45.j: Quote-driven, order-driven, and brokered markets
Trading sessions
Markets are classified as call markets if the trades can be arranged when the markets are called at specific time and place. In continuous markets, on the other hand, trades can be arranged at any time when the market is open.
Key characteristics:
• Call markets:
o Easy to find buyer/seller as all the traders are present at the same place/time
o Very liquid when called but illiquid at other times
o Uses single price auction to match buyer/seller. All the orders are consolidated and the price set such that the volume of trade is maximum
• Continuous markets:
o Trade can be executed anytime
o Execution may be an issue if both buyer/seller aren’t present at the same time/place
Execution mechanism:
1. Quote-driven markets are markets where traders use prices quoted by dealers who work for investment banks, commercial banks etc. They are also called over the counter (OTC) markets as trades are often settled at the dealers’ office. Except for stocks, it is the most common platform for the trading world over and is used for trading currencies, commodities, and bonds. Dealers drive liquidity in these markets. Orders can be placed over the phone, proprietary computer systems, messaging apps etc.
2. Order driven markets work on matching buy-sell orders mechanism. The orders are placed by an investor or dealer on an automated trading system. The key concern here is the settlement of trades since trades happen between strangers. In these markets, traders supply liquidity to each other. The two key rules of such a system are:
a. Order matching rules which match the buy orders to sell orders and rank the buy/sell orders on price criteria and often along secondary criteria as well. The order precedence hierarchy decides which orders are placed first. The highest priced buy order and the lowest priced sell order are the ones on top. Secondary precedence rules decide the ranking of similarly priced orders and are generally based on the timing of order i.e. earlier placed order will take precedence over an order at the same price but at a later time. Similarly, display orders get precedence over hidden orders.
b. Trade pricing rules: once order matching is done, the system uses pricing rules to determine the trade price. The most commonly used pricing rules are:
i. Uniform pricing rule chooses the price that maximizes the traded quantity. Call markets generally use it.
ii. Discriminatory pricing rule chooses the price of the order that arrived first (i.e. standing order). This allows large traders to discriminate the current standing orders by first filling the most aggressive (highest buy/lowest sell) bid first and then going on to less aggressive bids at generally less favorable term. Continuous markets generally use this system.
iii. Derivative pricing rule uses the price from another market to settle trades. Crossing networks use this pricing rule and are defined as systems that match buyer/seller who are willing to use prices from other markets.
3. Brokered markets are used for expensive and less liquid assets. The broker organizes buyer/seller meet in such markets. Real estate, a large block of shares, art, etc are some examples of assets traded on such markets.
Example 7
The order book for a company Galactico looks like this:
Buyer
Bid size
Limit price ($)
Bid size
Seller
A
8
10.1
B
10
10.3
C
6
10.4
10.5
5
D
10.7
2
E
10.9
10
F
John, a trader, places a bid to buy 10 contracts at $10.8.
a. How many orders placed by John will be filled/executed?
b. What will be his average buy price?
c. What will the order book look like once John’s order has been filled?
Solution:
a) John’s order at $10.8 will first fill the most aggressive sell bid at $10.5 of 5 lots by trader D, then the next bid by trader E at $10.7 for 2 lots. The bid by trader F at $10.9 being higher than John’s bid will not be executed. Hence, John will be able to buy 5+2=7 lots. He will have 3 orders (10-7) left for execution.
b) Average buy price for John = [5*10.5+2*10.7]/(5+2)= $10.56
c) The order book after John’s order execution will look like this:
Buyer
Bid size
Limit price ($)
Bid size
Seller
A
8
10.1
B
10
10.3
C
6
10.4
John
3
10.8
10.9
10
F
Market information system: Market transparency is driven by the trade data that a market publishes to public. Traders call a market pre-trade transparent if real-time data on quotes/orders is available. Post-trade market transparency, on the other hand, is when post-trade data on price/size is made available.
Bid-ask spread and transaction costs tend to be higher in less transparent markets.
Dealers prefer less transparent markets as they can exploit their knowledge of available trades while traders prefer more transparent markets to get more information available deals, transaction costs etc.
Check your concepts:
(45.26) Which of the following pricing rules is most likely to be used by the call markets?
(45.27) Which of the following statements is most accurate for the market transparency?
(a) Dealers prefer more transparent markets and traders prefer less transparent markets
(b) Dealers prefer less transparent markets and traders prefer more transparent markets
(c) Both dealers and traders prefer more transparent markets
Solutions:
(45.26) Correct Answer is A: Call markets generally uses uniform pricing rule i.e. all the trades happen at the same price.
(45.27) Correct Answer is B: Dealers prefer less transparent markets as they can exploit their knowledge of available trades while traders prefer more transparent markets to get more information available deals, transaction costs etc.
Exam Alert: Candidates should understand the differences between call markets and continuous markets. They should also be comfortable with quote-driven and order-driven markets. It is a highly testable area in the exam.
CFA Institute does not endorse, promote or warrant the accuracy or quality of products and services offered by Konvexity. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
