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4 SEPTEMBER 1978

HANS R. STOLL

THERE HAS BEEN much discussionof a policy nature about the function of dealers

in equity securitiesmarkets,the efficiencyof differentmethodsof providingdealer

servicesand the regulatoryconstraintsunder which dealersshould operate. Some

empiricalworkhas been carriedout to determinewhat factorsunderliedealercosts

and to assess the efficiency of different market organizationsand regulatory

constraints, but that work has not been based on a very explicit theoretical

foundation [see Demsetz (1968), Institutional Investor Study, Ch. 12 (1971), Tinic

(1972),Tinic and West (1972),and Benstonand Hagerman(1974)].The purposeof

this paperis to developa more explicitand rigorousmodel of the individualdealer

and to discussthe implicationsfor the cost of tradingof differentmarketorganiza-

tions of dealers. It is hoped this model will provide a better framework for

empirical work and for discussion of the policy issues involved. The paper is

restrictedto the supplyside. For steps in the directionof specifyingthe demandfor

dealer servicessee Copeland(1976) and Epps (1976). Dealers facilitate tradingby

investorsbecausethey are willingto tradefor theirown accountas principalswhen

investors'agents(or investorsacting for themselves)cannot immediatelyfind other

investorswith whom to trade.' Following Demsetz (1968) one can, therefore,think

of dealersas providingthe serviceof immediatetradingor immediacy.The cost of

immediacydevelopedin this paper is the sum of: (1) holding costs, the price risk

and opportunitycost of holding securities;(2) order costs, the costs of arranging

trades,recordingand clearinga transaction;and (3) informationcosts which arise

if investorstradeon the basis of superiorinformation.

Dealers are to be distinguishedfrom brokers who act strictly as agents for

investorsand do not assumerisk.This paperemphasizesholding costs, which have

also been the emphasisof earlierstudieson dealers.Ordercosts, which are incurred

both by dealers and brokers, are included in the analysis but do not receive

extensivedevelopment.Informationcosts facing dealersare also modeled, but see

Jaffe and Winkler(1976)for a more extendedtreatmentof that issue. Dealers exist

Pennsylvania.I benefitedgreatlyfrom the commentsof my colleaguesat the Universityof Chicago

while a visitortherein 1975-76,from the commentsof my colleaguesat Ecole Superieuredes Sciences

Economiqueset Commercialeswhile a visitor there in 1976-77, as well as from the commentsof my

colleaguesat the Universityof Pennsylvania.Specialthanksare due MarshallBlume,BernardDumas,

ThomasEpps, RobertHamada,JonathanIngersoll,RobertLitzenberger,Ron Masulis,MertonMiller,

JamesMorris,Roland Portait,RandolphWesterfieldand JosephWilliams.All are absolvedfrom the

remainingerrors.The financialsupportof the Universityof PennsylvaniaLaw School Centerfor the

Studyof FinancialInstitutionsis gratefullyacknowledged.

1. For the purposesof this paperinvestorsincludeindividualsand institutionalinvestorswho in other

contextsmightbe consideredto be intermediaries.

1133

1134 The Journal of Finance

themselves(by placinglimit orderswith brokersand borrowingor lendinguntil the

limit order is executed, for example).Not everyone is a dealer because there are

fixed costs (office, phone, etc) to the dealerbusiness.

Section I presentsan intuitiveapproachto holding costs. Section II of the paper

discusses the principalassumptionsunderlyingthe analysis. Section III develops

the holding cost function in a one period context. Implicationsof the model for

determinantsof bid-ask spreadsand for the role of diversificationby dealers are

discussedin Section IV. Ordercosts and informationcosts are discussedin Section

V. In Section VI certain policy issues related to the industrial organizationof

dealersare discussedin the context of the model. In Section VII modificationsare

made to put the model in a multiperiodcontext. The conclusionsare summarized

in Section VIII.

I. A FAMILIAR PICTURE

The dealer can be viewed as any investor who has a desired portfolio (his

investment account) based on the opportunitieshe sees and on his preferences.

Supplying immediacy to other investors means moving away from this desired

portfolioin orderto accommodatethe desiresof investorsto buy or sell a stock in

which the dealer specializes.As a result the dealer assumes unnecessaryrisk and

moves to a level of risk and returnwhich may be inconsistentwith his personal

preferences.

These points are best illustratedby consideringFigure 1. Line RfE is the dealer's

efficient frontier,which representsthe possible combinationsof his efficient port-

folio of risky assets (point E) and the risk free asset (yielding Rf). Assume the

dealer'sdesired position-his investmentaccount-is point N. By taking nonop-

timal portfoliopositions the dealer moves away from N and indifferencecurve U0

to a lower indifferencecurve such as Ul. The dealer is forced off the efficient

frontierbecauseit is assumedthat he cannot initiatetradesin his efficientportfolio

of stocks, E. The portfolio acquiredin the process of acting as a dealer is termed

the trading account. Long or short positions in his trading account may de-

diversifythe dealer'stotal portfolio and cause the frontierof his new portfolio set

(trading plus investment account) to be described by a line such as ANB, the

positionof which dependson the riskcharacteristicsof the tradingaccount.

