Plate iii in print

The Immediacy

Demsetz and the price of immediacy: that the spread buys the right to trade now, without waiting to find a counterparty, and that liquidity is a service like any other.

What the exchange sells, beyond the thing itself, is the power to buy or to sell at once; and the gap between the two prices is what that immediacy costs.

— the principle of this plate, after Harold Demsetz, 1968

The first thing the middleman sells, beyond the goods, is time — or rather the saving of it. He stands ready to trade the instant you wish to, sparing you the wait to find a willing counterparty of your own; and that readiness, that immediacy, is a service with a price, and the price is the spread.

Harold Demsetz, in 1968, gave the idea its modern form, in the study of how shares trade on an exchange. At any moment, he observed, there are two prices, not one: the highest price at which someone standing ready will buy, the bid, and the lowest at which someone standing ready will sell, the ask, the latter always above the former. The gap between them is the bid-ask spread, and it is the price of immediacy — the cost of trading now, at once, against a dealer who is always there, rather than waiting, perhaps for hours or days, until a natural counterparty happens to appear who wants exactly what you are selling, in the quantity you are selling it, at a price you both accept. The patient can wait and save the spread; the impatient pay it to trade at once.1

1. Harold Demsetz, "The Cost of Transacting" (1968): at any moment a market shows two prices — the bid (the best price to sell into) and the ask (the best price to buy at) — and the spread between them is the price of immediacy, the cost of trading at once rather than waiting for a natural counterparty to appear.

Immediacy must be supplied by someone, and the supplier is the dealer, or market-maker, who undertakes to stand always ready — to buy from anyone who wishes to sell and to sell to anyone who wishes to buy, at the prices he quotes. He absorbs the mismatch in time between buyers and sellers: when sellers arrive before buyers, he buys and holds; when buyers come first, he sells from his stock. By interposing himself, he spares every trader the search for a counterparty and the wait for one to appear, converting a market of intermittent, ill-matched arrivals into one where anyone can trade at any moment. The spread is his compensation for providing this continuous readiness, and it is, in the first instance, the price of a genuine and valuable service: the abolition of waiting.2

2. Immediacy is supplied by the dealer or market-maker, who stands ready to buy and sell continuously, absorbing the mismatch in the timing of buyers' and sellers' arrivals and converting an intermittent market into a continuous one. The spread compensates this readiness; his other costs — inventory risk and adverse selection — are taken up in the next two plates.
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What immediacy is to a single trade, liquidity is to a market as a whole: the property that one can buy or sell quickly, in size, without moving the price much against oneself. A liquid market is one densely supplied with immediacy — with standing readiness to trade — and the spread is the most visible price of that liquidity. The narrower the spread, the cheaper it is to get in and out, and the more liquid the market is said to be; the wider the spread, the dearer and the thinner. Liquidity, on this view, is not a free background condition of markets but a produced service, supplied at a cost and sold at a price, and the spread is its meter. Markets that look frictionless are in fact markets where the price of immediacy has been driven very low by abundant competition to supply it.3

3. Liquidity — the ability to trade quickly and in size without moving the price — is the market-wide form of immediacy: a produced service whose price is the spread. Narrow spreads mean cheap, deep liquidity; wide spreads, thin and dear. Apparent frictionlessness is a low price of immediacy, not its absence.

That immediacy should command a price at all rests on the fact that needs to trade arrive at inconvenient times and rarely match. A pension fund must invest today's contributions today; a household must sell an asset when it needs the cash, not when a buyer appears; a firm must hedge a risk when the risk arises. To force each to wait until a natural counterparty materialized would impose real costs — delay, uncertainty, the risk that the price moves while one waits, the labor of searching. The dealer who stands ready removes those costs, and the spread is less than they would be; the trader pays the spread because immediacy is worth more to him than it costs. The service is real, the price is fair, and at this level the middleman is vindicated entirely: he sells something genuinely wanted, and sells it for less than its worth to the buyer.4

4. Immediacy is valuable because needs to trade arrive at inconvenient, ill-matched times; waiting for a natural counterparty imposes delay, price risk, and search costs. The dealer removes these for a spread smaller than they would be, so the impatient trader gains — the service is real and fairly priced.

Yet the spread is not pure profit to the dealer, and the rest of its anatomy is the subject of the next plates. To stand ready, the dealer must hold inventory — buying before he has a buyer, selling before he has restocked — and so bears the risk that prices move against the stock he carries; that risk must be paid for, and part of the spread is its premium. And he must quote his prices to all comers, including those who trade precisely because they know something he does not, and who therefore tend to buy from him just before the price rises and sell to him just before it falls; against these he loses systematically, and must widen his spread to recoup the loss from everyone else. Immediacy is the first and cleanest component of the spread, but inventory risk and adverse selection are woven through it, and together the three make up the price of standing ready.5

5. The spread is not pure profit: providing immediacy forces the dealer to hold inventory (bearing price risk, the subject of The Inventory) and to quote to better-informed traders (suffering adverse selection, the subject of The Informed). Immediacy, inventory risk, and adverse selection are the three classic components of the spread.

The price of immediacy is the spread's honest foundation: the dealer sells the right to trade at once, the abolition of waiting, and it is a service worth paying for. At this level the ancient charge of parasitism simply fails — the middleman who supplies liquidity does something real and valued, and earns his cut. But immediacy is not the whole of what the spread must cover. To stand ready is to hold, and to hold is to risk; to quote to all is to quote to those who know more. The next plate takes up the risk of holding — the inventory the dealer must carry, and the premium the spread must include to pay him for bearing it.