by
Charles Lamson
The participants in financial markets are the buyers and sellers, and market makers. The market makers function as coordinators who link up buyers and sellers of financial instruments. The link involves arranging and executing trades between buyers and sellers. Market makers may make markets in only one type of security, say, Treasury bills, or in several different types of securities including stocks and corporate and government bonds. Who are these market makers? Where are they located? Why do they exist? What does"making a market" entail. These are some of the questions to which we now turn.
You probably have heard of large Wall Street firms such as Merrill Lynch, Solomon Smith Barney (part of Citigroup) Morgan Stanley, Dean Witter, and Goldman Sachs---five leaders of finance. The main offices of these five financial firms are in New York City, the financial capitol of the United States. These offices are linked by telephone and telex to other major cities in the United States and the rest of the world, where branch offices and regular customers are located. Like most enterprises, these firms are in business to earn profits. In this industry, profits are earned by providing financial services to the public. These services include giving advice to potential traders, conducting trades for the buyers and sellers of securities in the secondary market, and providing advice and marketing services to issuers of new securities in the primary market.
To better understand the role of market makers, it will be helpful to distinguish between brokers and dealers. A broker simply arranges trades between buyers and sellers. A dealer, in addition to arranging trades between buyers and sellers, stands ready to be a principal in a transaction, more specifically, a dealer stands ready to purchase and hold securities sold by investors. The dealer carries an inventory of securities and then sells them to other investors. When we refer to market makers in this next series of posts, we will be referring to dealers, the market makers.
As a key player in financial markets, the market maker has an important role in our financial system. In particular, a market maker helps to maintain a smoothly functioning, orderly financial market. market makers stand ready to buy and sell and adjust prices---literally making a market. Let us assume that there are 100,000 shares of stock for sale at a particular price. If buyers take only 80,000 shares at that price, what happens to the remaining 20,000 shares? When such a short-term imbalance occurs, rather than making inconsistent changes in prices the market takes a position (buy) and holds shares over a period of time to keep the price from falling erratically, or the market maker may altar the prices until all (or most) of the shares are sold. Thus, in the short-term market makers facilitate the ongoing shuffling and rearranging of portfolios by standing ready to increase or decrease their inventory position. If there is not a buyer for every seller or a seller for every buyer, These actions enhance market efficiency and contribute to an orderly, smoothly functioning financial system.
Market makers also receive, process, interpret and disseminate information to potential buyers and sellers. Such information includes the outlook for monetary and fiscal policy; unemployment, newly published data on inflation, unemployment and output; fresh assessments of international economic conditions; information on the profits of individual firms; and analysis of trends and market shares in various industries. As holders of outstanding securities and potential issuers of new securities digest all this information, they may take actions that bring about a change in current interest rates and prices of stocks and bonds.
To illustrate, assume the political situation in the Middle East deteriorates, and experts believe a prolonged war which would disrupt the flow of oil to the rest of the world is likely. Analysts, employed by the market makers, would assess the probable impact on the price of oil, the effect on U.S. oil companies' profits, and so forth. Such information would be disseminated to and digested by financial investors, and lead some of them to buy (demand) or sell (supply) particular securities.
In general, when something affects the supply or demand for a good, the price of that good will be affected. in the financial markets when something affects the supply of, or demand for, a security, its prices will move to a new equilibrium and the market maker will facilitate the adjustment. Securities prices change almost every day. Because of the activity of market makers, these changes usually occur in an orderly and efficient manner.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, BURTON & LOMBRA, PGS. 116-118*
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