A movement upward along NA means the dealer has an undiversifiedlong

position financed by borrowingat Rf. At point A he has, for example,borrowed

100%of his wealth. This imposes a total percentageholding cost of g on him. In

other words,his customersmust pay him g per cent on his currentwealth in order

to keep the dealer at his initial indifferencecurve. Part of the cost is due to the

de-diversificationcausedby dealingin few stocksand partis due to the assumption

of a level of risk not consistentwith the dealer'spreferences.Even if a dealerwere

to trade a fully diversifiedportfolio and therebymaintainRfE as his frontier,he

incurs costs because he moves to a lower indifferencecurve. A movement along

NB means the dealer has an undiversifiedshort position in the tradingaccount.

Once the dealeris at a nonoptimalpoint like A, the cost of anothertransactionis

the difference between the total percentagecost at A and at the new position

The Supply of Dealer Services in Securities Markets 1135

U0

fR

FIGURE 1

position and trades a different stock so as to increase diversificationand reduce

risk. The case of a decrease in position accomplishedby selling another stock is

illustratedin Figure 1 by the move fromA to A1. Sinceg, Kg, the cost to the dealer

of the transactionsis negative,i.e., he is willing to pay customersto take him from

A to AI1.The cost would be positive were the transactionsto increasethe dealer's

position and reduce diversification.If the dealer specializes in one stock, his

movementis along a curve like ANB. If he makes a marketin many stocks, many

paths are possible.

The task now is to make more explicit the holding cost incurredby a dealerand

its relation to the size of the transactionand other variables.Before doing so the

assumptionsunderlyingthe model are set out.

II. AsSUMPTIONS

financed solely at the risk free rate of interest,Rf. Thus dealerpurchasesof shares

are financedsolely by borrowingat Rf, and the proceedsof shortsales are invested

solely in the risk free asset. The dealer'spersonalwealth (his investmentaccount)

and the positionin the tradingaccount serveas collateralfor the borrowingof cash

1136 The Journal of Finance

or of shares. Ruled out under this assumptionis the possibility that dealers can

acquirefunds by sellingother stocks or that they use the proceedsof short sales to

buy other stocks. To permit this would simply transfer costs of immediacy to

anotherdealer.

However,by appropriatechangesin his bid-askquotationsthe dealerencourages

transactionsby the public that will rebalance his portfolio. In other words, the

dealeracts passivelysettingprices and letting the public choose which stocksit will

purchase from him and which stocks it will sell to him. Portfolio adjustments

arisingfrom his dealeractivity are thereforerestrictedto those stocks in which he

makes a market,i.e. his tradingaccount. The assumptionof constant Rf could be

relaxed at the cost of complicating the model, and the possibility is discussed

below.2

2. The dealer is assumed to have a utility function over terminalwealth. Since

the vast majority of dealers are proprietorships,partnershipsor closely held

corporations,ascribinga utilityfunction to the dealeris realistic.3Alternativelyone

can assume the utilityfunctionbelongs to the ownersof a dealerfirm and that the

ownerscannot offset on personnelaccount the positionstakenby the firm (because

they are unawareof the positionsor becauseit is too costly for them).

3. The dealermakes estimatesof the "true"price and "true"rates of returnthat

would exist in the absence of transactioncosts. This "true"price is the discounted

value of the dealer'sexpectedequilibriumprice one period hence. This estimateis

derivedfrom the fundamentalcharacteristicsof the stock and need not be the same

as the estimatesof other dealers or investors.All rates of returnin the paper are

"true"rates of return.The analysis is a partial equilibriumanalysis of the dealer

industry and the determinantsof "true"equilibriumprices are for example not

treated.

4. The dealer makes one transaction per trading interval during which the

stock's price does not change. Prices may change between tradingintervals.In a

one period world, the dealer buys or sells shares in the first tradinginterval and

becomes subject to one period of uncertainty.The period is assumed to be very

short,and certainapproximationsto be specifiedlater may be justified.The world

ends in the second tradingintervalwhen the dealer'sinventoryis liquidatedat the

equilibriumprice of the second tradinginterval.

Certainother assumptionsof lesser importanceare detailed in the development

of the model. These involve constraints on the utility function and certain

approximations.

and have,on deposit,customersecurities,that can be borrowedat no cost. It is also realisticif aggregate

borrowingsof stockare smallsince competitionby lenders(owners)of stock would tend to drivedown

the cost to the borrowerof stock. Discussionswith nonbrokerdealerssuggestthat thereis at presenta

sharingbetweenborrowerand lenderof the intereston the proceedsof short sales. Recognitionof this

fact changessomewhatthe resultsof the model and the implicationsare discussedat the appropriate

point in the paper.

3. A possible explanationfor the observedtendencyto find noncorporateforms of organizationin

the securitiesindustryis the frequencyof verbal commitments,the fulfillmentof which depends on

personalintegrityand the threatof personalbankruptcy.

