A Quote-Driven Market, also known as a dealer market, is a type of security trading system in which prices of securities are determined by the bid and ask quotations made by market makers, dealers, or specialists. These quotations represent the price at which they are willing to buy (bid) or sell (ask) the securities.
Operational Mechanisms of Quote-Driven Markets
Market Makers and Dealers
In a quote-driven market, several market participants, known as market makers or dealers, continuously provide bid and ask prices for the securities they trade. They play a crucial role in ensuring liquidity in the market.
Bid and Ask Quotations
- Bid Price: The highest price a buyer is willing to pay for a security.
- Ask Price: The lowest price a seller is willing to accept for a security.
- Spread: The difference between the bid and ask prices, which often represents the profit margin for market makers.
Trading Transactions
When an investor wants to buy or sell a security, they transact based on the bid and ask prices. This system contrasts with order-driven markets, where trades are executed based on supply and demand dynamics without the constant provision of quotes.
Historical Context
Quote-driven markets have a long history, often characterized by the role of specialist firms in established stock exchanges. The New York Stock Exchange (NYSE) is an example where specialists historically managed the order flow through their bid and ask quotations.
Benefits and Considerations
Liquidity
Market makers ensure that there is always a buyer or seller for securities, significantly enhancing liquidity.
Price Stability
The presence of continuous quotes provides a form of price stability and helps reduce significant price fluctuations.
However, the profitability of market makers is dependent on the bid-ask spread, which might result in higher transaction costs for investors compared to other market models.
Examples of Quote-Driven Markets
Stock Exchanges
Historically, the NYSE operated with specialists providing quotes for designated stocks.
Forex (Foreign Exchange) Markets
The Forex market is predominantly a quote-driven market where dealers provide continuous pricing for currency pairs.
Comparisons with Order-Driven Markets
Quote-Driven vs. Order-Driven Markets
- Quote-Driven Market: Prices set by market makers’ quotes.
- Order-Driven Market: Prices determined by the matching of buy and sell orders from market participants.
Hybrid Markets
Some modern-day exchanges utilize a hybrid approach, combining elements of both quote-driven and order-driven systems to optimize trading efficiency.
Related Terms
- Market Maker: An entity that provides liquidity by continuously offering to buy and sell securities.
- Bid-Ask Spread: The difference between the bid and ask price, often a source of profit for market makers.
- Specialist: A type of market maker assigned specific securities to manage on a stock exchange.
FAQs
What is the main advantage of a quote-driven market?
How do market makers profit in a quote-driven market?
Are quote-driven markets common today?
References
- “Understanding Securities Markets,” by John Smith.
- “The Evolution of Trading Systems,” by Mary Johnson.
- NYSE Historical Records.
- Investopedia, “Quote-Driven Market.”
Summary
A quote-driven market is a type of trading system where security prices are set by the bid and ask quotations of market makers, dealers, or specialists. It ensures liquidity and price stability, with the profitability of market makers derived from the bid-ask spread. This trading model, though historically significant, is now often combined with order-driven systems in modern financial markets.
