Learning Objective
1.4.1 Know the main characteristics of order-driven markets and quote-driven markets and the differences between principal trading and agent trading, and on-exchange and over-the-counter
Secondary markets, as stated above, are those that permit the trading of securities already issued. This trading is conducted through trading systems broadly categorised as either one of the following: quote-driven; and order-driven.
4.1.1 Key Features of Order-Driven and Quote-Driven Markets
An order-driven market is one that employs either an electronic order book, such as the London Stock Exchange (LSE)’s SETS, or an auction process, such as that on the NYSE floor, to match buyers with sellers. In both cases, buyers and sellers are matched in strict chronological order by price and the quantity of shares being traded and do not require market makers.
The key features of order-driven markets are:
• Buyers and sellers will each use a broker who will act on their behalf as agent.
• The broker’s role is to find a matching buyer for his client’s shares or vice versa and to obtain best execution for the client.
• The broker will charge commission for arranging the deal.
• This trade takes place on the floor of an exchange or via a computerised trading system.
• The price for the trade will be governed by demand and supply and so can be affected by large orders which can move the price, although computerised trading systems can hide part of a large order and allow it to be placed in smaller amounts.
To operate effectively, an order-driven market needs good liquidity, otherwise there will be problems with filling orders and pricing.
By contrast, quote-driven trading systems employ market makers, to provide continuous two-way, or bid and offer (buy and sell) prices during the trading day, in particular securities regardless of market conditions. Market makers make a profit, or turn, via this price spread.
The key features of a quote-driven system are:
• Liquidity is provided by a market maker.
• The market maker is required to buy and sell securities under all market conditions.
• Market makers quote a price for buying and for selling and make their profits through the difference at which they buy and sell.
• Buyers and sellers will use a broker, as with order-driven markets, who will act as their agent. The broker will execute the trade, however, with the market maker that is offering the best price. The broker will charge the client a commission for executing the trade.
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Although they are outdated in many respects, many practitioners argue that quote-driven systems provide liquidity to the market when trading would otherwise dry up. The NASDAQ-OMX is an example of a quote-driven equity trading system.The following examples detail how both an order-driven and quote-driven system operate on the LSE.
4.1.2 Order-Driven System
SETS is an order-based system for all the large UK company shares. SETS stands for Stock Exchange Electronic Trading Service and is used to trade the nearly 1,000 shares that are contained within the FTSE All Share Index.
It combines electronic order-driven trading with integrated market maker liquidity provision, delivering guaranteed two-way prices for the most liquid and international securities.
In this system, LSE member firms (investment banks and brokers) input orders. These orders may be for the member firms themselves or for clients. The clients might be pension funds, insurance companies or private clients.
Very simply, the way the system operates is that these orders will be added to the ‘buy queue’ or the
‘sell queue’, or executed immediately. Investors who add their order to the relevant queue are prepared to hold out for the price they want. Those seeking immediate execution will trade against the queue of buyers (if they are selling) or against the sellers’ queue (if they are buying).
For a liquid stock like Vodafone there will be a deep order book – lots of orders waiting to be dealt on either side. The top of the queues might look like this:
Buy Queue Sell Queue
We will buy for at least We will sell for at least
7,000 shares £1.24 3,550 shares £1.25
5,150 shares £1.23 1,984 shares (2) £1.26
19,250 shares (1) £1.22 75,397 shares (2) £1.26
44,000 shares (1) £1.22 17,300 shares £1.27
Queue priority is given on the basis of price, and then time.
So, for the orders noted (1), the order to buy 19,250 shares must have been placed before the 44,000 order – hence its position higher up the queue. Similarly, for the orders noted (2), the order to sell 1,984 shares must have been input before the order to sell 75,397 shares.
4.1.3 Quote-Driven System
SEAQ is an acronym for Stock Exchange Automated Quotation system. It is a quote-driven system used for fixed income stocks and some Alternative Investment Market (AIM) shares which are smaller companies that are not traded as frequently.