The Supply of Dealer Services in Securities Markets 1137

The dealer tradesa stock if the dollar compensationpaid him is enough to offset

the loss of utility caused by deviatingfrom his initial portfolio. In other words he

will requirethat expectedutility of terminalwealthof the initial and new portfolios

be the same:

EU(W*)= EU(W) (1)

W= terminalwealth of the new portfolioafter the transaction.

indicatesrandomvariable.

The initial portfoliois a combinationof the dealer'sinvestmentaccount (repre-

sented by point N in Figure 1) and his initial tradingaccount.Thus

k = optimal fraction of the dealer's wealth invested in portfolio E, a

constantbecause of assumption1.

Re= returnon portfolio E-the optimal efficient portfolio of risky assets.

(Under homogeneousexpectationsthis would be the so-called market

portfoliothat includesall risky assets.)

QP= "true"dollar value of stocks in tradingaccount. Although one period

remains, the dealer is allowed to enter the trading interval with a

non-zero trading account, acquired in prior periods. If Q= 0, the

initial portfolio is the desired portfolio-point N in Figure 1. Qp 0

according to whether the dealer has long or short position in the

tradingaccount.

R = rate of returnon the tradingaccount.

Rf= risk free rate.

To simplifyexposition,(2) may also be writtenas follows:

W*=Wo(I+R*) (3)

where RP*is the rate of returnon the initial portfolio and is defined by the last

three termsinside the bracketsof (2).

Terminalwealth under the new portfoliois given by:

W= WO(I+ R*) + (I + Rj)Q - (I + Rf)(Qi -C ) (4)

where Qi= "true"dollar value of the transactionin stock i, the stock in which

immediacyis being provided.Negative values indicate a sale; positive

values, a purchase.

Ri = rate of return on stock i.

Ci presentdollarcost to the dealerof tradingthe amount Qi. Ci is positive

1138 The Journal of Finance

costs of holding the inventoryQP.

The dealer'scost, Ci,is incorporatedas in (4) because,undercurrentinstitutional

arrangements,Ci, is not paid explicitly to the dealer at the time he provides

immediacy.Instead the dealer trades at the bid or ask price different from the

"true"price of the stock. Thus he need borrowonly Qi- Ci to finance a purchase

the "true" value of which is Qi. On a short sale he earns interest on Qi+ C1

althoughthe present"true"value of the shortsale is Qij4

Approximating(1) by expanding each side in a Taylor series around the

respectivemeansand droppingtermsof orderhigherthan two yields5:

where the bar () over a variableindicates expected value and where tildes have

been dropped when the meaning is clear. Writing W and W* in terms of initial

wealth and rates of returnand takingexpectationsyields:

where a* and a are the varianceof rate of return of the initial portfolio and of

the cost, Ci, only in perfectcompetition.When competitionis less than perfect,the dealercan price

above cost, and thereforethe discountfrom "true"value exceedscost.

5. Droppingthesehigherordertermscan be justifiedby assumingthat the pricedynamicsfor stocks

is given by

R,= jliAt+ a,V@Z

WhereRi=rate of returnduringthe intervalAt.

- expectedrate of returnduringAt.

a,= standarddeviationof returnduringAt.

Z = normalrandomvariablewith zero mean and unit variance.

vt= time interval.

Droppingtermsof orderhigherthan two implies that termsin At raisedto powersof 2 or more are

dropped,which is justifiedsince At is assumedto be very small in this analysis:let W= WO(l+ R). In

termsof the above process

Wi= W0(I+,IAt+aKt Z)

Then in (5)

(W- W)=-W0aV?IZ

(W- W*)= Woa*.VKZ

Thereforetermsof orderthreewould involve(At)2.

The Supply of Dealer Services in Securities Markets 1139

U(W)- U(W*)

U(-)-U(W_ ) = w- W* (A.2)

U'(W*)

The approximationsare legitimatein termsof the processdescribedin footnote 5.6

Using (A.1) and (A.2), (6) can now be writtenas:

I z [Q a2+2WoQ cov(R*,R.)[ WW*]O (7)

Note from (3) and (4) that

W W = Qi(Ri -Rf ) + Ci(I + Rf )(8)

where o.e is the covariancebetween the rate of return on stock i and the rate of

returnon portfolioE, and a.s is the covariancebetween the returnon stock i and

the return on the initial trading account. Furthermorek, the desired holding of

portfolioE (representedby point N in Figure 1) can be eliminatedfrom (9) since it

dependson the utilityfunctionand the knowndesiredopportunityset (the line RfE

in Figure 1). By setting the slope of the dealer'sindifferencecurve equal to the

slope of the desiredopportunityset, it can be shown that7

Re-Rf

k= e (10)

ZoJe

U(W*)+ 2 U"( W*)W2G2At= U(W)+ U"(W)W02A2t (F6.1)

A.1 and expand U"(W*)aroundW by one term:

Now consi~der

U"(W*)= U''(W)+(W*- Ww"(W). (F6.2)

Substitutingfor (W*- W) on the basis of the processin fn. 5 and substituting(F6.2)in (F6.1) will show

that neglectingthe second term in (F6.2) neglectsa term in (At)2which is small. Followinga similar

procedurefor A.2, one gets

I (F6.3)

U(W )-U( W*) = (W_ W*)U,( W*) + (W_ W*)2U"( W*)

Or

I

U(W) _ U( W*) = (W W*) U'( W*) + W0( t- _*)2(At)2U"( W*) (F6.4)

The last termin (F6.4) involves(At)2and can thus be neglected.

