Dealer Markets vs. Broker Markets

Markets across the world can also be segregated based on the type of intermediary. Prima facie, it may appear that the type of intermediary is not of much consequence. However, over time, market participants have realized that the type of intermediaries has a profound effect on the liquidity, efficiency as well as transaction costs related to trading.

Primarily, all markets can be divided into two types based on the type of intermediaries. Some markets are known as broker markets, whereas others are known as dealer markets. Each type of market has its own advantages as well as disadvantages. This is the reason why both types of markets are still found in the world. For instance, the New York Stock Exchange (NYSE) is a prominent example of a broker market, whereas the NASDAQ is a prominent example of a dealer market. The difference between the types of markets has been listed in this article.

Difference between a Broker Market and a Dealer Market?

Brokers, as well as dealers, are both intermediaries. However, there is a huge difference in the way they operate in the market. For instance, the job of a broker is to ensure that buyers and sellers meet.

The broker charges a commission on the sale price of the goods or securities being sold in the market. This means that brokers never actually take ownership of the underlying goods or securities being sold. As such, they do not have to invest their own capital or take any risks.

Since brokers have limited liability, companies with limited capital and a limited network can also become brokers. The barriers to entry are low, and the competition amongst brokers is intense. This is the reason why brokerage rates are reducing. Nowadays, there are many discount brokers who charge a fixed fee regardless of the transaction value!

Dealers perform a very different function as compared to the brokers. This is because dealers are actually the counterparty for both transactions. This means that for the buyer, they are the seller, whereas, for the seller, they are the buyer. Hence, if a person or an institution wants to sell something, they purchase the goods or securities from them, keep them in their possession and sell them when they find a suitable buyer. This means that they have to invest their own capital in order to buy the asset. It also means that they will have to absorb the loss if the asset drops in price before they can find another buyer. Since dealers take additional risks, they need more compensation. This is the reason they do earn via commissions. Instead, they earn via spreads.

A spread is a difference between the price at which the dealer is willing to buy and the one at which it is willing to sell. Spreads reflect the riskiness of the underlying asset. If the asset is likely to experience a steep drop in value, the spread is higher to ensure that the dealer has an appropriate margin and does not suffer a loss. Also, becoming a dealer is quite difficult. This is because it requires a lot of capital. Also, it requires a huge network, so that the dealer is able to offload securities and minimize their risks as soon as possible. This is the reason why only banks and huge financial institutions perform the role of a dealer.

Disadvantages of a Dealer Market

Prima-facie, it may appear that the dealer market is actually a better market system as compared to the broker market. This could be because of the fact that the dealer market provides fast liquidity. If a person wants to sell their goods or securities, they can do it instantaneously. They do not have to wait for a counterparty. Finding the counterparty becomes the job of the dealer.

However, it needs to be understood that the dealers charge a hefty premium for this service. The spread charges are much higher when compared to brokerage. Therefore, the transaction costs in the markets made by dealers are prohibitively high. This leads to lower transaction volumes.

Also, markets made by dealers do not guarantee higher liquidity. This is because, in times of crisis, when prices are falling rapidly, dealers quickly stop buying more goods and securities and actually look to offload what they have. This phenomenon has been seen several times, the most recent example being the Great Recession of 2008.

Lastly, dealers actually have more information as compared to regular market participants. They can transact at lower transaction costs as compared to other participants in the market. Also, they have more information as compared to other participants in the market. In many cases, dealers choose to side-line their socially important function of providing liquidity. Instead, they choose to become efficient proprietary traders. Because of their special abilities, they are able to exploit opportunities that other market participants are not able to exploit.

The bottom line is that dealer led markets do provide certain advantages over broker markets. However, these advantages do come at a cost. In general, markets in which a lot of people trade are made by brokers because finding counterparties is not so difficult. On the other hand, markets with fewer participants are dealer made markets since finding counterparties is a challenge.