What it means
Securities markets are often described in four tiers. The first market is the main stock exchange, the second is the over-the-counter market for unlisted securities, the third is over-the-counter trading in exchange-listed shares by non-members, and the fourth is institution-to-institution trading that bypasses brokers altogether.
The numbering reflects history rather than rank. Large investors have a particular problem.
A pension fund selling five million shares on an exchange can push the price down simply by showing its hand, so it pays in a worse price as well as in commission. Trading directly with another institution that wants the other side of the deal avoids the exposure.
The trades take place on electronic systems that match buyers and sellers, often anonymously. Prices are normally taken from the exchange's current quote, such as the midpoint between the best bid and the best offer, so the parties pay no spread to a market maker.
This is why the fourth market can be significantly cheaper for big orders. There are drawbacks.
Because trades happen away from public exchanges, they are less visible to the wider market, and regulators monitor them to make sure other investors are treated fairly. Liquidity is also limited, as a match will only occur if another institution wants the opposite trade at the same time.
For a non-specialist, the point to understand is that not all trading happens on the exchanges shown on the news. A large share of institutional volume is routed through private systems.
This is part of why companies talk about the fragmentation of markets. Fund managers choose between the fourth market and conventional trading according to urgency.
If an order can wait for a counterparty to appear, a private network is often cheaper, while an urgent order is usually better sent to the exchange. Trading desks therefore combine both routes in the same day.
In practice
Real-world examples.
Example
A pension fund wants to sell $50,000,000 of a mid-sized company's shares. It uses a private matching system to find an insurance company that wants to buy. The two institutions trade at the exchange midpoint and avoid moving the quoted price.
Example
An asset manager rebalances a portfolio and needs to buy several large blocks. The trading desk sends the orders to an electronic network that anonymously matches orders from other institutions. The firm reports that it has cut its dealing costs by more than half. The head of trading tells the investment committee that the remaining orders, which needed immediate execution, still went through the exchange.
Example
A regulator reviews the share of volume traded away from the main exchanges. It asks whether the growth of private networks has harmed transparency for smaller investors, and requires them to report the trades after completion. The review concludes that the networks bring lower costs for pension savers, as long as the reporting rules are kept strong.
Formula
Calculation
Saving from direct trading = Trade value x (Broker cost rate - Direct trading cost rate)
Suppose a pension fund sells $20,000,000 of shares. Using a broker on an exchange costs 0.10% in commission, which is 20,000,000 x 0.0010 = $20,000, plus an estimated price impact of 0.15%, or $30,000. The total cost is $50,000.
On the fourth market the fund pays a system fee of 0.02%, which is 20,000,000 x 0.0002 = $4,000, and has no price impact because the trade is matched at the prevailing midpoint. The saving is 50,000 - 4,000 = $46,000.Case study
Seen in the real world.
Granite Pensions is a fictional pension fund with a $2,000,000,000 portfolio. Its trading head, Helen, noticed that the fund was losing about 0.25% on every large share sale because of commission and price impact.
She moved a portion of the fund's trading to a private matching network. On annual turnover of $400,000,000 the saving of 0.20 percentage points was worth 400,000,000 x 0.0020 = $800,000 a year, which accrued to the members.
In this illustrative example, Helen also noted limits. About a third of the orders never found a match and had to be returned to the exchange, so she used the network for patient orders and the exchange for urgent ones. Her trading report also showed that the fund's average cost per trade fell steadily over the year as the matching network attracted more institutions. In this illustrative example the board approved a permanent policy to route at least a third of eligible orders through such systems.
Watch out
Common mistakes.
- Thinking the fourth market is open to individual investors, when it is largely restricted to large institutions.
- Assuming the prices are secret or arbitrary, when they are normally derived from the public exchange quote.
- Confusing the fourth market with the third market, which involves brokers dealing in listed shares outside the exchange.
Questions
People also ask.
Why do institutions use the fourth market?
They want to trade large blocks cheaply, without paying broker fees or moving the price against themselves.
Is the fourth market legal and regulated?
Yes, in most countries it is, although trades are subject to reporting and fair-treatment rules set by the market regulator.
Does the fourth market affect ordinary investors?
Indirectly, because it can reduce the visible trading volume on exchanges, though it also reduces costs for pension funds and other institutions that invest on behalf of ordinary savers.
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