7. For Qp 0, terminalwealthis:

W*= Wo[h+R*= Wo[I +kRe+( -k)Rf].

1140 The Journal of Finance

2Z Q22

+ z p;,JC(l+Rft)-Q[(Ri-RfJ)-(Re-RfJ Cie _- (II)

2 o WO'4 J/ 2L

and

z Q~~~~~~~~~~~~~~~[0

WO iP i2 W0 i(i-t-R-g i2e

ci = l+Rf (12)

-Rf (13)

Ge

and assumessecurityi is in his investmentaccount.Given (13), the last termin the

numeratorof (12) is zero. Note also that letting Rf= 0 in the denominatorof (12)

has minimal effect on (12). These modifications yield the dollar holding cost

functionwhich is to be viewedas an incrementalcost functionsince it refersto the

cost of a single additionaltransactionundertakenin the tradinginterval:

Ci WO

p 2W1 l (14)

i

= ci= aipQp + 2 Qi (15)

(1) Dealer characteristics-relativerisk aversionz, and dealerequity W0.Of two

dealersin the same stock, the one with largerz and/or smallerW0chargesa higher

fee for taking a position of given size; or, at the same fee, would take smaller

positions.

aW* ak*

Note that aW*/ *= WOand a= kae,set the differentialequal to zero and solve for the slope of the

indifferencecurve:

dR* u",(W*)Wke

do. U'(W*)

Settingthis equal to the slope of the opportunityset, (Re- Rf)/tae,yields (10).

8. Under homogeneousexpectationsthis would be the Sharpesecuritymarketline, an equilibrium

relationship,with portfolioE being the marketportfolioand aie/ae2 the well-known"Beta"coefficient.

The Supply of Dealer Services in Securities Markets 1141

(2) Size of the transactionin stock i, Qi.Total cost rises as the squareof Qi, and

percentagecost rises linearlywith Qi.

(3) Characteristicsof the stock-variance of returnand the covariancebetween

the returnon stock i and the returnon the initial tradingaccount portfolio.9Note

that the covariancewith the investmentaccountdoes not enter.

(4) Size of the initial position in the tradingaccount, Qp.If Qpis positive (and

a. > 0), the cost of buying stock i is largerthan if there were no initial position.

donverselythe cost of sellingstock i is smallerthan if therewere no initialposition.

In Figure2, Ci is plottedas a functionof Qi using some reasonablevalues for the

remaining variables. Placement of the curves depends on the dealer's initial

position, QP,and the size of aip.If Qp= 0 or if sip= 0, dollarcost has a minimumof

Qi= 0. If Qp# 0 and sip> 0, the minimumis at Qit 0 accordingas Qp O. 0 A notable

aspect of (14) illustratedby Figure2 is its symmetry-a sale of given size costs the

dealer the same amount as a purchaseof given size. Assumingthat the dealer has

no initial holding in the trading account and is thereforeat N in Figure 1, this

result implies that points A and B in Figure 1, which representlong and short

positions of the same amount, lie on the same indifference curve, as shown.

AlthoughB is much fartherinside the efficient frontierthan A, it is closer to the

level of risk desired by the dealer and these two factors are offsetting. If the

probabilityof purchasesby the dealerequals the probabilityof sales by the dealer,

C1 Ci I Q, = 50,0ooo0

1 000

._~~~~~~~~~~ 500

pR

FIGURE 2

9. Note that ai2and aipare not directlyobservablesince they dependon variabilityin "true"returns.

Observedvariabilityof returndependsas well on the cost of immediacywhich is reflectedin bid and

ask pricesand whichin turndependson the volumeof tradingand othervariables.

1142 The Journal of Finance

the symmetriccost function implies that the optimal inventory in the dealer's

tradingaccountis zero; or, in otherwords, that the optimaloverallportfolioof the

dealer is the same as that of any nondealer with the same preferences and

expectations.Thus even afterbecominga dealerthe desiredportfolioremainspoint

N in Figure 1.

