How does banking actually work? Part 3: Dealers

 Dealers provide liquidity in most financial markets. The dealers are those who connect sellers and buyers. This is through buying equity, bonds and even currency from those who want to sell them and selling them to those who want to buy them. They are some of the most important financial intermediaries in the world.

How do dealers provide liquidity?

A liquid market is "one in which an individual transaction does not disrupt the continuity of the market" Meaning that you can buy and sell quickly without having drastic changes in the price. This can be shown in terms of price very clearly.

Dealers are vital in upholding the financial market’s liquidity. Dealers make it easier for someone to sell much more of the derivative without crashing the market. This is important as in the present-day banks and many other financial institutions confront their liquidity risk though being able to sell their assets, typically at a moment’s notice. Acting as the middleman, the dealers effectively bail out many financial institutions by purchasing the banks’ assets and supplying them with money, allowing them to face their liquidity risk.

Why do dealers do it?

In short, to make money. This can be shown by the “Treynor model” (Below)

This is an image of a basic Treynor model. The LHS is the maximum short position (Betting against) and the RHS is the maximum long position (Betting for). The middle is a neutral position. The top, slanted line is the “offer line”. The “offer line” is the price at which the dealer is willing to sell their equity, bonds or whatever they are in the market for. And the “Bid” price is the price that the dealer is willing to purchase at. Hence, dealers make money by operating in this spread. They are also the ones which get a discounted price whenever any company needs to liquidate their assets very quickly.

What risks do these institutions face?

The dealers are also facing some risks themselves, the most notable ones for us are liquidity and price risk. We have come across liquidity risk before; when the company is not able to sell assets to supply cash for any short-term liabilities, however, price risk is a new type of risk. Price risk is when the offer price falls below the bid price. This could be because of a recession, collapse in the value of stock/ bond et cetera. This puts the dealer in a speculative position as they have to speculate on which asset will be valuable in a week, a month or even a year.

How does this fit in with the big picture?

As I stated before, banks are forced to regulate their liquidity risk with the Volcker Rule making them have a matched book. Most people without knowing much about banks assume that banks have cash handy as they need it to make transactions and face the liquidity constraint. But in most balance sheets banks rarely hold cash, instead, they hold MBS (mortgage-backed securities) as their assets. This is only possible because of the dealers.

 

[Note: MBS are regarded as safe assets which is why most banks hold them and why Lehman Brothers and Bear Stearns both collapsed when MBS collapsed in 2008]