Trading and Exchanges Chapter 14: Spread Components and What They Tell You (Part 2)
In Part 1 we covered dealer spreads, the two spread components (transaction costs and adverse selection), and why uninformed traders lose no matter what order type they use. Now Harris finishes the chapter with equally important stuff: what determines equilibrium spreads in real markets, how public traders compete with dealers, and what factors predict whether a given instrument will have wide or narrow spreads.
When Traders Don’t Know Values Perfectly
Harris relaxes his earlier assumption that everyone knows exact values. Funny thing: if all traders are equally ignorant, spreads actually shrink. The volatility of an estimate is always lower than the volatility of the real thing. Less perceived volatility, smaller spreads.
But in practice spreads are wider when nobody understands what something is worth. The trick is that in real markets, ignorance is never distributed equally. Some people know more. That asymmetry drives spreads wider.
Well-informed traders race to exploit their edge, so they use market orders. Limit order traders get picked off. Their orders fill fast when they are wrong, and sit unfilled when they are right. Equilibrium spreads must widen to compensate.
Public Traders vs Dealers
In many markets, regular public traders compete with professional dealers to provide liquidity. And they compete on unequal terms, but not in the way you might expect.
Public limit order traders have no business overhead. No office, no compliance department. So they can quote tighter spreads than dealers who need to cover all that. A retail trader who wants to buy anyway can place a limit order so aggressive that no dealer can match it and still make money. Public limit orders can literally push dealers out.
But dealers see more order flow, change quotes faster, and spot patterns that public traders miss. They survive razor-thin spreads by being smarter about the flow of orders.
The catch: when dealers exploit these advantages, limit order strategies become less attractive for everyone else. Fewer public limit orders means less competition, which means wider spreads.
The Three Things That Determine Every Spread
Harris boils it down to three primary spread determinants. Every spread in every market comes back to these:
Asymmetric information. When some traders know things others don’t, spreads widen. Liquidity suppliers set prices far from the market to recover from uninformed traders what they lose to informed ones.
Volatility. Volatile instruments have wide spreads. Limit orders on volatile instruments are more valuable options for the other side to pick off. Plus volatile things are harder to value, which means more information asymmetry, which means even wider spreads.
Utilitarian trading interest. Fancy economics speak for “do regular people actually want to trade this thing?” Investors, hedgers, borrowers, even gamblers count. High utilitarian interest means active markets, and active markets have narrow spreads. Dealers spread fixed costs over more trades, manage inventory easier, and face more competition. Uninformed traders also dilute the information in order flow, shrinking the adverse selection component.
These three factors interact. High information asymmetry leads to wide spreads, discourages uninformed traders, lowers volume, makes spreads even wider. It’s a feedback loop.
Secondary Factors: What You Can Actually Observe
You can’t directly measure information asymmetry or utilitarian interest. So Harris introduces observable proxies.
For information asymmetry: disclosure rules (more transparency means narrower spreads), analyst coverage, insider trading enforcement, and portfolio diversification. Stock index futures have tiny spreads because insider knowledge about one company barely matters in a basket of 500.
Harris makes a great point about established vs emerging industries. Old boring companies with predictable cash flows are easy to value. Growth stocks in new industries are the opposite, and anyone with inside knowledge has a huge edge. So growth stocks tend to have wider spreads, all else equal.
For volatility: financial leverage, operating leverage, uncertain growth, perishable commodities, weather-dependent supply. Fun story: when cold weather hits Florida, meteorologists and local farmers suddenly have an edge over other traders, and spreads on orange juice futures blow out.
For utilitarian interest: trading volume is the best proxy. Also firm size, debt issue size, and whether a commodity contract matches what hedgers actually need. Government bond spreads start small when first issued and widen as they age because buy-and-hold investors lock them away.
When Markets Fail Completely
If information asymmetry is extreme and utilitarian interest is near zero, spreads get so wide that nobody trades at all. Harris calls this market failure. Not failure as in something broke, but the market simply does not exist.
This is why Tommy’s Burgers cannot issue public stock. Nobody would buy it because the secondary market would be illiquid. Dealers would be terrified of trading with people who know Tommy’s actual sales numbers. So small businesses get financing from banks and venture capitalists, who do due diligence and monitor the business directly. That kind of relationship works in private financing but not in public markets.
The Bottom Line
Spreads are not random. They are the market’s way of pricing the risks of providing liquidity. If you understand information asymmetry, volatility, and utilitarian interest, you can predict which instruments will be cheap to trade and which will be expensive. And if you are an uninformed trader, you pay the adverse selection spread no matter what you do. The only way to avoid it is to not trade at all.
Previous: Chapter 14: Bid/Ask Spreads (Part 1)