same document, pages 100–101, "４．スプレッドの決定要因" (4. Determinants of the spread). ↩ ↩2

  10. Mark Paddrik and Stathis Tompaidis, "Market-Making Costs and Liquidity: Evidence from CDS Markets," page 1, the second paragraph of "Introduction." ↩

  11. The same document, page 11, the first paragraph of "II. Model." The source cites studies by Ho and Stoll (1983) and Madhavan and Smidt (1993). ↩

  12. The same document, footnote 8 on page 16. The source describes the model of Ho and Stoll (1981) in this way. The 10 yen and 20 yen in the example are hypothetical amounts chosen for illustration. ↩

  13. The same document, pages 11–12 and 14–16 (equations (2) to (4) and Figure 1 in "II. Model"). The model sets the position limits at one unit above and one unit below the preferred level. ↩

  14. The same document, the abstract (page 2 of the PDF), and pages 16–17, the last paragraph of "II. Model" (the testable implications of the model). ↩

  15. 17 CFR 37.9(a)(2)(i) and (a)(3). Checked against the text in the Electronic Code of Federal Regulations (last amended December 18, 2020, 85 FR 82329). The three participants must not be affiliates of the requester or of each other. ↩

  16. Osaka Exchange, "先物・オプション取引に係るマーケットメイカー制度の取扱い" (in Japanese), page 1, II.1 "定義" (Definitions), and page 9, the remarks column of II.5(1) "LP の役割" (Role of LPs). ↩

  17. The same document, page 2, the remarks column of II.1 "定義" (Definitions). An end customer that uses more than one trading participant may apply for the same product more than once only if the exchange allows it. ↩

  18. The same document, page 7, II.4(1)① "マーケットメイクの条件" (Market making conditions). ↩

  19. The same document, page 21, the table for "タイプ１" (Type 1) of Nikkei 225 mini in Appendix 2 ("別紙２") and note ※5. ↩

  20. The same document, page 7, II.4(1)② "リクエスト・フォー・クォートへの応答" (Responding to requests for quote). ↩

  21. The same document, page 12, Appendix 1 ("別紙１"), "マーケットメイクに係る条件充足率の算出方法" (How the condition fulfillment rate for market making is calculated). ↩ ↩2

  22. The same document, page 7, II.4(1)④ "マーケットメイクの条件不履行時の取扱い" (Handling when market making conditions are not met). ↩

  23. The same document, page 8, II.4(2)① "取引手数料の割引" (Trading fee discounts) and ② "固定額の支給" (Fixed payments), and the remarks column. ↩ ↩2

  24. The same document, page 9, II.5(2) "LP のインセンティブ" (Incentives for LPs). ↩

  25. The same document, page 10, II.6(4) "PMM（項番４関係）" (PMMs: related to item 4). ↩

  26. The same document, page 5, the remarks column of II.3(2) "マーケットメイカーの指定申請" (Applications for designation as a market maker). ↩