What it means
In a quote-driven market, the key players are market makers, firms that publish a bid (the price at which they will buy) and an ask (the price at which they will sell) for a security. Investors who want to trade simply accept one of those prices.
The market maker holds the securities in its own inventory, so it takes on the risk of holding them until they are sold on. The market maker earns money from the bid-ask spread, which is the gap between the two prices.
If a dealer buys at $24.90 and sells at $25.10, it keeps $0.20 per share each time it completes both sides. In return it provides liquidity, meaning that investors can trade quickly without waiting for a matching counterparty.
This design contrasts with an order-driven market, where buyers and sellers submit orders to a central book and prices emerge from matching those orders. Many stock exchanges are order-driven, while foreign exchange and corporate bond markets are largely quote-driven.
Some markets blend both, with a book for small orders and dealers for large ones. Quote-driven markets suit assets that trade infrequently or in large sizes, since dealers can take big blocks onto their own books.
They can also work well in volatile periods, because a dealer is obliged to keep quoting. The cost is that spreads can be wide for less popular securities, and prices may be less transparent than in a public order book.
For a business, the practical point is to compare quotes from more than one dealer. A treasurer buying currency or a company issuing bonds can ask several banks for prices and choose the best.
The difference between dealers can be significant, especially on large trades. Dealers manage their risk by adjusting quotes as their inventory changes.
A dealer that has bought too much will lower its prices to attract buyers, and one that is short will raise them. This is why quotes can differ between dealers at the same moment.
In practice
Real-world examples.
Example
A company treasurer needs to convert $3,000,000 into euros and phones three banks. Each gives a quote, and the best one is 0.05% better than the worst, saving $1,500. The treasurer executes the trade with the winning bank.
Example
A pension fund wants to sell a large block of corporate bonds that rarely trade. It asks dealers for bids, and one agrees to buy the whole block at a discount to the last price. The fund accepts, because finding individual buyers would take weeks.
Example
A small investor places an order for a thinly traded share through an online broker. The broker routes it to a market maker who fills it at the displayed ask price. The investor notices that the buying price is higher than the selling price.
Formula
Calculation
Dealer gross profit = number of shares traded x (ask price - bid price)
Suppose a market maker quotes a bid of $24.90 and an ask of $25.10 for a share. During the day it buys 10,000 shares from sellers and sells 10,000 shares to buyers.
Step 1: spread = $25.10 - $24.90 = $0.20.
Step 2: gross profit = 10,000 x $0.20 = $2,000.
Check: it paid 10,000 x $24.90 = $249,000 and received 10,000 x $25.10 = $251,000, a difference of $2,000. This is before costs and the risk of price moves while holding inventory.Case study
Seen in the real world.
Alder Treasury Services is a fictional corporate advisory firm used for illustration. A client, a mid-sized exporter, was always converting foreign currency through its single relationship bank. The adviser showed that currency is a quote-driven market, and that comparing dealers could reduce costs.
In this illustrative story, the client began requesting quotes from three banks for each large conversion. Over a year, the improvement in prices saved about 0.04% on $50,000,000 of conversions, or $20,000. The client's finance team kept a simple log of quotes to prove best execution to its auditors.
Watch out
Common mistakes.
- Assuming there is one single price in a quote-driven market. Different dealers can quote different prices at the same moment.
- Ignoring the spread. The gap between bid and ask is a cost of trading.
- Using one dealer for every trade. Comparing quotes can save real money, especially on large transactions.
Questions
People also ask.
What is the difference between quote-driven and order-driven markets?
A quote-driven market uses dealers who post prices, while an order-driven market matches buyers' and sellers' orders directly.
Who are market makers?
They are firms that post bids and asks and stand ready to trade, earning the spread for providing liquidity.
Which markets are quote-driven?
Foreign exchange, many bond markets and some share markets rely mainly on dealers' quotes.
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