1. How do Dealers Make Money? Economics 71a Spring 2007 Extra Lecture notes 2.4a

2. Objective  Several people have asked just how dealers make money  These notes are designed to go over this

3. Market Types  Securities markets vary in structure  There are two extremes Pure dealer market (bonds, FX) Completely open limit order markets (ECN)  There are many options in between

4. Pure Dealer Market  This market operates like a used car dealer  Dealer maintains inventory  Tries to buy low and sell high  Provides immediate liquidity  Buyers and sellers do not need to reveal anything

5. How does this dealer make money?  Assume dealer knows stock is worth $100 (big if)  Tells buyers they can have the stock for something like $101  Tells sellers that they could sell it to him for $99  Makes money on this price spread

6. Why is this tricky?  What if the dealer doesn’t really know how much the stock is worth?  Could buy some stock at $99, when some bad news is about to come out, and the price falls to $95  When there is no information dealing is great  When new info comes out things can get bad for the dealer

7. How does this work on an ECN?  In a pure ECN there are no “dealers”  However: We can all try to be dealers by trying to buy low and sell high a stock which is staying close to a constant value

8. Assume again that the value is $100 (you know this)  You have obtained an inventory of stock purchased at $100  There are offers to sell on the ECN at 104 (10 shares) 103 (10 shares) 102 (10 shares) 101 (5 shares)  A large buy order comes in demanding 25 shares immediately  This sweeps up the book to a price of 103

9. Assume again that the value is $100 (you know this)  There are now offers to sell on the ECN at 104 (10 shares) 103 (0 shares) 102 (0 shares) 101 (0 shares)  You are watching from the comfort of your computer  Immediately you put in limit sell orders at some of these prices hoping to get “hit” yourself  Hopefully, someone buys these from you and you pocket the difference  You now wait, hoping you can buy some more at or near $100 in the future as more orders come in

10. What is the Risk?  The problem is similar to the dealer market  If that price is rising because there is new information on the stock you might get hurt  Your selling prices would be too low in this case  You run the risk of a new information coming in