What it means
In the traditional classification, the first market is the exchange where a security is listed. The second market covers shares that are not listed and trade over the counter, which means directly between dealers rather than on an exchange.
The third market involves listed securities traded off the exchange by firms that are not members of it. Institutions such as pension funds and mutual funds use the third market to trade large blocks of shares.
Trading a big block on the open exchange can push the price against the buyer, but a dealer willing to take the other side may reduce that impact. Dealers can also offer lower commissions than exchange brokers.
The market grew in the 1960s as institutions pushed for lower trading costs, and it forced exchanges to become more competitive. Modern equivalents include off-exchange trading venues and dark pools, which are private platforms that do not display orders publicly.
Today the boundaries between these venues are less clear than the original three-way classification suggested. Regulators require trades in listed securities done off the exchange to be reported, so that the public can see prices and volumes.
The goal is to keep the price-setting process fair even if a large share of volume takes place away from the main exchange. Rules vary by country and change over time.
For a non-specialist, the point is that the same share can trade in several places at once. A fund manager chooses the venue that gives the best combination of price, speed and discretion, which is known as seeking best execution.
The related fourth market describes institutions trading directly with each other, without any dealer or broker in the middle, usually through electronic networks. Together these four labels form a ladder of how trades can be arranged, from the formal exchange to private, direct dealings.
The labels are historical, but they still help explain how trading venues developed.
In practice
Real-world examples.
Example
A pension fund needs to sell 500,000 shares of a large listed company. Placing the order on the exchange could depress the price. The fund asks a third-market dealer to buy the block at an agreed price, which limits the market impact.
Example
A mutual fund manager wants to cut commission costs on a series of trades in listed shares. She routes the orders to a dealer outside the exchange who quotes a competitive price. Over a year, the savings add up to a meaningful improvement in fund returns.
Example
An insurance company sells a large stake in a listed bank through an off-exchange venue that does not show orders publicly. This prevents other traders from spotting the sale and trading ahead of it. The insurer receives a price close to the prevailing market quote.
Case study
Seen in the real world.
Summit Peak Capital is an illustrative, fictional asset manager that needed to sell $30,000,000 of a listed industrial company's shares. The trading head worried that selling on the exchange would signal distress and push the price down.
She contacted two off-exchange dealers and asked each for a quote on the whole block. One dealer offered a price 0.2% below the exchange quote, which was better than the 0.8% impact her team had estimated for selling on the open market.
The illustrative sale saved roughly $180,000 against the estimated cost, and the trade was reported to the market as required. The trading head recorded the comparison in the firm's best-execution file to support its choice of venue. Several months later a client asked why the firm had not simply sold on the exchange. The file showed the two quotes, the estimated market impact and the final price, which answered the question in minutes and strengthened the client's confidence in the firm.
Watch out
Common mistakes.
- Believing the third market deals in unlisted securities, when it actually trades securities that are listed on an exchange.
- Assuming that off-exchange trades are hidden from regulators, when they must be reported under market rules.
- Ignoring execution quality, since the cheapest commission does not always give the best overall price.
Questions
People also ask.
What is the difference between the second and third markets?
The second market trades unlisted securities over the counter, while the third market trades listed securities away from the exchange.
Who uses the third market?
Mostly institutional investors, such as pension funds and asset managers, that trade large blocks.
How does it relate to dark pools?
Dark pools are a modern form of off-exchange trading that fits the spirit of the third market, though they are more complex. They hide orders until a trade is complete, which protects large investors from being front-run by other traders.
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