As is stated in any book on market microstructure (including the present one!), markets must be organised such that trading is fair and orderly. This means that markets should make the best efforts to be an even playing field for all market participants, and should operate such that prices are as stable as possible. As we emphasised in Chapter 1, market stability relies heavily on the existence of liquidity providers, who efficiently buffer instantaneous fluctuations in supply and demand, and smooth out the trading process. It seems reasonable that these liquidity providers should receive some reward for stabilising markets, since by doing so they expose themselves to the risk of extreme adverse price moves. However, rewarding these liquidity providers too heavily is in direct conflict with the requirement that markets are fair. In summary, if bid–ask spreads are too small, then liquidity providers are not sufficiently incentivised, so liquidity becomes fragile; if bid–ask spreads are too wide, then the costs of trading become unacceptable for other investors.

The rise of electronic-markets with competing venues and platforms is an elegant way to solve this dual problem, through the usual argument of competition. In a situation where all market participants can act either as liquidity providers or as liquidity takers (depending on their preferences and on market conditions), the burden of providing liquidity is shared, and bid–ask spreads should settle around fair values, as dictated by the market. As we saw in Chapter 17, this indeed seems to be the case in most modern liquid markets, such as major stock markets, futures and FX markets, in which the average bid–ask spread and the costs associated with adverse selection offset each other almost exactly.