Inability of the dealer to borrow and lend at the same rate of interest can

eliminate the symmetryof the cost function and could complicate the problem

slightly. In particularsuppose the dealer can borrow at Rf but can lend the

proceedsof shortsales only at a fraction,E(,of Rf. This affects the thirdtermin the

numeratorof (12) because eRf replaces Rf. Given (13), the term does not go to

zero but to Q'Rf(E)- 1),where Q. <0 is the dollarvalue of short sales requiredand

e)=I if Qi7=0 and e <I if Q <0.'0 The effect is to raise Ci by the amount of

interest not earned on the proceeds of a short sale. Dollar costs are therefore

greaterfor Qi<0 than for Qi>0. Given a symmetricprobabilitydistributionon

purchasesand sales, the dealer tends, in this case, to keep a positive inventoryin

the tradingaccountto avoid the extracost of shortselling."

It should be pointed out that 0 can be made a more complicatedfunction of

other variables.For exampleif the bank is concernedabout default risk on dealer

borrowings,the logical variableis the dealer'sdebt-equityratio, L = (Qi+ QP)/WO,

where dE)(L)/dL>O. Such a modificationis straightforwardand would tend to

raise dealer costs above those in (14). However, since the theoreticalform and

empiricaljustificationfor these modificationsare not clear and since these modifi-

cations would not alter the character of the final model while adding to its

complexity,the modificationsare omitted from furtherconsideration.

the "true"price, P*, and by selling shares at the ask price, pa, usually above the

"true"price. Consider a dealer who specializesin a single stock i. Curve cio in

Figure 3 representsthe percentageholding cost function of the dealer with no

initialpositionin the stock. Supposehe standsready to buy Qb > O and sell Q,. < 0,

and quotes bid and ask pricesthatjust cover his costs of doing so.'2 Then the price

of immediacy of a sale of Q b to the dealer is set at (P.O_

- Pbo)/

P.Os= cio(Qbo),and the

price of immediacy of buying from the dealer is (Pio- P1)/ Pio= cio(Qao).If a seller

appearsand trades Qb at P.bo,the dealer sets the new ask price in the second (and

final) trading interval at the new equilibrium price, Pia = Pi',+,, and the position

10. Since the dealermay have stock i in his tradingaccount,shortsales may not be necessarywhen

the dealersells stock i.

11. The observedtendencyto find positiveinventorymay be due to a numberof other factors.For

example dealers may be able to anticipatebuying by the public better than selling by the public.

Second, and probablymost important,there are often tax benefits to carryingstock on one's trading

accountratherthan one's investmentaccount.If the dealeris taxed as a corporation,the corporatetax

may be lowerthanhis individualtax. Long termlosses can receiveordinaryincometax treatmentin the

tradingaccount.

12. It is assumedthat the dealeris in a competitiveenvironmentfor the purposesof this illustration.

The Supply of Dealer Services in Securities Markets 1143

P*- p

CC

b 11 ii c~~~~~~~~~~

io

Ci i)

(qb Ptl -- -

b -o i,^

io

iO iO) P*= C

Qio ~ ~ ~ Q

QiG i

1i 10 P

(Qa) -o

P*o ai

/~~~~~~~~~i |o

FIGURE 3

is sold. If a buyer appears and trades Q,Oat P,.O,the dealer sets Pb= pe in the

second tradinginterval,and the shortpositionis covered.

A dealerfaced with a tradeof Q,would like in the same tradingintervalto make

an offsetting transaction,in the same stock or some equivalent combination of

stocks, that perfectlyhedges his portfolio. Real world constraintsimposed in this

model are that the dealer cannot actively and immediatelytake such offsetting

positionsin the same stock or other stocks. However,the bid-askquotationin any

stock is set so as to encouragetransactionswhich reduce the risk of holding the

initial portfolio.This point is illustratedin Figure 3 by the line cil, the percentage

cost function for Qp>0, qip>0. Since in this case the dealer already has a long

position the returnon which is positively correlatedwith stock i's return,the bid

and ask prices are set so as to encourage sales by the dealer of stock i and to

1144 The Journal of Finance

discouragepurchasesby the dealerof stock i. Thus the bid price,P, l, is lower than

if there were no initial position and the ask price, Pial,is lower. If QP= Q,

= - 2(z/ WO)aiQi;and in this case the dealeris willing to pay customersto take

him back to his optimumportfolio (N in Figure 1) an amount equivalentto the

cost of holding the risky position. If it is assumed he has been paid off for the

immediacy costs of trading Qp, the dealer just breaks even and is properly

compensatedduringeach time intervalfor bearingrisk.

The percentagespreadis the percentagedifferencebetweenbid and ask price, or

just the verticaldistancebetweenthe two percentagepricesin Figure3. The spread

function correspondingto (15) for Qib = Qa = IQil is:

pa - pb

whichis independentof the initialinventoryof the dealerand does not involve any

covarianceterm. Thus, if the dealerpricesjust to cover the costs of each transac-

tion, the spread(but not the bid or ask price)is independentof the initialinventory

and thereforeholds for the dealer in many stocks as well as for a dealer in one

stock.This resultdependson the assumptionsthat previousinventoryholdingcosts

are sunk costs and that only one stock is tradedper tradinginterval.

