Securities: Introduction to Financial Markets

Financial Markets

Types of Markets

Direct Search Markets

A direct search market is the least organized market. Buyers and sellers must seek each other out directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller advertises for buyers in a local newspaper or on Craigslist. Such markets are characterized by sporadic participation and low-priced and nonstandard goods. Firms would find it difficult to profit by specializing in such an environment.

Brokered Markets

The next level of organization is a brokered market. In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to help them conduct the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market.

Notice that the primary market, where new issues of securities are offered to the public, is an example of a brokered market. In the primary market, investment bankers who market a firm’s securities to the public act as brokers; they seek investors to purchase securities directly from the issuing corporation.

Dealer Markets

When trading activity in a particular type of asset increases, dealer markets arise. Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”) prices are a source of profit. Dealer markets save traders on search costs because market participants can easily look up the prices at which they can buy from or sell to dealers. A fair amount of market activity is required before dealing in a market is an attractive source of income. Most bonds trade in over-the-counter dealer markets.

Roughly 35,000 securities trade on the over-the-counter or OTC market. Thousands of brokers register with the SEC as security dealers. Dealers quote prices at which they are willing to buy or sell securities. A broker then executes a trade by contacting a dealer listing an attractive quote.

Before 1971, all OTC quotations were recorded manually and published daily on so-called pink sheets. In 1971, the National Association of Securities Dealers introduced its Automatic Quotations System, or NASDAQ, to link brokers and dealers in a computer network where price quotes could be displayed and revised. Dealers could use the network to display the bid price at which they were willing to purchase a security and the ask price at which they were willing to sell. The difference in these prices, the bid–ask spread, was the source of the dealer’s profit. Brokers representing clients could examine quotes over the computer network, contact the dealer with the best quote, and execute a trade.

As originally organized, NASDAQ was more of a price-quotation system than a trading system. While brokers could survey bid and ask prices across the network of dealers in the search for the best trading opportunity, actual trades required direct negotiation (often over the phone) between the investor’s broker and the dealer in the security. However, as we will see, NASDAQ is no longer a mere price quotation system. While dealers still post bid and ask prices over the network, what is now called the NASDAQ Stock Market allows for electronic execution of trades, and the vast majority of trades are executed electronically.

Auction Markets

The most integrated market is an auction market, in which all traders converge at one place (either physically or “electronically”) to buy or sell an asset. The New York Stock Exchange (NYSE) is an example of an auction market. An advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save the bid–ask spread.

Notice that both over-the-counter dealer markets and stock exchanges are secondary markets. They are organized for investors to trade existing securities among themselves.

Electronic Communication Networks (ECNs)

Electronic communication networks allow participants to post market and limit orders over computer networks. The limit-order book is available to all participants. An example of such an order book from NYSE Arca, one of the leading ECNs, appears in Figure 3.4. Orders that can be “crossed,” that is, matched against another order, are done automatically without requiring the intervention of a broker. For example, an order to buy a share at a price of $50 or lower will be immediately executed if there is an outstanding ask price of $50. Therefore, ECNs are true trading systems, not merely price-quotation systems.

ECNs offer several attractions. Direct crossing of trades without using a broker-dealer system eliminates the bid–ask spread that otherwise would be incurred. Instead, trades are automatically crossed at a modest cost, typically less than a penny per share. ECNs are attractive as well because of the speed with which a trade can be executed. Finally, these systems offer investors considerable anonymity in their trades.

Specialist Markets

Specialist systems have been largely replaced by electronic communication networks, but as recently as a decade ago, they were still a dominant form of market organization for trading in stocks. In these systems, exchanges such as the NYSE assign responsibility for managing the trading in each security to a specialist. Brokers wishing to buy or sell shares for their clients direct the trade to the specialist’s post on the floor of the exchange. While each security is assigned to only one specialist, each specialist firm makes a market in many securities. The specialist maintains the limit order book of all outstanding unexecuted limit orders. When orders can be executed at market prices, the specialist executes, or “crosses,” the trade. The highest outstanding bid price and the lowest outstanding ask price “win” the trade.

Specialists are also mandated to maintain a “fair and orderly” market when the book of limit buy and sell orders is so thin that the spread between the highest bid price and lowest ask price becomes too wide. In this case, the specialist firm would be expected to offer to buy and sell shares from its own inventory at a narrower bid-ask spread. In this role, the specialist serves as a dealer in the stock and provides liquidity to other traders. In this context, liquidity providers are those who stand willing to buy securities from or sell securities to other traders.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.