12. Why dealers provide liquidity?

“He thinks the Fed should extend its responsibilities beyond the lender of last resort for banks in need, and become the dealer of last resort, meaning it should provide short-term liquidity for the 23 primary dealers that help implement monetary policy. “

When we think of dealers, we probably think of shady guys selling drugs. Here we are talking about legal financial dealers providing liquidity for the monetary system. Imagine a bank runs into liquidity problems but it owns securities like treasury bills, which will mature in a year. The bank can sell these securities to a dealer to make cash. (Note: When we talked about the central bank being the lender of last resort we were talking about borrowing money to ensure liquidity and using an asset as security. Now we are going one step further and talk about selling a security to get cash).

 

What are dealers doing?

The dealers make sure that the market is liquid, which means one can sell their assets quickly, in large volume and without moving the price too much. 

The dealers have a huge inventory of assets, securities, and cash so the prices do not fluctuate too much and one can continuously buy or sell an asset to or from them. Obviously, dealers are making profits doing that. How do they make profits?

They are like a supermarket.  They buy an asset for a certain price, add a certain percentage and then sell that asset at a higher price. A supermarket is doing the same thing, buying cheap, selling more expensive.

Dealers buy at the "bid" price and sell at the "ask" price. There we have the "bid-ask" spread. I give you an example: The supermarket buys my drinks for $250 from the wholesales market that is the bid price. Afterward, it adds a margin to it to money and pays its workers etc. The market sells the drinks to me for $500 that is the "ask" price. The "bid-ask" spread would be $250.

The Treynor-Black Model

The dealer does the same thing, but his spread is more influenced by the risk premium and the volatility. The dealer carries a risk. Imagine he buys 100 securities and 1 defaults. If he takes a risk premium from all the others, he is still doing fine, because he made enough money with the risk premiums to balance his loss. The more volatile a market is, (the more it moves up and down) the higher is the risk premium, because the dealer faces losses. The bid-ask spread is called the inside spread. The price depends on the inventory. So if the dealer has a lot of inventory he is willing to sell his inventory at a lower price, whereas if he runs out of securities, he wants more money for his securities. You can see this here in the dealer model from Fischer black and Jack Treynor.

In the model, one can clearly see the higher ask price and the bid-ask spread. You can also see that asset prices are falling when the dealer has a higher inventory. 

 

To long means to possess something and to short means to have less than zero of it, because you sold it even though you don’t own. (That is possible in the financial markets) If the dealer would sell a lot of inventory, prices would rise.

On the outside, we see two boundaries and on both sides, we have value based traders. Imagine everyone is selling their securities but no one is buying new ones. The price of securities would go down. At one point the value based trader is going to jump in and buy the cheap securities, even though no one else is doing so. Same on the other side, if the price is high enough the value based trader is willing to sell his securities even though no one else in the market wants to sell their securities. 

If I need to sell my house and no one is buying it, I have to lower the price. Even during the financial crisis, when almost no one would buy houses if my house is cheap enough someone (a value based trader) would buy it. Or if I have a house that is worth 500,000 $ and I don’t want to sell it, but if someone comes by and offers me one million, I probably change my mind. Normally, value-based investors or traders act against the market and look for things that are over or underpriced. It is not easy to be a value investor because what you do, seems to be very stupid for the rest of the world and you need to have a lot of cash laying around to make these deals when they suddenly knock on your door. Waren Buffet is probably the most famous value investor.

Why does he provides liquidity, because he buys your securities for cash if you need cash or sells you securities if you need securities.  When he buys a lot of securities he gives a lot of cash to you or banks, which makes the entire market more liquid.

 

Financial Times Quote: The FT Quote combines the dealer topic and the central bank. Both provide liquidity, but even though dealers are mostly linked to the banks they do not have to follow the same regulation, so new policies and conflicts are probably coming up, because the CB would rescue banks again but what would they do if dealers have liquidity problems, because they are a major source of liquidity!

Introduction

The first article: The hierarchy of money

The second article: Why do we need banks?

The third article: Why we need a central bank?

The fourth article: How can banks create money out of thin air?

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

The seventh article: What are Fed Funds?

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

The eleventh article: Discounts, Discounts, Discounts

The twelfth article:  Why dealers provide liquidity

Written by: Philine Paschen

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