4 ms·

I don't get it. How is arbitrage supposed to increase liquidity, if it is in practice increasing the cost of transaction? Isn't the middleman increasing the fri

• ww520 17y ago
  When something is illiquid due to insufficient buyers and sellers, the bid and ask spread is large. A big discount is needed to motivate people to buy it. E.g. you ask for $100 to sell your lawn mower because that's what every seller asking for. People only bid $60 to buy a lawn mower because they know it's difficult to resell it. The spread is $40. Now from time to time, a few buyers would get desperate and buy at $100; likewise a few sellers would sell at $60. Someone then comes in and says the spread is crazy. He offers to bid to buy at $70 and to ask to sell at $90. The few desperate sellers of course would sell to him at $70 instead of $60. And the few desperate buyers would buy from him at $90. He narrows the spread from $40 to $20, and makes $20 in between. He basically increases the buyer and seller pools by adding himself to them, thus increased the liquidity of the lawn mower secondary market. The risk to the arbitrager is that he guesses the amount of potential buyers or sellers wrong and set the wrong narrower bid and ask prices. E.g. he could buy a lot of lawn mowers at $70, but there are much fewer buyers willing to buy at $90. He would have to reduce his offer price to $85, $80, $75, $65, or $60 to really get the buyers going. As you can see his profit margin erodes and eventually turns into a loss.