An Economic Theory, Second Edition
Chapter 10: Organizing the Supply of Market-making Services
147 10.2 THE PRICING OF MARKET-MAKING SERVICES It is important to consider how the package of market-making services is priced. Experience suggests that, in many markets, buyers pay only for market-making services if the transaction is successful. The explanation lies in yet another service that the market maker supplies to his transactors. This is insurance against the risk that the transaction will break down. Essentially, the market maker insures the transactor against the risk that the payments he would normally have made for market-making services will be incurred in vain. The market maker is therefore supplying insurance against market entry risk: the risk that the transactor faces when he commits resources to entering a market in pursuit of a trade. The natural explanation is that the market maker is relatively optimistic about the opportunities for creating trade, which is why he has taken a speculative position in entering, or even creating, the market. The customer has no particular reason to be optimistic, and so it is sensible for the market maker to bet with the customer about whether he will eventually make a trade. The market maker encourages the customer to enter the market and if he is correct then the customer will trade at a price which provides the intermediator with a margin that covers not only his market-making expenses but also a payment for winning the bet. To increase his chances of winning the bet, the market maker needs to maximize his opportunity to persuade the customer to...
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