What is a Dealer Market?
Liquidity is an important factor in financial markets. There needs to be a mechanism for moderating supply and demand, and to ensure buyers and sellers have a way to transact transparently. In a dealer market, it’s dealers who provide these services.
Dealers are market makers, charged with displaying the buying and selling prices for securities. They facilitate these transactions at the posted rates, using their own inventory to promote liquidity. Using a bid-ask spread, dealers ensure market participants get the best possible prices, while also mitigating their own risk.
Here’s a closer look at how dealer markets work, the primary functions of market makers and how the bid-ask spread creates a self-governing system.
How Dealer Markets Work
Dealer markets aren’t physical locations; rather, they’re a series of electronic trading channels where participants buy and sell through dealers (market makers).
Within a dealer market, each dealer uses a bid-ask spread. Market makers will look at the bid-ask prices in the dealer market to price their own, and adjust depending on whether they want to buy or sell a certain security. Because dealers compete with one another, it tends to mean that the spreads posted represent the best prices for investors.
Say, for example, if Dealer A wants to sell shares of XYZ Company, it’ll look at the current bid-ask spreads in the market. If the spread is $25-$25.05, Dealer A knows that it needs to post its own bid-ask at a more attractive rate if it wants to facilitate transactions. Dealer A puts up a bid-ask of $24.95-$25. As a result, buyers in the market will come to Dealer A because it offers a lower price. The same would work in reverse, if the dealer wanted to buy shares of XYZ Company.
Market makers constantly adjust bid-ask spreads to be competitive. And, because these spreads are transparent, investors get the guarantee of the best price available at any given time. This, in turn, promotes liquidity, since there’s always an outlet for both buyers and sellers.
Looking Closer at the Bid-Ask Spread
In a dealer market, the bid-ask spread is the lynchpin for everything. It represents a mechanism for moderating supply and demand, as well as price control. It’s transparent, ever-changing and governed by competition, which makes it a pure driver of capital markets. Here’s how it works:
- The bid price is the highest price at which they’ll buy a specific security
- The offer (ask) is the lowest price at which they’ll sell that same security.
Spreads are often a few cents; however, they can become quite large depending on how much volatility comes attached to a stock. The reason is simple: the spread represents the dealer’s risk. Dealers profit from the spread, but in fast-moving markets, there’s risk that could leave them vulnerable if prices shift quickly. For instance, a blue-chip bellwether stock might have a spread of $100-$100.05, while a highly volatile growth stock might have a spread of $20-$20.25.
No matter the depth of the spread, it functions the same for every security. It’s meant to attract buyers and sellers, so the dealer can facilitate transactions within the market at those posted rates.
Dealer Markets vs. Auction Markets
Auction markets differ from dealer markets in that a specialist fields buying and selling prices in real-time. They take multiple selling prices and combine them with multiple buying offers, choosing the highest price buyers are willing to pay and the lowest price sellers will sell for. The result are transactions filled for the best possible rates.
For example, a specialist might field bids for ACB Company. They collect three bids from buyers: $50, $50.02 and $50.03. At the same time, they field three bids from sellers $50.03, $50.05 and $50.08. In this example, the price per share would settle at $50.03, and transactions would occur between buyers and sellers who agree on that price.
This works inverse to a dealer market, where market makers establish the bid-ask spread based on competition among themselves.
Dealer Markets vs. Brokered Markets
While similar, broker markets differ from dealer markets in a few key areas. Specifically, broker markets require a defined buyer and seller for the transaction to take place, since they’re not relying on the market maker’s inventory. Brokers merely execute trades on behalf of clients, whereas dealers trade on behalf of themselves.
For example, Jim wants to buy 10 shares of XYZ Company. He goes to a brokered market and submits his order for 10 shares based on the posted price per share. At the same time, Mary wants to sell 10 shares of XYZ Company. The broker facilitates both sides of the transaction and ensures Jim settles with 10 shares of XYZ company and Mary settles with the total sum value for those shares. Along the way, the broker may take a broker fee for facilitating the transaction.
Most retail investors go through brokered markets when it comes to equities, whereas most institutional investors deal directly with dealer markets.
The Importance of Dealer Markets
Dealer markets are a critical pillar of the economy because they facilitate the buying and selling of securities. Market makers live up to their name by ensuring liquidity and by offering an ever-competitive bid-ask spread that governs buying and selling prices. Not only that, market makers help modulate risk through the bid-ask spread, while also improving market transparency.
To see the efficacy of this system, investors need only look at the bond market or the forex market, where trillions of dollars change hands daily thanks to dealers.