Question

Identify the basic types of securities markets and describe their characteristics; describe broker markets and dealer markets and discuss how they differ from alternative trading systems?

Answer 1

Ans. Security Markets are relatively global markets these markets relating upon dealers to provide liquidity by establishing firm prices at which securities can be bought or sold. The markets are

The Primary Market
The primary market refers to the market where new issues (stocks and bonds not sold before) are sold. Investment bankers, acting as underwriters, bring new issues to the market through the primary market. This can be done as either an Initial Public Offering (IPO), when the stock has not previously traded, or as a seasoned offering once the stock has traded but new shares are being added to the market.

The Secondary Market
A secondary market is the market in which assets are traded after they have been sold through the primary market. In this market, investors trade directly with each other through an exchange.

If the secondary market for a stock follows the characteristics we discussed previously, such as liquidity and marketability, and the issuer would like to issue more shares through a seasoned offering, the issuer would have a much easier time selling the new shares in the primary market.

For more on the markets where securities are traded, check out the article, Markets Demystified

Secondary markets for U.S. government/municipal bonds are traded primarily through banks, including investment banks. Treasuries, however, are traded through treasury dealers. Secondary markets for corporate bonds are primarily through the OTC market. In addition to the OTC market, secondary trading for corporate bonds also takes place on the New York Stock Exchange and the American Stock Exchange.


The dealers will buy securities for inventory at a specified offer price and sell securities from inventory (or short) at a specified ask price. The dealers’ benefit for providing liquidity is the difference between the bid and ask prices (the bid-ask spread).
Dealer bid and ask prices are subject to a limit on the number of shares offered (bid or ask size). In effect, the bid and ask are limit orders placed by the dealer. If multiple dealers are placing orders, it is not necessary for the same dealer to have the best bid and the best ask. Consider the following dealer order book:
Dealer C is offering the best bid for shares at $100.10. Any sell orders will go to dealer C. Dealer D is offering the best ask price at $100.25 and will fill any market buy orders. Although Dealer B is willing to accept the smallest spread, he is not offering the best price at either the bid or the ask and will only fill orders that exceed the bid and ask sizes offered by dealers C and D.

The inside quote is the best bid from any dealer and the best ask by any dealer. The spread for the inside quote will be less than or equal to the smallest bid-ask spread for a given dealer.

Order Driven Markets
In order driven markets, transaction prices are established by  public limit orders and there is no intermediation by designated dealers. The lack of dealers could have different types of impact on order prices:

• Competition could be higher because there are more public participants than there would be dealers. This is often true of highly liquid securities.
• Competition could be lower because there are no dealers who are required to fill orders by taking in or drawing down inventory. This can be the case for less liquid securities.

Current trends favour order-driven markets, including:

• Electronic crossing networks that batch orders together and cross them at a specific time. The fulfilment price will be the price at which the most shares can be traded – all buy orders with prices above the trading price are matched with the sell orders below that trading price. When trading on such networks there is no price discovery – the price at execution is not known until there is execution.
• Auction markets in which orders compete for execution. Since the orders are visible there is price discovery. Auction markets can be batch markets or continuous auction markets.
• Automated auctions operate continuously and offer price discovery. Execution is based on a set of rules.

Brokered Markets
The broker is an agent of the buy side trader who collects a commission in exchange for skilful execution of the trade. Particularly when a trade involves blocks of illiquid securities, a broker may be useful for finding a natural counterparty. In some cases the broker may put its own capital at risk and take the other side of the order, hoping to find various parties willing to accept parts of the order at a later time. Brokers may also be useful in providing a reputational screen – offering the trade only to parties that will not try to trade in front of it.
Hybrid Markets
many markets operate as a combination of the types listed above. For example, the New York Stock Exchange batches orders for market-on-open and market-on-close execution using a batch auction process. During the day, trading is accommodated using a continuous auction process. This consists of both order-driven quotes that do not reach a dealer and dealer-driven quotes offered by the specialists.

• Specialists: Specialists are the market makers for stocks, controlling the limit book and posting bid and ask prices.
• Commission Brokers: Commission brokers are employees of a firm that is a member of the exchange. The commission broker buys and sells shares for the clients of its firm.
• Floor Brokers: Floor brokers function much like commission brokers buying and selling shares. Unlike commission brokers who are employees of member firms however, floor brokers are independent and aid commission brokers when they become too busy.
• Registered Traders: Registered traders are members that buy and sell for their own account. They help to provide liquidity. Because they are independent, however, the exchange places limits on how they trade.

A broker is an intermediary who has a license to buy and sell securities on a client's behalf. Stockbrokers coordinate contracts between buyers and sellers, usually for a commission. A market maker, on the other hand, is an intermediary that is willing and ready to buy and sell securities for a profitable price.

A broker makes money by bringing together securities' buyers and sellers. Brokers have the authorization and expertise to buy securities on an investor's behalf - not just anyone is allowed to walk into the New York Stock Exchange and purchase stocks; therefore, investors must hire licensed brokers to do this for them.

A flat fee or percentage-based commission is given to the broker for carrying out a trade and finding the best price for a security. Because brokers are regulated and licensed, they have an obligation to act in the best interests of their clients. Many brokers can also offer advice on what stocks, mutual funds and other securities to buy. Due to the availability of internet-based automated stock brokering systems, clients often do not have any personal contact with their brokerage firms.

A market maker makes a profit by attempting to sell high and buy low. Market makers establish quotes whereby the bid price is set slightly lower than listed prices and the ask price is set slightly higher in order to earn a small margin. Market makers are useful because they are always ready to buy and sell as long as the investor is willing to pay a specific price. This helps to create liquidity and efficiency in the market. Market makers essentially act as wholesalers by buying and selling securities to satisfy the market; the prices they set reflect market supply and demand. When the demand for a security is low and supply is high, the price of the security will be low. If the demand is high and supply is low, the price of the security will be high.