What is a “locked” market?

A “locked” market is trader parlance where there is no difference between a “bid” and an “offer”. Most securities trade at a spread, which is the difference between a “bid” and an “offer”, to enable a market-maker to earn the difference for engaging in the transaction. Naturally then, “bids” are lower than “offers” – in terms of price – to enable a dealer or market maker to buy a security at the “bid” price and sell it immediately at the “offer” price. The more liquid the market, it follows that the difference between the “bid” and the “offer” would shrink to reflect the lower risk of “carrying” a security past the market-maker’s bid, and before it is almost instantaneously sold. Therefore, it is common to see shrinking spreads between “bids” and “offers” in Treasury securities, large cap equities and the like. Similarly, larger spreads are common in riskier, less-liquid securities like high yield, distressed etc.

The ultimate shrinkage of spreads to zero is reflected in a “locked” market, where the “bid” and “offer” level is identical. “Locked” markets, by their very definition, are temporary because there is always a “spread”– or cost to make a market– regardless of whether the “spread” reflects risk or pays for fixed costs (like rent or electricity) or variable costs like tickets or electronic trails. A “spread” needs to exist purely to compensate market-makers for these costs, and to earn a profit. Also; more interestingly, “locked” markets can happen anywhere, in liquid markets like AA paper and even in riskier, illiquid sectors like EM or high yield.

The question then becomes: why would a market-maker offer a “locked” market? The answer is: to right-size his inventory, or position to a desired level. For example, dealer A is too long on some bank paper–say the 2s of 2015 issued by “Best Farmers Bank–and wishes to downsize that position by half. Let’s say the “Best Farmer’s” trade at 100-100.1 in price (bid-offer). Dealer A would “lock” himself at the bid side (100) or even slightly lower, like 99.99. At this price–say 100–he is willing to buy more “Best Farmer’s” or sell. He is now the cheapest “offer” on the security, and he should naturally be engaged to sell this paper, bringing his inventory naturally down to his desired level. But alternately, he may be engaged to buy more of this paper (not his desired direction); but even in this case, he should be able to unload this new paper back at 100 since other dealers are bidding similarly in the market.

In a reverse of the above, let’s say Dealer B is short these “Best Farmer’s” and is nervous about his shortage and wants to cover his position. He would “lock” himself at the “offer” side (100.1) and thus become the “best” bid for the paper, thereby covering his shortage.

So then, this begs the question: why can’t dealers just improve their bids or offers since that should get them the same result, given the superior levels? Well, we then come to the final appeal of “locked” market- advertising! When a “locked” market is broadcast, participants stop everything to notice the “locked” market. It is rare, and an opportunity to trade at the best levels (depending on the counter position), and it signals whether the dealer is long or short that security. In short, a lot of information travels in a “lock” and a lot more eyeballs are observing the “lock” than they are observing regular markets. This market attention and higher probable execution is the main reason why a dealer “locks” himself.

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