Why Bid-Ask Spreads Exist
The Hidden Cost of Liquidity and the Economics of Market Making
Every financial transaction begins with a simple but often overlooked reality.
The price at which you can buy an asset is usually higher than the price at which you can immediately sell it, this difference is known as the bid-ask spread.
The bid represents the highest price a buyer is currently willing to pay. The ask represents the lowest price a seller is currently willing to accept. The gap between these two prices forms the spread; at first glance, spreads may appear insignificant.
For highly liquid stocks, the difference may be only a few cents. In major foreign exchange markets, spreads can appear almost negligible. Yet across the global financial system, bid-ask spreads collectively represent one of the largest and most important sources of transaction costs.
More importantly, they reveal something fundamental about how markets function. Many investors assume that markets exist naturally and continuously provide liquidity, they imagine a world where assets can always be bought or sold instantly at fair value.
Reality is more complicated, as liquidity is not free.
Someone must stand ready to buy when others want to sell and sell when others want to buy. The bid-ask spread exists largely because providing this service involves risk.
At MorMag, bid-ask spreads are viewed not merely as transaction costs but as windows into the underlying structure of financial markets. They reveal information about liquidity, uncertainty, information asymmetry, competition, and market efficiency.
To understand why spreads exist is to understand why markets themselves exist.
The Simplest Explanation
Imagine a merchant buying and selling gold.
The merchant may offer to buy gold for £995 per ounce and sell it for £1,005 per ounce. The £10 difference represents compensation for operating the business.
Financial markets operate similarly, as market makers effectively function as merchants of liquidity. They stand ready to buy from sellers and sell to buyers, thus, he spread compensates them for providing this service. Without compensation, few participants would willingly accept the risks associated with continuous liquidity provision. The spread therefore exists because liquidity has value.
The Role of Market Makers
Modern markets depend heavily upon market makers; a market maker continuously posts both bid and ask prices. They are willing to buy from sellers and sell to buyers throughout the trading day, this service creates market liquidity.
Investors can execute trades immediately because market makers stand between buyers and sellers. However, market makers do not know whether future prices will rise or fall.
As every transaction creates risk; thus, the spread exists partly to compensate them for accepting this uncertainty. Without market makers, many markets would become significantly less liquid and more volatile.
Liquidity Is Not Free
One of the most important lessons in market structure is that liquidity is a service, services require compensation.
Imagine a situation where an investor wishes to sell a large position immediately. Finding a natural buyer at that exact moment may be difficult, so the market maker solves this problem by purchasing the asset. However, the market maker now holds inventory that may decline in value; the spread compensates them for assuming this risk.
Viewed through this lens, the spread represents the price of immediacy. Investors pay for the ability to trade instantly.
Inventory Risk
One major reason spreads exist is inventory risk. When market makers buy assets, they temporarily hold inventory, this inventory exposes them to price movements.
Suppose a market maker purchases shares from a seller. If prices decline before the inventory can be sold, losses may occur. The wider the potential price fluctuations, the greater the inventory risk.
Consequently, spreads often widen when volatility increases, as the market maker demands greater compensation for bearing greater uncertainty. Inventory risk therefore forms a fundamental component of spread formation.
Information Asymmetry
Perhaps the most fascinating explanation for bid-ask spreads comes from information economics.
Not all market participants possess the same information. Some investors may know more than others, this creates a problem for market makers.
Imagine a trader aggressively purchasing shares. Why are they buying?
The market maker cannot know with certainty. Perhaps the trader possesses valuable information; perhaps a positive announcement is imminent; perhaps the asset is significantly undervalued.
If informed traders consistently transact against market makers, the market maker faces adverse selection risk. The spread helps compensate for this possibility; as in many markets, information asymmetry represents one of the most important drivers of bid-ask spreads.
Adverse Selection and the Spread
Adverse selection occurs when one party in a transaction possesses superior information. This concept lies at the heart of modern market microstructure theory; market makers worry that informed traders may exploit them.
If a trader buys because they know favourable news is coming, the market maker may soon face losses as prices rise. On the other hand, if a trader sells because they know negative news is coming, losses may occur as prices fall.
The spread acts as protection against this informational disadvantage; as the greater the likelihood of informed trading, the wider spreads tend to become. This relationship explains why spreads often widen around earnings announcements, economic releases, and major news events.
