Roles, transactions, & spreads

After a security is sold for the first time in the primary market, it then trades in the secondary market. The issuer raised capital (money), and now stockholders trade the security with other investors at its market price. There are various roles, rules, and dynamics in the secondary market that we’ll discuss in this unit.

In this first chapter, we’ll discuss three big secondary market topics:

• Roles in the secondary market
• Agency vs. principal transactions
• Bid & ask spreads

Roles in the secondary market

Later in this chapter, you’ll learn about the Securities Exchange Act of 1934, which is a law that governs the secondary market and its participants. In general, there are three participants (roles) you’ll need to be aware of:

• Traders
• Broker-dealers
• Market makers

Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. However, traders rarely speak with or maintain relationships with clients. For example, many mutual funds employ several or dozens of traders to fulfill the strategy of the fund manager. The fund manager may create and adjust the fund’s strategy, but traders execute the strategy by buying and selling securities for the fund. Traders that work for large portfolios (like mutual funds) generally do not maintain relationships with their clients (those who invest in the portfolios).

Previously in this material, we discussed what a broker-dealer is and what they do. As a reminder, broker-dealers are financial firms in the business of performing securities transactions on behalf of others (broker/agency) or for their own account (dealer/principal). In plain English, broker-dealers help their customers trade securities and make a profit doing so. They can operate in one of two capacities: agency or principal. The differences between the two capacities are discussed later in this review (see below).

Here’s a list of the 5 largest broker-dealers in 2020:

• Fidelity Investments
• Charles Schwab
• Wells Fargo
• Edward Jones
• TD Ameritrade

While traders and broker-dealers sound similar, broker-dealers tend to maintain relationships with their clients, while traders do not. If you currently have an account at a broker-dealer, you’re probably offered various services like retirement planning, portfolio analysis, and cash management. Relationship management is an important part of a broker-dealer’s business model due to competition and ease of moving assets (it’s very quick and easy to move assets from broker-dealer to broker-dealer). On the other hand, traders simply trade for their clients usually because it’s their sole job as a part of a large portfolio.

Market makers are financial organizations that buy from and sell securities solely on a principal basis (with inventory) to traders, broker-dealers, and other public customers. These organizations maintain ongoing bid & ask spreads (see below), which are prices they’re willing to trade securities at. Market makers serve a very important function in the financial markets as they provide much-needed liquidity for the securities they trade.

The last paragraph is full of financial lingo, so let’s discuss the topic in plain terms. Assume you have a large inventory of apples (for whatever reason). If you put an apple stand in front of your house with a sign that said:

I will buy or sell apples with anyone who is willing to do so. You can sell an apple to me for $1, or you can buy an apple from me for $2.

You’re willing to trade apples with anyone who wants to buy or sell apples, which makes you an apple market maker. The $1 apple quote is your bid (the price you’re willing to buy apples at) and the $2 apple quote is your ask (the price you’re willing to sell apples at). Your presence in the neighborhood makes it very easy to buy and sell apples, which is another way of saying apple liquidity is high. If there are multiple apple market makers in your city, liquidity would be even higher.

Now, replace apples with securities. Market makers buy and sell securities with the public and make a profit doing so. They maintain bid and ask prices (discussed in more detail below) which enable profits, while adding liquidity to the market. If you place a trade with a broker-dealer*, the firm is most likely to send your trade to a market maker, who then fulfills the trade request. With most publicly traded stocks (especially those that are listed on exchanges), there are dozens of market makers trading the security. Traders and broker-dealers seek out market makers with the best possible price to maximize returns for their clients.

*When investors place trades with broker-dealers, most trades are fulfilled on an agency basis. In this scenario, the broker-dealer connects the investor with a market maker and charges a commission. Broker-dealers have the structure and capacity to act as a principal, usually in one of two ways. First, they can act as market makers and trade with the public on a principal basis. Second, they act as a dealer while taking part in underwriting syndicates.

