WHAT IS a 'Smart Market'

Smart market refers to a type of auction in which transactions take place among a pool of participants, rather than bilaterally between one buyer and one seller. The definition of smart market includes modern systems for exchanging stocks, futures and options across multiple exchanges, as well as systems used to trade anything from petrochemicals to electric power.

These systems are designed to reduce transaction costs and the effect of externalities, and typically deploy a market manager to monitor trading. Smart markets make use of order-routing systems that leverage algorithms and defined rules to speed the matching of buyers and sellers and to automatically search for the best-possible pricing.

BREAKING DOWN 'Smart Market'

Smart markets typically get smarter over time. The first smart markets for equities appeared in the late 1980s, and helped to speed the transactions of large block trades via direct market access. Systems improved markedly in the U.S. by the late 1990s, and began to spread to other markets, then to many European exchanges by the mid-2000s, with a larger and larger percentage of trades conducted with the help of algorithms.

Today, improvements in order routing allow smart equity markets to handle high-frequency, or programmatic trading, as well as the ability to incorporate dark pools. Moreover, they allow for the trading of one security across several different venues, for instance, the same stock that trades on multiple international exchanges.

Participation in a smart market sometimes requires the payment of an upfront fee as well as a per-unit bid.

Private and closed markets also make use of smart-market technology. For example, multiple producers of electric power use algorithms to review the bids of power distributors, taking into account current electricity demand, available storage, and the overall capacity of transmission lines. Calculations then determine how much each power generator should create, the transmission lines that will transfer the power from the generators to specific distributors, and how much power each distributor will process.

Elsewhere, gas-pipeline operators use smart markets to match supply with demand among various large customers and regional markets. Also, governments use smart markets to procure services from multiple contractors.

Pros and Cons of Smart Markets

Over time, smart markets could make their way to even more organizations, helping sports teams determine who is willing to pay the most for playoff games, by airlines to get the highest-possible price per seat, and movie theaters to set variable prices for an afternoon matinee.

The downside is that widespread use of smart markets may introduce unneeded complexity in some situations, customer disappointment in others, and the potential risk of additional system outages. Also, smart markets sometimes raise concerns related to the transparency of information among market participants.

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