What Is Pre-Arranged Trading?

Pre-arranged trading can refer to trading that takes place at specified prices, that were mutually agreed to, before execution. Conditional orders generally rely on the concept of pre-arranged prices which allow an investor to set a specified price for execution on an exchange. Over-the-counter (OTC) orders are also pre-arranged in most cases.

Key Takeaways

  • Pre-arranged trading is where counterparties to a market transaction specify the price and terms of the trade in advance.
  • Conditional orders generally rely on the concept of pre-arranged prices which allow an investor to set a specified price for execution on an exchange. 
  • Pre-arranged trading is common practice in over-the-counter (OTC) markets and with some block orders.
  • Pre-arranged trading is illegal when it involves the exchange of securities by market makers at pre-arranged prices.

Understanding Pre-Arranged Trading

Pre-arranged trading can help an investor to specify a price to execute a trade in the open market. Conditional orders are broadly based on the concept of pre-arranged trading, allowing an investor to manage their risk by designating specific prices for buying and selling. Block orders are also pre-arranged in many cases and may be crossed on regional exchanges or electronic crossing networks without breaking any rules.

The pre-arranged trading of stocks, futures, options, and commodities among market makers is illegal. Most stock exchanges also have rules about pre-arranged trading and, in the commodities market, the Commodity Exchange Act expressly prohibits it.

Across all types of market exchanges, orders are executed based on a bid-ask process that relies on market makers to match buyers and sellers. Market makers include a wide range of entities as well as trading systems. Investors can place a variety of different types of orders on a variety of different securities available for trading. If an order, whether it's a market or limit order, is executed it will be done through the bid-ask process facilitated by a market maker.

Illegal Pre-Arranged Trading

Pre-arranged trading is illegal when it involves the exchange of securities by market makers at pre-arranged prices. Market makers work to facilitate the orderly exchange of securities available for trading on the open market. They match buyers with sellers and profit from the spread on the trade.

Exchange rules such as NYSE Rule 78 and certain laws such as the Commodity Exchange Act prohibit these market makers from collusively exchanging securities among each other. Trading rules find this practice to create an unorderly and unfair market for brokers, traders, investors, and any other market participants. Moreover, these trades also are not exposed to the market pricing and market risks associated with standard security exchange trades.

Examples of this type of trading among market makers in the equity market may include an offer to sell coupled with an offer to buy back. Inversely, a market maker could arrange a buy order coupled with an offer to sell to another market maker at the same price or some other pre-arranged price that benefits the dealers engaging in the pre-arranged trading.

In a commodities market example, two commodity dealers could potentially use pre-arranged trading to execute risk-free trades at set prices rather than at market prices. This type of illegal trade would limit risk and potentially be profitable for the dealers involved. However, since it is not based on market maker pricing factors, it inhibits the market and available market prices for other participants.