What it means
Unlike a broker, who simply passes an order to the market for a fee, a dealer takes the other side of the trade. If you want to sell bonds, the dealer buys them from you using its own money and holds them until it finds a buyer.
This makes markets smoother, because there is nearly always someone ready to trade. The dealer quotes two prices: a bid (what it will pay) and an ask (what it will sell at).
The difference between them is the spread, and it pays for the risk of holding stock, the cost of running the desk and a profit margin. Tighter spreads usually signal an actively traded, easy-to-price product.
Dealer banks play a central role in government bond markets, foreign exchange, corporate debt and derivatives. Some governments appoint primary dealers, which are banks that must bid at government debt auctions and make markets afterwards.
This gives the issuer a dependable group of buyers. Holding inventory carries risk.
If prices move against the dealer before it can sell, it makes a loss, so dealers manage positions closely, hedge where they can and hold capital against the risk. Regulations since the financial crisis of 2008 have limited how much risk some banks can take in this way.
For a business, a dealer bank is often the counterparty on a currency deal, an interest rate swap or a bond purchase. Knowing that the dealer is taking the opposite side helps explain why quotes from different banks differ and why it pays to ask more than one.
It is also worth knowing that dealer banks differ from the big commercial banks that take deposits from the public. Some institutions do both, which is why regulators set rules on how deposit money can be used for trading and how much capital must sit behind risky positions.
In practice
Real-world examples.
Example
An exporter wants to sell euros for dollars. A dealer bank quotes a buy and sell rate, and the exporter trades at the bank's bid rate, which is slightly worse than the mid-market rate.
Example
A pension fund needs to sell a large block of corporate bonds quickly. A dealer bank buys them at once and holds them on its own books until it finds other investors.
Example
A government sells new bonds at auction. The primary dealer banks bid for them and then resell them to clients through the following weeks.
Formula
Calculation
Formula: Dealer spread revenue = (Ask price - Bid price) / 100 x Face value traded (for a bond quoted per $100)
Worked example: a dealer bank quotes a government bond at a bid of $99.50 and an ask of $99.70 per $100 of face value. A client buys $10,000,000 face value and the dealer later sells the same amount to another buyer.
Spread = $99.70 - $99.50 = $0.20 per $100
Spread revenue = $0.20 / $100 x $10,000,000 = $20,000
If the dealer buys at $99.50 and sells at $99.70, it earns $20,000 for providing liquidity. Had the price fallen before the second sale, part or all of that gain would have disappeared.Case study
Seen in the real world.
Meridian Capital Bank is a fictional dealer bank used here as an illustrative example. A mid-sized manufacturer asked it to sell $20 million of corporate bonds on a day when markets were nervous. Few buyers were around, so the dealer bought the entire block at a slightly lower price and kept it on its own books.
Over the next fortnight the dealer sold the position in pieces to different investors, earning a spread but also carrying the risk of a price drop. The manufacturer got its cash on the day it needed it. This illustrative story shows the service a dealer provides, which is immediacy, paid for through the spread.
A competing dealer, quoting a wider spread, would have cost the manufacturer thousands of dollars more, so it now asks for at least two quotes on large trades.
Watch out
Common mistakes.
- Confusing a dealer with a broker. A broker arranges a trade for a fee, while a dealer trades from its own account.
- Assuming the quoted price has no cost built in. The spread is the dealer's payment, and it is part of your transaction cost.
- Believing a dealer bank guarantees you a profit. It only guarantees a price at the time, not future movement.
Questions
People also ask.
How does a dealer bank make money?
Mainly from the bid-ask spread and from gains on the positions it holds. It also earns fees for related services.
What is a primary dealer?
A bank approved by a government or central bank to deal directly in its debt, usually with an obligation to bid at auctions and quote prices afterwards.
Why do different dealers quote different prices?
Each has its own inventory, view on the market, risk limits and cost of funding. Comparing quotes can save real money on larger trades.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%