V. OTHERCOSTS

In additionto holdingcosts the dealerincursothercosts that shall receiverelatively

brief treatmenthere. First the dealer incurs certain explicit costs-called order

costs-in carryingout a transaction.These costs which are incurredby brokersas

well as by dealers include the cost of labor, the cost of communicating,and the

cost of clearingand recordkeeping.The simplestassumptionis that ordercosts are

a constant dollar amount, M, per transactionand thereforea declining propor-

tional amountM/ Qi per dollar traded.

A second cost arises if some investorstrade with the dealer because they have

superiorinformation.[See Bagehot(1971).Jaffe & Winkler(1976)on this point.] In

organizedmarkets,a dealerquotes a bid price at which he is willingto buy and an

ask price at which he is willing to sell withoutknowingwhetherthe next tradewill

be a purchaseor sale. Even if the dealer possesses inside information(because of

knowledgeof the book of limit orders,for example), such informationwould be

reflectedin bid and ask prices;and relativeto such knowledgehe is still subjectto

losses from investorswho have informationhe does not possess.On the assumption

that the dealercannot distinguishinformationtradersfrom otherswithoutinforma-

tion (liquidity traders),the dealer must increase his bid-ask spread vis-a-vis all

traders to protect himself against possible losses of dealing with information

traders.He widens the spreadso as to recoverfrom liquiditytraderswhat he loses

to informationtraders.

For the purposesof this paper,informationtradingcan be incorporatedinto the

dealer's cost function by recognizing that (13) does not hold in such a case.

Instead:

Ri Rf =(Re Rf ) 2Yai (17)

ge

The Supply of Dealer Services in Securities Markets 1145

with the dealer, assumed the same for buyers and sellers and independent of

transactionsize, and

fY 1 if dealerpurchasesshares.

-1I if dealersells shares.

In other words the dealer expects to earn less than he would in the absence of

informationaltrading, and his bid-ask spread must be wider as a result."3In

additioninformationaltradingmay cause ai2and cipto.be different,but this is not

assumedhere. The effect of (17) is to make the last term in the numeratorof (12)

nonzero and equal to - yak.

Modifyingthe percentagecost function (15) to include ordercosts and informa-

tion costs yields:

=

Ci= Q + 2~-j-a7Q

ipQ+ WoQI + i-a1 +- Qi (18)

(18)

WO

The adverse informationcost (at) and order cost M/Q, could undoubtedly be

treatedin a more complexway. For examplethe likelihoodof adverseinformation

may be a functionof the size of the transaction(becausethe rich are smarter).This

would result in higher bid-ask spreadsas Qiincreasesnot only because of larger

holding costs but also because of larger informationcosts. In principle the two

costs could be distinguishedbecauseinformationcosts are not a function of dealer

inventorylevel whereasholding costs are. Similarlyorder costs may in part be a

function of transactionsize. This would resultin a less steeply decliningper dollar

ordercost as a function of transactionsize.

Such modificationsare unlikely to change the basic shape of the cost function

(18) which is plotted on Figure 4. The differencebetween Figures4 and 3 is that

thereis now a discontinuityat Qi= 0 due to switchesin sign of y and the presence

of M.

A second more importantdifferenceis that thereis now an optimal-scalefor the

dealer because falling order costs are offset by rising holding costs. Adverse

information costs do not affect the scale decision because they are assumed

independentof transactionsize. If the dealer operates at minimumaverage cost,

[the minimumof (18)] output is at:

Qi* 2W

=+ ZG2 (19)

numberof otherfirmsmakinga marketin the stock and on the existenceof special

skills of the dealer,etc.

A spreadfunction independentof Qpcorrespondsto (18):

13. a, is analogous to the Jensen (1968) measure of mutual fund performance.

1146 The Journal of Finance

c.

_ 0 ~ ~ ~ ~ _Q

C.~~~~~~~~~~~~~~~~~~~~~~~~~~~C

1~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0l

FIGURE 4

should foster -whether a monopolisticspecialistsystem such as has existed on the

New York Stock Exchangewhere no stock has had more than one dealer or a

competitivedealersystemsuch as has been permittedin Over-the-Counter stocks.14

Probablythe principalundesirableaspect of monopoly dealersis pricingabove

marginal cost, the extent of which depends on the elasticity of demand for

immediacy,a subjectnot consideredhere. Howeverthe organizationof dealersalso

affects the cost of dealerservices.

First consider the effects of changing from monopoly dealers to competitive

dealers in the short run where the numberof dealers is fixed. In a free market a

14. As of the Spring 1976 competingdealers were permittedon the NYSE, but few have as yet

appeared.

