60 ATaleofTwoMarkets
stocks at a lower price (called the bid) and selling them at a higher
price (called the ask). The difference between the bid and the ask
price is called the bid-as kspread. It is the price buyers and sellers
pay so that they don’t have to wait.
The bid-ask spread also compensates the market maker for the
risks he is exposed to in taking positions in stocks so that others
don’t have to wait. Making a market in stocks exposes her to the risk
of error in her own valuations and the valuations of others. Market
makers can make a market at a price below or above a stock’s fun-
damental value.
If they make a market at a price below value, more buyers should
arrive. But the price goes up when buyers arrive (they pay the ask
price). Therefore, a maker will sell more shares at the ask than it
buys at the bid. It may then have to buy more shares to make a
market, and the price will be pushed up, exposing it to losses if the
bid-as kspread is too small.
Market makers respond to that risk by widening the bid-ask
spread—raising the price at which they will sell to buyers and/or
lowering the price at which they will buy from sellers. Transaction
volatility in stoc kprices arises from such changes in the bid-as k
spread. It is undesirable volatility because it is driven not by changes
in fundamental values but by a market maker’s exposure to loss from
value errors amid orders arriving at different times seeking different
things.
Market makers also create transaction volatility when they re-
spond to changes in order flow. If more buy orders than sell orders
are coming in, they raise the bid and as kquotes. They do this be-
cause they must assume that the order imbalance reflects changes
in fundamental values. When they are right about that, their raise
reflects positive information volatility (i.e., price moving closer to
value). But when they are wrong about that, their prices deviate from
value and the change creates transaction volatility.
The rise of electronic computer networks (ECNs) has put reg-
ulatory and economic pressure on the traditional exchanges to re-
duce transaction volatility resulting from market making. ECNs con-
duct trading solely on computer screens rather than through brokers,
traders, and market makers. The swiftness and transparency of this
computerized technique allows trades to be handled as in the first
example above, where two brokers swap their respective customers’
mirror trades, and with far less or no waiting time.
Each customer posts his desired trade on the ECN’s screen, say,