The fact of imbalances explains the need for the dealer or market maker, who stands ready and willing to buy a financial asset for its own account (add to an inventory of the security) or sell from its own account (reduce the inventory of the security). At a given time, dealers are willing to buy a security at a price (the bid price) that is less than what they are willing to sell the same security for (the ask price).
In the 1960s, economists George Stigler and Harold Demsetz analyzed the role of dealers in securities markets. They viewed dealers as the suppliers of immediacy—the ability to trade promptly—to the market. The bid-ask spread can be viewed in turn as the price charged by dealers for supplying immediacy, together with short-run price stability (continuity or smoothness) in the presence of short-term order imbalances. There are two other roles that dealers play: they provide better price information to market participants, and in certain market structures they provide the services of an auctioneer in bringing order and fairness to a market.
The price-stabilization role relates to our earlier example of what may happen to the price of a particular transaction in the absence of any intervention when there is a temporary imbalance of order. By taking the opposite side of a trade when there are no other orders, the dealer prevents the price from materially diverging from the price at which a recent trade was consummated.
Investors are concerned with immediacy, and they also want to trade at prices that are reasonable, given prevailing conditions in the market. While dealers cannot know with certainty the true price of a security, they do have a privileged position in some market structures with respect to the flow of market orders. They also have a privileged position regarding “limit” orders, the special orders that can be executed only if the market price of the security changes in a specified way.
Finally, the dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market. For example, the market maker on organized stock exchanges in the United States performs this function by organizing trading to make sure that the exchange rules for the priority of trading are followed. The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market.
One of the most important factors that determine the price dealers should charge for the services they provide (i.e., the bid-ask spread) is the order processing costs incurred by dealers, such as the costs of equipment necessary to do business and the administrative and operations staff. The lower these costs, the narrower the bid-ask spread. With the reduced cost of computing and better-trained personnel, these costs have declined over time.
Dealers also have to be compensated for bearing risk. A dealer’s position may involve carrying inventory of a security (along position) or selling a security that is not in inventory (a short position). There are three types of risks associated with maintaining a long or short position in a given security. First, there is the uncertainty about the future price of the security. A dealer who has a long position in the security is concerned that the price will decline in the future; a dealer who is in a short position is concerned that the price will rise.
The second type of risk has to do with the expected time it will take the dealer to unwind a position and its uncertainty. And this, in turn, depends primarily on the rate at which buy and sell orders for the security reaches the market (i.e., the thickness of the market). Finally, while a dealer may have access to better information about order flows than the general public, there are some trades where the dealer takes the risk of trading with someone who has better information This results in the better-informed trader obtaining a better price at the expense of the dealer. Consequently, in establishing the bid-ask spread for a trade, a dealer will assess whether the trader might have better information. Some trades that we will discuss below can be viewed as “information- less trades.” This means that the dealer knows or believes a trade is being requested to accomplish an investment objective that is not motivated by the potential future price movement of the security.