Linkage: What It is, How It Works, Example

What Is Linkage?

Linkage is the ability to buy a security on one financial exchange and sell that same security on another exchange. Certain depositary receipts, such as American Depositary Receipts (ADRs), allow for linkage, which means that an investor can purchase shares of a company on a foreign exchange, such as the Toronto Stock Exchange, and then sell those shares on a domestic exchange, such as the New York Stock Exchange.

Linkage can also refer to the relationship between formal and informal financial institutions. This relationship allows for financial services to be provided to those in underdeveloped or far to reach places that may otherwise not have the access to important financial services, such as loans.

Understanding Linkage

Linkage can mean buying a security on one exchange and selling it on another exchange. Note, however, that linkage is different from the concept of a dual listing on two exchanges.

ADRs allow investors around the world to buy and sell large international companies' stock. Because a security’s price may be different on various exchanges, an investor might profit by selling the stock for a higher price on one exchange than for which they bought it on another exchange, thus creating an arbitrage opportunity.

Often, when investors engage in linkage, they are in fact seeking an arbitrage situation—profiting from the same stock’s price differential on different exchanges. Arbitrage generally promotes healthy competition among the various exchanges, and this type of linkage has become easier with the advent of electronic exchanges and trading platforms. 

Practical Use of Linkage

Linkage is often used in the Bitcoin (BTC) economy, where arbitrage serves an important function. In BTC trading, individual traders, as well as automated bots, actively scan for price differences between the various Bitcoin exchanges, then buy from one and sell to another exchange if the price disparity ever becomes high enough for the transaction to be profitable.

Linkage can also apply to off-exchange situations, such as in the microfinance space. Here, “linkages” between established (or formal) financial services institutions and less established (or informal) financial institutions combine to provide financial services to those who may otherwise not have the opportunity to receive them.

Formal financial institutions have extensive infrastructures, systems, and access to funds; they are usually far removed from rural or poor clients, which makes it difficult to obtain adequate information, reach these clients, and mitigate their own risks.

In contrast, informal financial institutions operate close to rural clients, possess good information and enforcement abilities; and are typically more flexible and innovative than formal institutions. They, however, do not have the same wide breadth of services or the ability to reach many clients.

The strengths of one complement the weaknesses of the other, which enables the linked institutions to offer millions of unserviced people the opportunity to receive financial services, such as loans, transfers, savings instruments, and more, through the linked relationship between established and less established financial institutions.

Example of Linkage

The stock of company ABC is trading at $200 on the New York Stock Exchange (NYSE) and at the same moment, it is selling for $200.75 on the Tokyo Stock Exchange (TSE). A trader can buy the stock for $200 on the NYSE and then sell it for $200.75 on the TSE, earning a profit of $0.75. This may seem like a small profit, but if the trader did it with, say, 2,000 shares, that is a profit of $1,500.

The trader can take advantage of this arbitrage opportunity until the prices meet through the buying and selling of the stock, the specialists at the exchanges adjust their prices so the opportunity is erased, or the inventory of the stock at the NYSE is depleted.