A dealer market is a dynamic financial market where multiple dealers publicly post the prices at which they are willing to buy or sell specific securities or instruments. In this market setup, a dealer, also known as a ‘market maker,’ ensures liquidity and transparency by electronically presenting their bid (buy) and offer (sell) prices for securities. This market-making process helps maintain balanced trading activities.
Bonds and foreign exchanges predominantly operate within dealer markets, while stock trading on Nasdaq serves as a prime example of an equity dealer market.
Key Takeaways
- A dealer market is a transparent financial system in which multiple dealers post their buying and selling prices for specific securities.
- Primarily, bonds and foreign exchanges trade within dealer markets.
- Certain stock exchanges, such as Nasdaq, function as equity dealer markets.
- Dealer markets empower dealers to use their capital to provide liquidity, effectively eliminating brokers from transactions.
- These markets contrast notably with auction markets and brokered markets.
How Dealer Markets Work
In a dealer market, market makers (MMs) employ their own capital to provide liquidity for investors. One of their main risk control tools is the bid-ask spread — a measure of the difference between the buying price and selling price of securities that generates profit for dealers. This spread represents a cost to investors and a profit margin to dealers.
The dealer market principally differs from an auction market where a single specialist facilitates trading in a centralized spot by matching buyers and sellers for a specific security. Dealer markets involve multiple market makers, enhancing liquidity and competition.
Dealer Markets vs. Broker Markets: Key Differences
In a broker market, a buyer and seller need to be defined for a trade to occur. Conversely, in a dealer market, buyers and sellers execute transactions independently through dealers who act as market makers. Here are the key distinctions:
- Brokers execute trades on behalf of others, while dealers trade for themselves.
- Brokers buy and sell securities for clients, whereas dealers trade on their accounts.
- Brokers operate based on clients’ commands, unlike dealers who have more freedom in buying and selling.
- Brokers earn commissions, whereas dealers profit from their trades.
Real-World Example of a Dealer Market
Imagine Dealer A has ample stock of WiseWidget Co., which is listed on the Nasdaq market. If the national best bid and offer (NBBO) is $10 / $10.05, Dealer A might want to offload some holdings, quoting a lower bid-ask spread of $9.95 / $10.03.
Investors would prefer Dealer A’s offer at $10.03 over the other market makers’ $10.05, and thus, they would buy from Dealer A. Meanwhile, investors selling might not find Dealer A’s $9.95 bid attractive since other dealers bid higher at $10, driving the trading equilibrium.
Dealer vs. Trader: Understanding Their Roles
A dealer continuously makes two-sided markets by posting both bid and offer prices, aiming to generate profit from frequent trades. Traders, not occupying the role of market makers, can choose to buy or sell as per their preference and hope for favorable market movements.
Types of Securities Dealers
Broker-dealers (BDs) exist as regulated entities that trade securities for their own accounts or on behalf of clients. They can act purely as brokers who take commissions or as principals trading against clients using their own capital. BDs categorize into two: wirehouses, which sell proprietary products, and independent broker-dealers, which sell externally sourced products.
Is Robinhood a Dealer Market?
No, Robinhood, an online trading platform, functions as a broker. Registered as a broker-dealer with FINRA, Robinhood executes trades for customers but does not market-make or establish its own exchange.
Related Terms: auction market, broker market, bid-ask spread, broker-dealer.
References
- Citadel. “What Is a Market Maker?”