Agency vs. principal

Financial firms like broker-dealers make money trading with the public in the secondary market. Depending on the security traded and their role in the market, financial firms may trade on an agency or principal basis.

Assume a customer approaches a financial firm and wants to buy 100 shares of IBM stock. If the firm acts in an agency capacity, they work to match the customer’s order with another participant in the market.

On any given day, thousands of trades occur in IBM, so it shouldn’t be difficult for the firm to find someone willing to sell 100 shares of IBM. Depending on the price and trade specifications requested by the firm’s customer, the trade goes through when the firm finds a seller meeting those specifications.

When a firm matches an order on an agency basis, they collect a commission. In essence, a firm is acting as a middleman. You’ve probably heard of several different types of brokers in the world, all of which act in an agency capacity. For example, real estate brokers match buyers with sellers and charge a commission when a real estate transaction occurs. This is no different than how it works in finance.

How would our customer’s request to buy 100 shares of IBM stock work differently? If the firm acts in a principal capacity, they sell the shares out of their inventory. As we discussed earlier, market makers always act in a principal capacity. They open themselves up to the trading public and are willing to buy and sell securities with their customers. When a customer wants to purchase a security, the market maker sells the security out of their inventory. When a customer wants to sell a security, the market maker buys the security and places it into their inventory.

Firms acting in a principal capacity make money through mark-ups and mark-downs. You’ve heard of different types of dealers in the world, all of which act in a principal capacity. With a used car dealership, cars are bought from the public at prices lower than their market value. You may have experienced this yourself if you’ve sold your car to a dealership. When they buy your car below its market value, this is known as a mark-down. Next, the dealership attempts to sell the car at or above its market value, which is known as a mark-up. Essentially, dealers are trying to buy low and sell high, just like every other investor.

Acting in a principal capacity involves risk, as the value of the securities in the firm’s portfolio could drop drastically. If this occurs, they’ll lose money as they try to sell the security at lower prices.

Here’s a video breaking down a practice question on this topic:

Bid & ask spreads

Bid & ask spreads are maintained by market makers in the secondary market. The bid and ask represent prices they are willing to trade at.

The bid is the price the firm is willing to buy a security at. The term ‘bid’ comes from the perspective of the market maker. The firm is “bidding” on the security in the market in hopes of a customer showing up and selling. In addition to the bid price, the market maker also specifies how many shares they’re willing to buy at that price. We’ll discuss this later in this section.

The ask, sometimes referred to as the “offer,” represents the price the firm is willing to sell a security at. Again, the term ‘ask’ comes from the perspective of the market maker. The firm is “asking” a price for the security in the market in hopes of a customer showing up and buying. In addition to the ask price, the market maker specifies how many shares they’re willing to sell at that price.

Here’s an example of a bid/ask:

GM stock

$40 bid / $41 ask

4x7

In this example, we have a market maker for GM stock. According to the bid, they are willing to buy up to 400 shares of GM stock at $40 from the public. When a market maker publishes a quote, they signify how many round lots they’re willing to buy or sell with the public. With 4 on the bid side, it tells us they’re willing to buy 400 shares at the bid price specified.

According to the ask, the market maker is willing to sell up to 700 shares of GM stock at $41. The difference between the market maker’s buy price of $40 and the sell price of $41 is how they make a profit. Often referred to as the “spread,” this $1 difference can add up as market makers are known for performing thousands of trades daily.

A $1 spread is not common with actively traded stocks. In most cases, popular stocks have spreads in the pennies. In an efficient market, financial firms make substantial profits even with small spreads. An efficient market is defined as one with active trading and small spreads. As long as the market maker trades enough with the public, these small spreads tend to add up over the day.

There are always two sides to a trade. We’ve discussed the bid and ask from the perspective of the market maker. When a customer is involved, they take the opposite side of the trade. Here’s a summary of the two sides of the bid/ask:

Bid

• Market maker buys
• Customer sells

Ask

• Market maker sells
• Customer buys