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Trading driver: order or quote
Secondary financial markets are driven by one of two different types of trading: order and quote (see Figure 13.)
Order-driven markets are where clients place orders with their broker-dealers and the latter execute the order on the market. The orders may be:
• market orders
• limit orders
• day orders
• good-until-cancelled orders, etc.
The etc. is added because many financial markets have different types of orders or different terms for the main ones mentioned here.
Figure 13: organization of spot financial markets (4)
Market orders (also known as at-best orders) are those that are placed with broker-dealers with the request that the broker-dealer executes the deal at the best current market price. The client is banking on the broker-dealer's intimacy with the market to execute when s/he thinks the price is "best".
Limit orders are buy orders (sell orders) where the client states a price or price-range below (above) the current price; the broker-dealer executes when the price falls (rises) to the limit price / range.
Variations on market and limit orders are day orders and good-until-cancelled orders. Day orders are where the order is live until the end of the day. Good-until-cancelled orders are live until the client cancels them.
Quote-driven markets are also called primary dealer markets or professional markets or market-made markets. Essentially this means that certain participants (usually the large investment / merchant banks) quote firm buying and selling rates / prices simultaneously and the client is permitted to deal on either side of the quote. Issuers appoint market makers, as in the case of government bond issues (called primary dealers).
It will have been noted that up to this point we have used the terms broker-dealers (plural) and brokerdealer (singular). The reason is that there exist brokers, which can be defined as members of exchanges that execute deals on behalf of clients, dealers, which may be defined as members of exchanges and banks that deal for own account, and market makers (usually the banks) that operate as explained above. The latter two we refer to as dealers for the sake of simplicity, and to all three as broker-dealers. The term also encompasses the brokers who may act as dealers at times and the dealers and market makers who also act as brokers (on behalf of clients) in certain deals or markets.
Figure 14: organization of spot financial markets (5)
As seen in the expanded illustration (see Figure 14), there are essentially four types of trading systems:
• Floor trading.
• Telephone-screen trading.
• Screen-telephone trading.
• Automated trading [on an automated trading system (ATS).
Floor trading involves the physical presence of broker-dealers (i.e. members of the exchanges) in a large room (a room has a floor) and they cry out (also called open-outcry trading) or hand signal (in case of some derivative markets) the orders they have from their clients (or their own orders in the case of dealers) to other members in the hope that their orders match those of the other members. Orders are amended in the case of market orders until orders are matched.
Floor trading usually implies an order-driven market (in which dual capacity trading is allowed), and a formalized market - because rules of trading and behaviour by members are required to make the market credible.
Telephone-screen trading is where negotiation by broker-dealers of deals takes place over the telephone, and where a screen (communications system such as Bloomberg's / Reuters) is used to advertise prices / rates. Deals are consummated on the telephone. The screen prices / rates are usually indication rates, i.e. not binding. This trading system implies that the relevant market is an OTC market, but this market may also be formal.
Screen-telephone trading involves the advertising by broker-dealers of firm prices / rates for specified maximum amounts of securities on an internal trading system or a communications system, and the deals are also consummated on the telephone. Quite often the trading system is used to communicate deals struck to a clearinghouse (within an agreed period of time), meaning that this type of trading system is used in exchange-driven markets and that the trading is quote driven.
The automated trading system (ATS) is an internal electronic system (only available to the members, but not always so) where all orders of clients (indicating an order-driven market) are placed in the central order book of the ATS by the member broker-dealers and the system matches the orders when they coincide in price. Orders are price-time prioritized, and may be partly fulfilled. ATS systems are usually found in exchange-driven markets.
Trading form: single and dual capacity
Trading in dual capacity or single capacity (see Figure 15) was covered earlier under different terminology. Single capacity means that a broker-dealer deals only as a broker on behalf of clients or as a principal for own account (but not both). Dual capacity means that the exchange member or broker-dealer at a bank in the case of the informal markets trades as both a broker and a dealer for own account (which may be called an agency versus principal problem)}8 In exchange-driven markets there are usually strict rules in this respect - a client's order must always be executed first. Strict surveillance by the exchange ensures this.
Figure 15: organization of spot financial markets (6)