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Abstract |
THERE HAS BEEN much discussion of a policy nature about the function of dealers in equity securities markets, the efficiency of different methods of providing dealer services and the regulatory constraints under which dealers should operate. Some empirical work has been carried out to determine what factors underlie dealer costs and to assess the efficiency of different market organizations and 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 Benston and Hagerman (1974)]. The purpose of this paper is to develop a more explicit and rigorous model of the individual dealer and to discuss the implications for the cost of trading of different market organiza- 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 restricted to the supply side. For steps in the direction of specifying the demand for dealer services see Copeland (1976) and Epps (1976). Dealers facilitate trading by investors because they are willing to trade for their own account as principals when investors' agents (or investors acting for themselves) cannot immediately find other investors with whom to trade.' Following Demsetz (1968) one can, therefore, think of dealers as providing the service of immediate trading or immediacy. The cost of immediacy developed in this paper is the sum of: (1) holding costs, the price risk and opportunity cost of holding securities; (2) order costs, the costs of arranging trades, recording and clearing a transaction; and (3) information costs which arise if investors trade on the basis of superior information. |
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