A market maker in a
security is an entity that is willing to both buy and sell the security at the same point in time (but at different prices). The basis for the term is that market maker adds to the market
liquidity on both sides of the market. In other words: If an
investor tries to buy or sell a security in a market where there is an active market maker, the investor will always be able to complete his trade.
Market makers make their money due to the difference between their bid ("I'm willing to pay $XXX for this security") and ask ("I'm willing to sell this security for $YYY") prices. This is called the bid/ask spread, or just spread. The size of the spread is determined by how fast the market maker believes the security will move, and will usually be fairly constant for the same security.
A market maker will normally adjust its bid and ask prices depending on how much inventory it has of the security in question, attempting to keep inventory close to zero. If the market maker is short, it will raise the bid and ask prices in order cover the short; if long, it will lower them to get closer to zero.
Anybody can make a market (be a market maker) by just posting a limit order to sell and a limit order to buy at the same time (and without locking or crossing the market). However, it will usually not be profitable if you have to pay commisions for your trades, due to number of updates you will have to do to your limit orders.
An exchange will often try to encourage market making, in order to increase liquidity (ie, make sure people can make trades whenever they want, if not at the price they'd wish.)
This is done by providing "perks" for market makers. Two examples of these:
- In the specialist system, a single player is given the right to keep the order book for a security, getting information about who wants to sell and buy what amounts of the security at what prices. In exchange for this information, the specialist is obliged to always make a market in the security - ie, to always make sure there is at least one buy and one sell order, from the specialist itself if necessary.
- Lower exchange fees (seat price) for market participants that oblige themselves to always make a market in whatever security they trade in - ie, to never post a buy order without also posting a sell order for the same amount (at a different price).
I do not know of any case where the SEC forces anybody to be a market maker, but I may be ignorant.
And a quick correction/precision increase to Oriku: It is not possible to actually execute a trade above or below the market - when you execute it, it become the market price. A market maker bets on there being the common small up/down movements of the price, with some people selling and some people buying, and attempt to catch both sides of this action with different prices, thus making a profit on the overall set of trades.