Each stock has a page, and on that page LSE member firms display, if they wish, the prices and quantities at which they are willing to deal – their quoted prices. The prices at which they are willing to buy are known as the bid prices and the prices at which they are willing to sell as the offer prices.
The SEAQ screens can be thought of as advertisements of prices and quantities. Deals are done when a member firm reacts to the advertised prices and contacts the market maker by telephone. The market maker has to honour the prices and quantities that they are displaying on SEAQ – the market maker’s quotes are firm to other member firms.
4.1.4 Principal and Agent Trading
When a client wishes to place an order, the broker firm it deals with may act on an agency or principal basis when it executes the trade. First, it can act as principal. If it does so, when the client places an order with it to sell shares it will execute this order against its own trading book and, in doing so, will ensure that the client receives best execution, eg, a better price than currently offered in the market.
It holds shares in a trading book and will use those holdings to meet orders from clients to buy and sell shares and in so doing it hopes to make a profit on the difference between what it buys and sells at. Firms acting in this way are also described as dealers or broker-dealers and are stock exchange member firms that have chosen to trade as a principal.
Secondly, a firm can act as agent, arranging deals for others and making money by charging a commission on the deal. This agency role is commonly described as acting as a broker. Brokers arrange deals. They receive orders to buy and sell equities on behalf of their clients, and find matches for the trades that their clients want to make.
4.1.5 On-Exchange and Over-the-Counter Trading
Although many trades take place on a stock exchange, not all do so, as there are times when the size of the order or the type of instrument means that it might instead be negotiated separately between two market counterparties. On-exchange transactions are conducted through stock exchanges such as the LSE or the NYSE. Stock exchanges supervise the market to ensure that it operates efficiently and fairly and provides a safe business environment for customers. Obligations such as best execution require members to deal at the best available price and act in the best interests of their customers.
Off-exchange transactions take place outside the confines of a stock exchange, where there may be a greater degree of flexibility on offer. This is known as over-the-counter (OTC) trading. Bonds are typically traded on the OTC market, as the size of the order and the relative lack of liquidity mean that the market can operate more effectively by seeking out a counterparty to deal with.
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1 4.2 Stock Exchanges and Trading Systems
Learning Objective
1.4.2 Know the principal features of the following stock exchanges and their equity trading systems: US; UK; Euronext; Germany; Spain; Athens; Middle East; Asia; Australia
Stock exchanges used to operate from a physical marketplace and catered mainly for the needs of domestic investors and domestic issuers. Many were national monopolies that operated as not-for-profit organisations, and were bureaucratic and resistant to change. More recently, however, the challenges posed by competing trading systems and the globalisation of financial markets have forced exchanges to become increasingly price-sensitive and to invest heavily in the latest trading technology.
Mutual ownership has been abandoned in favour of stock exchanges becoming listed companies, and a series of strategic mergers and alliances are creating exchanges that operate throughout the world.
As electronic trading networks and trading have gathered pace, financial markets are becoming increasingly integrated, and this is reflected in the number of companies that, instead of listing only on their domestic exchange, will also list on overseas exchanges that best reflect the global distribution and capital requirements of their business.
In effect, a global capital market has been created through the globalisation of markets and economies.
Below is a brief review of some of the world’s stock exchanges. (Note: at the time of writing there are a number of proposals being pursued that may see some of the exchanges mentioned below merge and their names potentially change.)
Location Exchange Details
US New York Stock
Exchange
The NYSE trades in a continuous auction format – that is, member firms act as auctioneers in an ‘open outcry’ auction market environment in order to bring buyers and sellers together and to manage the actual auction. This makes it unique in world stock markets but, as more than 50% of its order flow is now delivered to the floor electronically, it is effectively a hybrid structure, combining elements of open outcry and electronic markets.
NASDAQ Although it is an electronic exchange, many of the trades on NASDAQ are still undertaken through market makers who make a book in specific stocks so that, when a broker wants to purchase shares, they do so directly from the market maker.
