Let’s suppose there is a trader, whom we’ll call “Trader X”. Trader X wishes to take a very large position on a bunch of related and correlated financial instruments. But Trader X has a problem. The size of the trade he wants to make is large relative to ordinary turnover in the asset. The market would almost surely move against him before he executed more than a fraction of his trades. Market-makers are very sensitive to the balance of order flow. If Trader X starts calling dealers and executing trades, they would observe one-sided flow and quickly adjust the price until trades on the other side were attracted and the flow returned to balance. This “adverse price action” would significantly reduce the profitability and increase the risk of X’s trade. It would also reveal his information or belief about future price movement to the market, enhancing market efficiency perhaps, but reducing his edge.
Bank Y considers for a moment, and comes up with an idea. “Suppose we start a little investment company up, something like a mutual fund devoted to the kind of positions you want to trade. Since you want to take a ’short’ position, we’ll find a manager enthusiastic about the prospects of the ‘long’ side and help him start this little fund. There are lots of reputable money managers in the world, with a wide variety of views, so we can find somebody excited and capable of running this fund. We have lots of connections among investors, and we are in the business of drumming up interest in new investment vehicles, so there’s a reasonable chance we’ll find people to fund the strategy at a scale large enough to match your trade. Once we do, there will be a natural buyer of what you want to sell, and you can enter the market without impacting prices. In fact, since both you and this fund will use us as market makers, we’ll just cross the trades internally at prevailing prices, and neither you nor the fund will have to worry about adverse price action.”