Quote-driven, Order-driven, and Brokered Markets

Quote-Driven Markets/Over-the-Counter (OTC) Markets

In quote-driven markets, customers trade at prices quoted by dealers that generally work for commercial banks, investments banks, broker-dealers, or trading houses. Most trades in these markets are conducted through proprietary computer communications networks or by phone.

Order-Driven Markets

Order-driven markets arrange trades using rules to match buy orders to sell orders submitted by customers or dealers. Almost all exchanges use order-driven trading systems, and every automated trading system is an order-driven system. Two sets of rules characterize order-driven market mechanisms: order matching rules, which match buy and sell orders, and trade pricing rules, which determine the price of the matched trades.

Order Matching Rules

Order-driven trading systems rank buy and sell orders by price (often along with secondary criteria), matching the highest-ranking orders (if possible) at the minimum order amount. If there is remaining size in a buy (sell) order, the trading system will match it with the sell (buy) order that is next in the rankings. The first rule in the order precedence hierarchy is price priority, followed by secondary precedence rules, which determine how to rank orders of the same price. The first order to arrive at the best price usually has priority over other orders, though sometimes trading systems trade displayed quantities before hidden quantities of the same price.

Trade Pricing Rules

Call markets commonly use the uniform pricing rule, in which all trades execute at the same price and the market chooses the price that maximizes quantity traded. Continuous trading markets use the discriminatory pricing rule, which determines the price base on the limit price of the first order or quote (the standing order). Crossing networks, trading systems matching buyers and sellers willing to trade at prices obtained from other markets, use the derivative pricing rule: usually the midpoint of the best bid and ask quotes for the underlying asset.

Brokered Market

Brokers arrange trades among their clients for unique instruments with limited liquidity as such instruments would not generate enough orders in order-driven markets. Trades in this market usually take place between a small number of people or institutions.

Question

What market would an art collector use to sell a number of valuable paintings?

A. Quote-driven market

B. Order-driven market

C. Brokered market

Solution

The correct answer is C.

Since there would not be enough liquidity for unique art pieces to have a quote-driven or order-driven market, the paintings would need to be sold in a brokered market.

Reading 44 LOS 44j:

Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.

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