UK London Stock
Exchange
Highly liquid shares are traded using the SETS (Stock Exchange Trading Service) automated system on an order-driven basis. For securities that trade less regularly, market makers are involved to keep the shares liquid. These market makers are required to provide bid and ask prices for the shares of the particular companies, ensuring that there is always a market for the stock.
Location Exchange Details
Europe NYSE Euronext NYSE Euronext is a cross-border exchange that operates equity, bond and derivative markets in Belgium, France, the UK (derivatives only), the Netherlands and Portugal. It has recently been the subject of a takeover bid from the derivatives exchange operator InterContinental Exchange (ICE). It is an order-driven market, and cash instruments are traded via a harmonised order book so that all listed stocks from the five NYSE Euronext European countries are included on a single trading platform that operates in the same way in each country.
Germany Deutsche Börse Deutsche Börse is the main German exchange operator. Xetra is Deutsche Börse’s electronic trading system for the cash market and matches buy and sell orders from licensed traders in a central, fully electronic order book.
Spain Bolsas y Mercados Españoles (BME)
BME is the company that integrates all the securities markets and financial systems in Spain. It is made up of the Madrid, Barcelona, Bilbao and Valencia stock exchanges, and the clearing and settlement institution, Iberclear. Its electronic trading platform (SIBE) is an automated electronic trading system.
Greece Athens Stock Exchange (ATHEX)
ATHEX (or ASE) is the main stock exchange in Greece, while screen-based trading in futures and options is available through the Athens Derivatives Exchange. Stocks and bonds are traded through the fully computerised OASIS system. ATHEX has more than 20 indices and introduced the FTSE Med 100 Index in 2003, a joint index involving ATHEX, the Tel Aviv Stock Exchange and the Cyprus Exchange.
Middle East
Saudi Arabia The Saudi Stock Exchange or Tadawul is the largest exchange in the Middle East. It has an integrated trading and settlement system which is order-driven and under which same-day settlement is achieved.
Japan Tokyo Stock Exchange (TSE)
The TSE uses an electronic, continuous auction system of trading. This means that brokers place orders online and, when a buy and sell price match, the trade is automatically executed. Deals are made directly between buyer and seller, rather than through a market maker.
Hong Kong Hong Kong Stock Exchange (HKSE)
The HKSE is one of the larger stock exchanges in the world. The Hang Seng Index consists of the largest companies traded on the exchange. The exchange is an integrated securities and derivatives exchange. The Hong Kong stock market also is perceived to offer a stable method for international investors to participate in the industrial evolution of China. Restrictions exist on foreign investment in the television sector, and no single investor may hold more than 5% of HKSE’s shares without approval from the Securities and Futures Commission.
China Shanghai Stock Exchange (SSE)
The SSE is the largest exchange in China. It trades stocks, bonds, and funds. There are two types of shares traded: A shares, which are priced in the local renminbi yuan currency, and B shares, which are quoted in US dollars. The SSE has a modern trading system where orders are matched automatically.
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The Indian stock market supports 23 stock exchanges. The National Stock Exchange (NSE) and the Stock Exchange Mumbai (formerly the Bombay Stock Exchange) account for the majority share of India’s exchange-traded turnover. All Indian stock markets now offer screen-based electronic trading. NSE also provides a formal trading platform for trading of a wide range of debt securities, including government securities.
Singapore Singapore Exchange Limited (SGX)
SGX was formed in 1999 following the merger of the Stock Exchange of Singapore (SES) and the Singapore International Monetary Exchange (SIMEX), the derivatives market. Shares are mainly traded in board lots of 1,000 shares, although the trading of odd lots is also allowed. Workstations installed at brokers’ offices are linked directly to the exchange’s computer system. Orders are routed to the central trade matching engine, known as the Central Limit Order Book.
Australia Australian Securities Exchange (ASX)
Trading is all-electronic and the major market index is the S&P/ASX 200, made up of the top 200 shares in the ASX. Specific restrictions exist on foreign ownership in a range of sectors, and a foreign investor may not own more than 15% of any one company.