Beware ... Liquidity, Buyers and Sellers

When we think of all the participants in the stock markets, we usually think of buyers and sellers.

On the other hand, it is much more useful to think in terms of "price makers" and "price takers!"

A price maker is someone who is willing to post a firm offer to buy or sell, and a price taker is someone who is willing to hit a bid or take an offer.

liquidity buyer seller

A market might have a massive number of buyers and sellers, but if none of them are willing to post a price (or alternatively, accept one), then the market is a failure!

Thus, another way of thinking about "wide open" or liquid markets. is to say that the requirement for a liquid marketplace is price makers interacting with willing price takers.

So, what motivates someone to post a price that they are obligated to honor?

What are the challenges of determining prices?

What motivates a price taker?

Motivating price makers is the most serious challenge any marketplace faces.

Within traditional financial exchanges, a variety of incentives have been tried to try to encourage traders to be price makers.

They included reductions in trading fees, outright cash payments, and low cost or free trading permits. Even food has been offered sometimes as an incentive!

In 1982, when the Chicago Mercantile Exchange launched the S&P 500 futures, the exchange offered a free breakfast to any trader who was willing to spend time in the pit.

A culinary allusion to the 1850s, when the very young Chicago Board of Trade offered free lunches to try to encourage traders to come to the exchange!

The real question is what motivates someone to accept a price?

Generally, we would expect that someone would be more willing to accept a price if the market is transparent.

But there is a very important exception to this seemingly obvious point:

In obscure markets where there is low or unknown volume, no liquidity and no price transparency, sometimes there is no shortage of willing price takers.

StockOptions

What explains this?

One possibility is that some brokers or dealers can "customize" products that are precisely tailored to the needs of the price taker!

But perhaps a more important reason is that brokers or dealers offer an "implicit or explicit guarantee" of liquidity and/or profitability, which is such an important feature that price takers are willing to trade with little or no knowledge of the bid/ask spread!

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