Financial Education

Global securities markets are organized into a number of different structures.

Quote Driven (Dealer) Markets

These markets rely on dealers to provide liquidity by establishing firm prices at which securities can be bought or sold. The dealers will buy securities for inventory at a specified offer price and sell securities from inventory (or short) at a specified ask price. The dealers’ benefit for providing liquidity is the difference between the bid and ask prices (the bid-ask spread).

Dealer bid and ask prices are subject to a limit on the number of shares offered (bid or ask size). In effect, the bid and ask are limit orders placed by the dealer. If multiple dealers are placing orders, it is not necessary for the same dealer to have the best bid and the best ask. Consider the following dealer order book:

Dealer C is offering the best bid for shares at $100.05. Any sell orders will go to dealer C. Dealer D is offering the best ask price at $100.15 and will fill any market buy orders. Although Dealer B is willing to accept the smallest spread, he is not offering the best price at either the bid or the ask and will only fill orders that exceed the bid and ask sizes offered by dealers C and D.

The inside quote is the best bid from any dealer and the best ask by any dealer. The spread for the inside quote will be less than or equal to the smallest bid-ask spread for a given dealer.

Order Driven Markets

In order driven markets, transaction prices are established by  public limit orders and there is no intermediation by designated dealers. The lack of dealers could have different types of impact on order prices:

• Competition could be higher because there are more public participants than there would be dealers. This is often true of highly liquid securities.
• Competition could be lower because there are no dealers who are required to fill orders by taking in or drawing down inventory. This can be the case for less liquid securities.

Current trends favor order-driven markets, including:

• Electronic crossing networks that batch orders together and cross them at a specific time. The fulfillment price will be the price at which the most shares can be traded - all buy orders with prices above the trading price are matched with the sell orders below that trading price. When trading on such networks there is no price discovery - the price at execution is not known until there is execution.
• Auction markets in which orders compete for execution. Since the orders are visible there is price discovery. Auction markets can be batch markets or continuous auction markets.
• Automated auctions operate continuously and offer price discovery. Execution is based on a set of rules.

Brokered Markets

The broker is an agent of the buy side trader who collects a commission in exchange for skillful execution of the trade. Particularly when a trade involves blocks of illiquid securities, a broker may be useful for finding a natural counterparty. In some cases the broker may put its own capital at risk and take the other side of the order, hoping to find various parties willing to accept parts of the order at a later time. Brokers may also be useful in providing a reputational screen - offering the trade only to parties that will not try to trade in front of it.

Hybrid Markets

Many markets operate as a combination of the types listed above. For example, the New York Stock Exchange batches orders for market-on-open and market-on-close execution using a batch auction process. During the day, trading is accommodated using a continuous auction process. This consists of both order-driven quotes that do not reach a dealer and dealer-driven quotes offered by the specialists.

For more information, see all articles on: Active Management, Institutional Investing, Investing in Stocks, Portfolio Management, Security Selection, Trading Execution

See also:

Secondary Capital Markets

Call Markets

Primary Capital Markets

Types of Risk in Equity Portfolio Management

Bid-Ask Spreads: Effective versus Quoted