In order to explain the characteristics of secondary markets, we will first describe a “perfect market” for a financial asset. Then we can show how common occurrences in real markets keep them from being theoretically perfect.
In general, a perfect market results when the number of buyers and sellers is sufficiently large, and all participants are small enough relative to the market so that no individual market agent can influence the commodity’s price. Consequently, all buyers and sellers are price takers, and the market price is determined where there is equality of supply and demand. This condition is more likely to be satisfied if the commodity traded is fairly homogeneous (for example, corn or wheat).
There is more to a perfect market than market agents being price takers. It is also required that there are no transaction costs or impediments that interfere with the supply and demand of the commodity. Economists refer to these various costs and impediments as “frictions.” The costs associated with frictions generally result in buyers paying more than in the absence of frictions, and/or sellers receiving less.
In the case of financial markets, frictions would include:
Commissions charged by brokers. Bid-ask spreads charged by dealers. Order handling and clearance charges. Taxes (notably on capital gains) and government-imposed transfer fees. Costs of acquiring information about the financial asset. Trading restrictions, such as exchange-imposed restrictions on the size of a position in the financial asset that a buyer or seller may take. Restrictions on market makers. Halts to trading that may be imposed by regulators where the financial asset is traded.
Tags: credit, mortgage, Perfect Market, spreads, taxes