The global securities market has been constantly evolving over the years to serve the needs of traders. Traders require markets that are liquid, with minimal transaction and delay costs, in addition to transparency and assured completion of the transaction. Based on these core requirements, a handful of securities market structures have become the dominant trade execution structures in the world. In this article, we'll take a look at some of the most popular market structures currently in use.
TUTORIAL: Brokers And Online Trading
Also called dealer markets, quote-driven markets are those in which the buyers and sellers engage in transactions with market makers, or dealers. The market makers post the bid and ask quotes for an inventory of stocks that they are willing to buy from, and sell to traders. Only certain dealers are allowed to perform the market making function and in return, they receive privileges, such as the right to post quotes, the ability to get information on the order flow and book, and generally lower or no fees paid to the exchanges.
Quote-driven markets are common in over-the-counter (OTC) markets such as bond markets, the forex market and some equity markets. The Nasdaq and London SEAQ are two examples of equity markets that have their roots as a quote-driven market. It should be noted that the Nasdaq structure also contains aspects of an order driven market.
The advantages of a quote driven market are typically best seen in illiquid markets. In securities that are thinly traded (low volume), dealers can step in to improve liquidity for traders, by maintaining an inventory of the security. In exchange for providing this liquidity, dealers make money from the spread between the bid and ask quotes. To generate profits, dealers will attempt to buy low (at the bid) and sell high (at the ask) and have high turnover.
Order Driven Markets
Another major dominant market structure type is an order driven market. In this type of market, the exchange matches buyers and sellers with each other and there is no middle man, like there is with quote driven markets. Price discovery is determined by the limit order of traders in the particular security. Most order-driven markets are based on an auction process, where buyers are looking for the lowest prices and sellers are looking for the highest prices. A match between these two parties results in a trade execution.
The biggest benefit of an order driven market in liquid markets, is the large number of traders willing to buy and sell the security. Generally, the larger the number of traders in a market, the more competitive the prices become; this theoretically translates into better prices for traders. The downside to this type of market is that in securities with few traders, the liquidity can be poor. An example of an order-driven market is the Toronto Stock Exchange (TSX), in Canada.
In addition, there are two main types of order driven markets, a call auction and a continuous auction market. In a call auction market, orders are collected during the day and at specified times an auction takes place, to determine the price. On the other hand, a continuous market, as the name suggests, operates continuously during trading hours and trades are executed whenever a buy and sell order match up. (For additional reading, check out: What Is The Difference Between A Quote Driven Market And An Order Driven One?)
A third popular market structure, a category in which the New York Stock Exchange (NYSE) falls in, is the hybrid market, also known as a mixed market structure. The hybrid market combines features from both a quote-driven market and an order driven market. Although dominantly an order driven market that matches buyers and sellers, the NYSE also utilizes dealers to provide liquidity, in the event of low liquidity periods. In addition to being a hybrid market, the NYSE is also a continuous auction market.
The last market structure we'll look at in this article is the brokered market. In this market, brokers are the middle men who find counterparties for trades. When a client asks their broker to fill an order, the broker will search their network for a suitable trading partner. Often, brokered markets are only used for securities that have no public market, these are generally unique or illiquid securities, or both. Common uses of the brokered markets are for large block trades in bonds or illiquid stocks. (To know more about broker, read: What Is The Difference Between A Broker And A Market Maker?)
The direct real estate market is also a good example of a brokered market. This market contains assets that are relatively unique and illiquid. Clients generally require the assistance of real estate brokers to find buyers for their home. In these types of markets, a dealer wouldn't be able to hold an inventory of the asset, like in a quote-driven market, and the illiquidity and low frequency of transactions in the market would make an order-driven market infeasible, as well.
The Bottom Line
There are different types of market structures simply because traders have different needs. The type of market structure can be very important in determining overall transaction costs of a large trade and can affect the profitability of a trade. In addition, if you are developing trading strategies, sometimes the strategy may not work well across all market structures. Knowledge of these different market structures can help you determine the best market for your trades. (For additional reading, take a look at The NYSE And NASDAQ: How They Work.)