The Supply of Dealer Services in Securities Markets 1147

given numberof dealersallocate themselvesamong stocks such that the cost of the

marginal transaction depends only on characteristics of stocks and not on

characteristicsof dealers.Wealthierdealers take larger positions (in the form of

holding more stocks or more per stock) than less wealthy dealersso that marginal

cost in any particularstock is equal across dealers.Similarlydealersless averse to

risk take larger positions than more risk averse dealers. To the extent that the

allocation of stocks to dealers under a monopoly dealer system is not optimal,

reorganizationinto a competitiVesystemproducesa net welfaregain to society by

equalizingmarginalcosts across dealers.Reorganizationinto a competitivesystem

benefits marketsin stocks with previouslyinadequatecapital or high z specialists

and harmsmarketsin stockswith previouslyexcessivecapitalor low z specialists.15

Second, if entry restrictionscause monopoly dealers to operate at too large a

scale (to the right of Q,*in Figure 4), competitionfrom new entrantswould push

costs to the minimum.The equilibriumnumberof dealersin a stock can be derived

using (19) if one is willing to assume that dealershave identicalcost functionsand

operateat the minimumaveragecost. Let IDl denote the absolutedollar value of

investors'tradingwith dealersin stock i at the price of immediacycorrespondingto

minimumaveragecost. Let I= absolute dollar value of minimumcost output.

The equilibriumnumberof dealers,d*, is the numberthat demand can supportif

all are operatingat minimumaveragecost. From (19) this is:

di*=1IQ*1IDil 2M (21)

stocks in which individual dealers are more risk averse; the number is less the

greater the order costs incurred by dealers and the greater the wealth of the

individualdealer.

It is interesting to note a few policy implications of (21). It is sometimes

suggestedthat undercompetition,dealersin riskystockswould not be forthcoming.

However, (21) suggests that, ceterisparibus, more dealers will operate in risky

stocks.This is due to the fact that each dealerwill take a smallerposition.Another

policy question concerns dealer capital requirements(our WO).Regulatorsargue

that dealers should be requiredto maintain a minimum capital in each stock.'6

Under monopoly dealerships such requirements may be useful in ensuring

adequatecapital since entry of dealerswith additionalcapital is prohibited.(The

appropriatelevel of capital depends on the characteristicsof the stock and the

dealer and would be quite difficult to set precisely.)Under competitivemarkets,

as implied here. For example,monopoly profits may make it possible for regulatoryauthoritiesto

requiredealersto act as if they had more capitalor a smallerz.

16. On the NYSE, the specialistmust be able to carry2,000 sharesof each stock (e.g., $80,000for

sharespricedat $40). However,most of the fundsfor carryinginventorycan be borrowed.On the OTC

a dealermust have net capitalof $2,000.

1148 The Journal of Finance

reduce the numberof dealersin a stock accordingto (21) and therebyreduce the

beneficial effects of competition. (Furthermore,minimum capital requirements

may have little effect in practice because it is difficult to compel utilization of

capital.)

A final issue concernsthe ease of entry and exit undera competitivesystem.To

the extent that entry and exit costs are zero, dealerswould fluctuateso that supply

is perfectlyelastic at the price of liquiditycorrespondingto IQi* even in the short

run. If short-runsupply is derivedfor a period in which the numberof dealersin

each stock is fixed, it is upwardsloping.This is realisticbecausethereare probably

entrycosts and becauseregulationsoften requiredealersto maintaina marketfor a

minimumperiodof time (6 monthsin the O.T.C.).Such regulationsare undesirable

in that they lengthenthe short-runand raise costs on average.

VII. MULTIPERIOD

CONSIDERATIONS

There is no guaranteethat the dealer can readily liquidate his inventory in the

second trading interval.Assume there is a cost, Di, of liquidatingthe inventory

should it still exist. This cost, a randomvariablein the first tradinginterval,can be

thought of as the paymentnecessaryto cause someone to accept the inventoryat

the new "true"price, or alternativelyas the differencebetween trade price (bid or

ask price)and the new "true"price that is necessaryto createsufficientincentiveto

othersto purchasethe dealer'sinventory.Under certainassumptionsone can view

D, as the (implicit)payment by the dealer to himself that makes him willing to

continueto hold the inventory.

It is helpful to think of events unwindingin the following time sequence.In the

first trading interval the dealer takes a position, Qi. He enters a period of price

uncertaintyin which thereis no trading.The second tradingintervalis dividedinto

two parts.The dealerentersthe second tradingintervalby pricinghis inventoryat

Pt*+, the new "true"price. Thus if he initially bought the stock (at P,tb), he sets

p,a +=P*t+1; if he initially sold the stock (at Pa) he sets t = Pt+ . In the

model of SectionII, the world ends here, and the dealeris assumedto liquidatehis

position at P,*t+ . In fact he may not be able to liquidate his inventory at Pi,t+. If

it is not liquidated,he sets at new concessionprice which deviatesfrom P,*t+, and

whichis sufficientto liquidatehis position.The dollaramountof the concessionon

all his sharesis Di, a randomvariablein the first tradinginterval.

