SUNNY SIDE OF THE STREET:: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 11)

Financial Markets Instruments and Market Makers (part B)

by

Charles Lamson

Why Market Makers Make Markets

The willingness of a market maker to make a market for any particular security will be a function of the expected profits and risks associated with buying, selling, and holding that type of security. The profits earned by a market maker flow mainly from the revenue generated by the price it charges for conducting a transaction. the number it charges for conducting a transaction. the number of transactions engaged in, and any capitol gains or losses associated with the market makers inventories of securities. Generally, a market maker charges a brokerage fee or commission for each transaction. The fee may be part item, such as 10 cents per share on stock, or a specified percentage of the total value of the trade, such as, 1 percent of the total proceeds from the sale of bonds. Market makers also collect a fee in some markets by buying a particular security at one price---the bid price---and selling the security at a slightly higher price---the "offer," or asked price. In this case, the revenue received by a market maker is a function of the spread between the bid, and asked prices, and the number of transactions in which the market maker and the public engage. Competition among market makers tends to minimize transaction costs to market participants.

1. Market Makers

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Market Making and Liquidity

The quality and cost of services provided by market makers affect the transactions costs associated with buying or selling various securities, the costs and convenience associated with buying or selling liquidity affect portfolio decisions, the market-making function influences, in turn, affect the liquidity of these securities. because transactions costs and liquidity affect portfolio decisions, the market-making function influences the allocation of financial resources in our economy. Some markets, such as the TR-bill market are characterized by high quality secondary markets. The large volume of outstanding securities encourages many firms to make markets in Treasury securities, and the volume of trading and competition among market makers, produces a spread between the dealer "bid," and asked "prices" of only 0.1 to 0.2 percent, well below the spread of 0.3125 to 0.5 percent associated with transaction in less actively traded, longer term government securities.

Substitutability, Market Making, and Market Integration

Market makers play another important, but less obvious, role in helping to integrate the various financial markets. Market makers such as Merrill Lynch and Solomon Smith Barney make markets in numerous financial instruments. In general, the trading floor of the typical market maker is a busy place on the floor of the trading room, the specialist in T-bills sits near the specialist in corporate bonds, who in turn, is only 20 feet from the specialist in mortgage-backed securities. Assuming that these people talk to one another, the activity in one market is known to those operating in other markets. With each specialist disseminating information to consumers via telephone, and continually monitoring computer display terminals, a noticeable change in the T-bills market (say a half percentage point decline in interest rates on T-bills), will quickly become known to buyers and sellers in other markets. Such information will, in turn, influence training decisions in these other markets, and thus, affect interest rates on other securities.

*SOURCE: THE FINANCIAL SYSTEM &THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 118-121*

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