2-Financial Markets Page 29 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 29selling, to find other parties wishing to sell or buy, to negotiate for good
prices, to serve as a focal point for trading, and to execute the orders.
The broker performs all of these functions. Obviously, these functions
are more important for the complicated trades, such as the small or
large trades, than for simple transactions or those of typical size.
A broker is an entity that acts on behalf of an investor who wishes to
execute orders. In economic and legal terms, a broker is said to be an
“agent” of the investor. It is important to realize that the brokerage activ-
ity does not require the broker to buy and hold in inventory or sell from
inventory the financial asset that is the subject of the trade. (Such activity
is termed “taking a position” in the asset, and it is the role of the dealer.)
Rather, the broker receives, transmits, and executes investors’ orders with
other investors. The broker receives an explicit commission for these ser-
vices, and the commission is a “transaction cost” of the capital markets.
A real market might also differ from the perfect market because of
the possibly frequent event of a temporary imbalance in the number of
buy and sell orders that investors may place for any security at any one
time. Such unmatched or unbalanced flow causes two problems. First,
the security’s price may change abruptly even if there has been no shift
in either supply or demand for the security. Second, buyers may have to
pay higher than market-clearing prices (or sellers accept lower ones) if
they want to make their trade immediately.
For example, suppose the consensus price for ABC security is $50,
which was determined in several recent trades. Also suppose that a flow
of buy orders from investors who suddenly have cash arrives in the mar-
ket, but there is no accompanying supply of sell orders. This temporary
imbalance could be sufficient to push the price of ABC security to, say,
$55. Thus, the price has changed sharply even though there has been no
change in any fundamental financial aspect of the issuer. Buyers who
want to buy immediately must pay $55 rather than $50, and this differ-
ence can be viewed as the price of “immediacy.” By immediacy, we
mean that buyers and sellers do not want to wait for the arrival of suffi-
cient orders on the other side of the trade, which would bring the price
closer to the level of recent transactions.
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^3 and Harold Demsetz^4 ana-
lyzed the role of dealers in securities markets. They viewed dealers as the
suppliers of immediacy—the ability to trade promptly—to the market.