The one period frameworkof section II can be maintainedbut modified simply

by noting that terminal wealth in (4) will be reduced by Di. The development

proceeds exactly as before except that some of the expressionsare more compli-

cated. The primarycomplicationarises in going from (5) to (6), which involves

writingE( W- W)2= a2(W) in termsof its components.With Di this is

a2( W)= WOa+ Qi +& (Di )+ 2 WoQicov(R*,Ri)

2 WOcov(R *, Di )-2 Qi cov(Ri, Di) (22)

Recall that Di is the concessionrelative to the "true"price and that R and R* are

The Supply of Dealer Services in Securities Markets 1149

correlatedwith these returns.Thus:

cov(R*, Di) = cov(Ri, Di) =0 (A.3)

II, the simplifiedcost functionbecomes:

z z

C= alp QpQ,+Di + wa 2(Di)+ 2 WOQi (23)

that there is never partialliquidationof any prior transaction.This implies that D.

1 and the value Ci if

is a Bernoullivariatetakingthe value zero if Qi is sold at P*,t+

the position is not sold. The correspondingprobabilitiesare (1 - 7i) and 'Wi.Then:

D==rg C, (24a)

Now suppose Ci = Ci, that the price concessionnecessaryto eliminatea position

equalsthe cost of assumingthe position in the first place. SubstitutingCi for Ci in

(24) and substitutingfor D and a2(D) in (23) yields

z lIz

aq,pQQ.+-

Q UQ2

I7QI

w0 ' W0(25)

2 WO ](5

WO

If the probabilityof a forced liquidationis zero, the cost functionis the same as in

(14).

The solution(25) can be statedin multiperiodterminologyby letting Ci represent

the cost to the dealerof continuingto hold the position acquiredin the first period.

Under this interpretation,the dealer does not liquidatehis inventoryat a conces-

sion price, but he continues to price it at the "true"price and to wait until an

investortradesin the opposite direction.This is not a true multiperiodframework

in which intermediatedecisionswould be allowed. It is the case that C,= C, under

the assumptionthat characteristicsof the stock (a72, cip)and the dealer (z, WO)are

unchanged over time and that the probability(,g) of holding the stock is un-

changed. Independence and stationarity of the distribution of returns and of

trading volume will lead to unchanged ai, ai , gi for given Qp.It is not unreasonable

to assume constantz. However WOchanges,and we must argue that the change is

too small to have a significanteffect.17

When viewed as the cost of continuingto hold the stock, it is naturalto specify

the dealer'scost in termsof the numberof periodshe expectsto hold the inventory

17. On average Wo increasesover time, which would reduce costs. This partly offsets the pre-

ponderenceof factorswhichlead to increasedcosts.

1150 The Journal of Finance

of the distributionof volume, there is a simple relationshipbetween the expected

holding period i and gi:

T

T = 1I+ E ihh(I - gT) (26)

h=1

T= total numberof possible periods.

Letting T-*oo (26) can be shown to be:

= 1 (27)

Z Z2l

,,Q, Q.+12 W

C WO W1q (28)

where

1 z 1 Ti-1 _

*i 2 WO Ti

This differs from (14), only in that the expected holding period multiplies the

per-periodvariance and covarianceand in the second term in the denominator,

which is small. If Ti = 1, (14) results.

A dealer cost function composed of holding costs, order costs and information

costs is developed.The emphasisis on the holdingcost componentwhich is derived

on the assumptionthat the cost is an amountwhich maintainsthe dealer'slevel of

expected utility of terminalwealth in responseto transactionsimposed upon him

by the public that tend to move him away from his optimalportfolio.The holding

cost depends on the dollar size of the transaction,the variance of return of the

stock-being traded, the size of the initial holdings of all stocks in the dealer's

tradingaccount, the covariancebetween the returnon the stock being traded and

the returnon the tradingaccount,the wealth of the dealer,and his attitudetoward

risk. Dollar holding cost for the incrementaltrade is a quadraticfunction of the

size of the position acquired,and percentageholding cost is thus linear.Under the

assumptionthat dealersare able to earn full intereston the proceedsof short sales,

the cost function is symmetric-that is, the cost of going short equals the cost of

going long. Under certain simplifyingassumptions,the multiperiodholding cost

function is shown to be quite similarto the one period function, differingonly in

that the holding period enters the function (or, equivalentlyin this model, the

The Supply of Dealer Services in Securities Markets 1151

price after one period).

The order cost is a minimumcost per transactionwhich thereforedeclines per

dollaras the size of the transactionincreases.Falling ordercosts and risingholding

costs determinean optimumscale of operationby the dealerin each of his stocks.

Informationcosts arise when investorstrade on the basis of superiorinformation,

which adverselyaffects the dealer'sexpectedreturnon his inventory.

The paper also examines some policy issues related to the organization of

dealers. Monopoly dealers are undesirablenot only for the standardreason that

they price above marginalcost but also becausethe assignmentof stocks to dealers

may be arbitraryand can result in a nonoptimumdistributionof dealer wealths

and risk attitudesacross stocks and because limits on entry may cause dealers to

operateat a nonoptimalscale. The equilibriumnumberof dealersin a competitive

systemis also considered.Given demand,the numberof dealersincreaseswith the

risk of the stock and the risk aversionof the "representativedealer".The desirabil-

ity of regulatingminimumcapital requirementsand imposing other entry condi-

tions is questioned.

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