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Quote driven market

What Is Quote Driven Market?

A quote driven market is a type of financial market structure where prices for securities are primarily determined by the bid and ask quotations posted by professional intermediaries known as market makers. This stands in contrast to systems where orders from individual buyers and sellers directly interact to set prices. In a quote driven market, also referred to as a dealer market or price-driven market, investors trade directly with these dealers rather than with other investors. This market structure is a key component of the broader financial market structure, facilitating transactions for a wide range of assets. The market makers maintain an inventory of securities and provide immediate liquidity by continuously standing ready to buy or sell at their quoted prices, profiting from the bid-ask spread between these prices.

History and Origin

The concept of a quote driven market predates modern electronic trading systems, with its roots in the traditional over-the-counter (OTC) trading environment. In the early 20th century, many securities that did not qualify for listing on major exchanges were traded through a network of dealers via telephone and, notably, through the "Pink Sheets," a physical publication that listed bid and ask prices. This manual system was cumbersome, requiring investors to contact multiple dealers to compare prices.

A significant evolution occurred with the founding of NASDAQ in 1971. The Securities and Exchange Commission (SEC) encouraged the National Association of Securities Dealers (NASD), now the Financial Industry Regulatory Authority (FINRA), to automate the over-the-counter (OTC) market. This led to the creation of the National Association of Securities Dealers Automated Quotations, initially a quotation system rather than a direct electronic trading platform. NASDAQ's launch on February 8, 1971, marked the world's first fully electronic stock market, fundamentally transforming how market makers could update and share their bid-ask quotes, thereby automating trading and making market data more widely available8.

Key Takeaways

  • A quote driven market relies on market makers who post bid and ask prices to facilitate trading.
  • Market makers provide liquidity by holding an inventory of securities and are obligated to trade at their quoted prices.
  • The primary revenue for market makers in a quote driven market comes from the bid-ask spread.
  • Commonly used for trading bonds, currencies, and commodities, and historically for many OTC equities.
  • Transparency of individual orders is limited compared to an order-driven market, as only market maker quotes are publicly displayed.

Interpreting the Quote Driven Market

Interpreting a quote driven market involves understanding the role of the broker-dealer and the dynamics of prices set by these intermediaries. Unlike markets where prices are formed directly by matching individual buy and sell orders, a quote driven market's pricing is a reflection of the market makers' willingness to take on inventory risk. The tighter the bid-ask spread offered by market makers, the greater the liquidity and typically the more competitive the market for that security.

Investors interact with a quote driven market by requesting or observing the quoted prices from market makers. They can choose to accept the quoted prices or, especially for larger institutional trades, attempt to negotiate a better price. The presence of multiple competing market makers for a particular security generally leads to narrower spreads and more efficient pricing.

Hypothetical Example

Consider an investor, Sarah, who wants to buy 100 shares of a small biotechnology company, "BioTech Innovations," which trades on an over-the-counter (OTC) quote driven market. Sarah contacts her broker-dealer, who then checks the available quotes from various market makers for BioTech Innovations.

Suppose Market Maker A quotes BioTech Innovations at a bid of $5.00 and an ask of $5.10. Market Maker B quotes a bid of $5.02 and an ask of $5.12. And Market Maker C quotes a bid of $5.01 and an ask of $5.09.

Sarah wants to buy shares, so her broker seeks the lowest ask price. In this scenario, Market Maker C offers the lowest ask price of $5.09. Sarah's order for 100 shares would likely be executed at $5.09 per share with Market Maker C. Market Maker C would sell these shares from its own inventory, aiming to replenish them later at a lower price or having previously bought them at a lower price. This transaction demonstrates how the market maker's posted quote directly facilitates the trade, with the investor accepting the dealer's stated price.

Practical Applications

Quote driven markets are prevalent in several key financial sectors due to their ability to provide continuous liquidity, especially for less frequently traded or specialized securities.

