Both defend themselves with liquidity arguments; with hedge funds (some of them, famously they're a compensation scheme not an an asset class) it's about medium- or long-term liquidity (buying assets that are going to pay off but only months, years or decades down the line), with market-makers it's about short term.

You might be right about that. Though liquidity arguments are a bit rarer for hedge funds. I hear more about claims of efficient capital allocation.

In any case, I agree that hedge funds are more of a compensation scheme. My opinion of them is relatively low, but that's from the point of that investing in them is a bad idea. I don't think on net they have any bad effects on the rest of the market.

I think if anything they're a force for good on the rest of the market - someone needs to be there to buy assets that are both illiquid and risky, and both broker-dealers and (more recently) pension funds have been gradually regulated out of being that buyer.