What it means
Market data comes in tiers. Level 1 gives the best bid, best ask and last trade, while Level 2 shows the full depth of the order book.
Level 3 is reserved for those who do more than watch the market, and includes the tools needed to post prices and keep them up to date. Market makers are the main users.
A market maker is a firm that continually quotes both a buy and a sell price in a security, which keeps trading smooth for everyone else. To do this, the firm needs to enter and change quotes in real time, and Level 3 access gave them that ability together with the full information flow of the market.
The term is strongly associated with Nasdaq's trading systems, where Level 3 was historically the tier for registered market makers. The way data products are packaged has changed over the years, and modern exchanges often sell direct feeds and full order book products under their own brand names.
The label "Level 3" is therefore less common now, but still appears in textbooks and trading guides. Access at this level brings costs and responsibilities as well as information.
A firm needs direct connections to the trading system, compliance staff to monitor its quoting, and enough capital to stand behind the prices it posts, so only firms with a real market-making business case apply. For most business people, the important point is what the tiers imply.
The more detail and access a participant has, the better they can price risk and manage inventory, but it also comes with obligations. Market makers typically have to follow exchange rules about quote size and spreads, so access is regulated.
It should not be confused with Level 3 assets in accounting. Those are assets valued using unobservable inputs, such as private equity stakes, and the name refers to a completely different hierarchy used in financial statements.
In practice
Real-world examples.
Example
A market-making firm quotes a bid of $30.00 and an ask of $30.04 on a listed share. Its traders use their direct access to update both prices several times a minute as news arrives. The firm earns the spread on trades that execute at both sides.
Example
An exchange compliance officer reviews how a market maker has been quoting in a thinly traded share. She checks that the firm has kept two-sided quotes of the required size throughout the day. The review depends on records of every quote entry and change.
Example
A new broker-dealer applies for market maker status. It budgets for the cost of the connection, the data feeds, the capital requirements and the staff needed to monitor quotes. The finance team compares these costs with the spread income it expects to earn.
Case study
Seen in the real world.
Northlight Securities is a fictional broker-dealer that decided to become a market maker in 30 small-cap shares. The finance director built a budget that included direct market access, data feeds, compliance staff and extra capital.
Annual running costs came to about $900,000, and the trading desk expected to capture an average of $0.01 per share on 120,000,000 shares traded a year, giving revenue of $1,200,000. The margin of $300,000 looked attractive on paper.
After the first year, volumes were 25% lower than forecast, which cut revenue to $900,000 and left the desk at break-even. The firm kept the business but narrowed it to 15 shares. This is an illustrative story, but it shows how the economics of Level 3 access depend on trading volume.
Watch out
Common mistakes.
- Believing Level 3 is simply a more detailed Level 2 screen. Its key feature is the right to enter and change quotes, not only to view them.
- Confusing it with Level 3 assets. One is a tier of market access, and the other is an accounting category for assets valued with unobservable inputs.
- Assuming every investor can buy it. Access is normally limited to registered market makers and certain exchange members who meet capital and regulatory requirements.
Questions
People also ask.
Who uses Level 3 access?
Market makers and other professional participants who must post and update quotes. Ordinary investors use Level 1 or Level 2 data through their brokers.
Is the term still used?
It appears in textbooks and trading guides, but exchanges now package their data and access products in many different ways. Check the exact product description from the exchange.
Why does a market maker need real-time access?
Because prices move constantly, and a stale quote can be picked off by faster traders. Quick updates protect the firm from losses and keep spreads tight for everyone.
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