  • Bond Markets: The vast majority of bonds, including corporate, municipal, and government bonds, trade in quote driven markets. This is because bonds are often less liquid than stocks and trade over-the-counter (OTC), relying on a network of broker-dealers to provide quotes and facilitate transactions7.
  • Foreign Exchange (Forex) Markets: The global currency market is a prime example of a quote driven market. Major banks act as market makers, providing continuous bid-ask spread prices for various currency pairs to facilitate international trade and investment6.
  • Commodities and Derivatives Markets (Spot): Many spot commodities and certain types of derivatives are traded in quote driven environments, particularly those that are highly customized or less standardized.
  • Over-the-Counter (OTC) Equities: While NASDAQ transitioned to a hybrid model, traditional OTC equity markets (such as those operated by OTC Markets Group) remain largely quote driven, with market makers displaying their prices for unlisted securities5. Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) establish specific requirements for market maker participation and quotation practices in these markets to ensure fair and orderly trading4.

Limitations and Criticisms

While quote driven markets offer crucial liquidity, they are not without limitations and criticisms. One primary concern is the potential for less transparency compared to order-driven markets. In a quote driven market, investors typically only see the best bid and ask prices from market makers, rather than the full depth of the order book or the prices and quantities of individual orders. This limited visibility can make it challenging for investors to ascertain the true supply and demand dynamics beyond the market maker's quotes.

Another criticism centers on the potential for increased trading costs. Since all trades must go through a market maker, investors invariably pay the bid-ask spread. Even if a matching buy or sell order from another investor exists, direct interaction between public orders is often not facilitated, meaning the spread is always incurred. This can result in higher transaction costs, particularly in less competitive markets or for less liquid securities where spreads may be wider3. Furthermore, because market makers profit from the spread, there is an inherent conflict of interest between their profit motives and potentially achieving the absolute best price for a client, although regulations aim to mitigate this2.

Quote Driven Market vs. Order-Driven Market

The fundamental distinction between a quote driven market and an order-driven market lies in how prices are determined and how trades are executed.

In a quote driven market, prices are set by market makers (also known as dealers or specialists) who continuously post bid (buy) and ask (sell) prices for securities. Investors trade directly with these market makers, who fill orders from their own inventory or by matching them with other orders they facilitate. This structure prioritizes liquidity and guarantees order fulfillment at the quoted prices, as market makers are obligated to honor their quotes. Examples include over-the-counter (OTC) bond markets and foreign exchange markets.

Conversely, an order-driven market, often associated with an auction market structure, operates by displaying all individual buy and sell orders (the "order book") from various participants. Prices are determined by the interaction of these collective bids and offers, with trades occurring when a buyer's bid matches a seller's ask. This system offers greater transparency, showing the full depth of market interest, but does not guarantee immediate execution, as an order might have to wait for a matching counterpart. Major stock exchanges like the New York Stock Exchange (NYSE) primarily operate as order-driven or hybrid markets.

FAQs

What is the primary role of a market maker in a quote driven market?

The primary role of a market maker in a quote driven market is to provide liquidity by continuously posting bid (buy) and ask (sell) prices for securities. They stand ready to buy from sellers and sell to buyers, using their own inventory, thereby facilitating continuous trading and ensuring that investors can always find a counterparty for their trades.

What types of financial instruments are typically traded in quote driven markets?

Quote driven markets are commonly used for financial instruments that may not have extremely high trading volumes or are traded over-the-counter (OTC). These include most bonds, currencies in the foreign exchange market, and many spot commodities and certain types of derivatives1.

How do market makers profit in a quote driven market?

Market makers in a quote driven market primarily profit from the bid-ask spread. This is the difference between the price at which they are willing to buy a security (the bid price) and the price at which they are willing to sell it (the ask price). By buying at the bid and selling at the ask, they earn a small profit on each transaction, multiplied by the volume of trades they facilitate.