Volatility and Uncertainty
Spreads also reflect uncertainty.
When future prices become more difficult to estimate, market makers demand additional compensation. Periods of calm market conditions often produce narrow spreads. Conversely, periods of stress frequently produce wider spreads, this occurs because volatility increases risk.
A market maker quoting prices during highly uncertain conditions faces a greater probability of adverse price movement. The spread therefore adjusts dynamically, it functions as a market-based measure of uncertainty. In many respects, spreads contain information regarding perceived risk.
Competition Narrows Spreads
While risk pushes spreads wider, competition pushes spreads narrower.
In highly competitive markets, numerous market makers compete for order flow. With each participant seeking to attract trading activity, this competition compresses spreads. The most liquid markets in the world often exhibit extremely narrow spreads because competition is intense. Examples include major currency pairs, large-cap equities, and heavily traded futures contracts.
The spread therefore reflects a balance between risk and competition. Risk widens spreads, but, competition narrows them.
Why Small Stocks Have Larger Spreads
Investors often notice that smaller companies tend to exhibit wider spreads than large companies, this observation arises from several factors.
Small stocks often possess:
lower trading volume
less liquidity
greater volatility
less analyst coverage
higher information asymmetry
Market makers therefore face greater risk, to compensate, they demand wider spreads. As such, the spread becomes a reflection of liquidity conditions. Large, heavily traded stocks generally exhibit narrower spreads because risk is lower and competition is stronger.
Spreads During Market Crises
Some of the most dramatic examples of spread behaviour occur during financial crises.
During periods of extreme uncertainty, market makers become reluctant to provide liquidity. Volatility increases, information becomes scarce, risk rises sharply. As a result, spreads can widen dramatically.
Assets that appeared highly liquid under normal conditions may suddenly become difficult to trade; this phenomenon highlights an important reality.
Liquidity is not constant, it is a market condition that can change rapidly. Spreads often provide one of the earliest indicators of deteriorating market quality.
The Hidden Cost of Trading
Many investors focus heavily on commissions while ignoring spreads.
In reality, spreads often represent a larger cost. As every time an investor buys at the ask and sells at the bid, value is transferred to liquidity providers; this cost may appear small on individual trades.
Over time, however, it accumulates significantly. For active traders, spread costs can become a major determinant of overall performance. Understanding spreads is therefore essential for understanding execution quality.
Spreads as Information
Bid-ask spreads are not merely costs, they are information.
A spread reflects the collective assessment of:
liquidity
volatility
uncertainty
competition
information risk
Wider spreads often signal stress; whereas, narrow spreads often signal confidence and liquidity abundance. Microstructure researchers frequently study spreads because they provide insight into underlying market conditions, the spread is therefore both a price and a signal.
Market Efficiency and Spreads
A common misconception is that efficient markets should exhibit zero spreads, this is impossible.
Even perfectly efficient markets require liquidity providers. Liquidity provision involves risk, and risk requires compensation. As long as uncertainty exists, spreads will exist.
The question is not whether spreads disappear; instead the question is whether spreads appropriately reflect underlying costs and risks. In this sense, spreads are a natural consequence of market functioning rather than a sign of inefficiency.
The MorMag Perspective
At MorMag, bid-ask spreads are viewed as a critical component of market structure analysis.
Spreads provide valuable information regarding:
liquidity quality
order flow conditions
information asymmetry
volatility expectations
market fragility
Research into market microstructure seeks to understand how spreads evolve across different regimes and what those changes reveal about underlying market dynamics. The spread is not merely a transaction cost, it is a real-time measure of the economics of liquidity provision.
Understanding it provides insight into the hidden mechanisms driving financial markets.
Conclusion
Bid-ask spreads exist because liquidity is valuable and providing liquidity involves risk.
Market makers stand ready to facilitate transactions, but in doing so they assume inventory risk, information risk, and uncertainty. The spread compensates them for these risks while allowing markets to function efficiently. Far from being an arbitrary feature of trading, the bid-ask spread reflects some of the deepest economic forces operating within financial markets: competition, information asymmetry, volatility, and liquidity.
At MorMag, spreads are viewed as more than transaction costs, they are signals, that reveal the hidden economics of market making and provide insight into the structure of modern financial systems.
Because every spread tells a story… a story about risk, uncertainty, information, and the price of immediacy in a world where liquidity is never truly free.
