Section 2.4. Key Concepts: Liquidity

We've seen that the buy-side refers to those that manage investments and the sell-side refers to those that provide services to the buy-side. Obvious questions are:

• The term "buy-side" suggests that the buy-side is buying something. What is it that the buy-side is buying?
• The term "sell-side" suggests that the sell-side is selling something. What is it that the sell-side is selling?

One might superficially suspect that the term "buy-side" is used because the buy-side is buying investments while the term "sell-side" is used because the sell-side is selling investments. But this is not the root of the terms "buy-side" and "sell-side." After all, an investment manager does not only buy investments - investment managers will engage in transactions to either buy or sell, depending on their views regarding the appropriate composition of their portfolios. Hence we are left with our question: What is it that the buy-side is buying and the sell-side is selling?

The answer is as follows: The buy-side is buying liquidity and the sell-side is selling liquidity.

What is liquidity? Liquidity refer to the ease with which one can trade. Hence, a trading opportunity with more liquidity refers to a trading opportunity that can be more easily executed. "Ease" can refer to the speed with which trading takes place; the cost of trading; and/or the size of trades that can be executed.

For example, a stock can be bought or sold on the New York Stock Exchange (NYSE) in under a single second. Further, the cost of buying or selling the stock is very low, and it is possible to buy or sell many shares. Hence NYSE stock trading is characterized as highly liquid. Conversely, to buy or sell a home often takes months; requires high broker fees; and finding an appropriate home is often difficult. Because it is not easy to engage in a real estate transaction, real estate transactions are characterized as illiquid.

A buy-side entity manages investments. While the formation of investment ideas is a central role of the buy-side entity, it is crucial for the buy-side entity to be able to easily implement its trading ideas before the opportunity is lost. Hence a buy-side entity is willing to pay fees for services that make it easy for it to trade - i.e., the buy-side buys liquidity.

A sell-side entity provide services to the buy-side. While there are many services provided by the sell-side to the buy-side, the commonality is that these services make it easy for the buy-side to trade. A sell-side entity receives fees and other compensation for the services it provides. In other words, the sell-side sells liquidity.

Question:

The sell-side is

1) selling liquidty

2) a provider of services to the buy-side

3) not an investment manager

4) all of the above