What is a Quote-Driven Market?

A quote-driven market is a market structure in which investors deal with dealers. Dealers, also known as market makers, quote bids and set the ask price, acting as intermediaries between buyers and sellers.

In a quote-driven market, the market maker facilitates the trade between the buyer and the seller, fulfilling orders from their own inventory. They buy the security from the seller and resell it at a higher price, the difference being the profit.

In this article, we will understand what a quote-driven market is, including its advantages and disadvantages.

What is a Quote-Driven Market?

A quote-driven market works through the dealer, also known as the market maker. We have already established that they quote the bid and set the ask price, and facilitate trades between the buyer and the seller by fulfilling orders through their own inventory.

However, there are a few elements related to this market structure that you must know to understand it better:

• The bid price is the highest price at which the buyer will pay for a security to buy it.
• The ask price is the lowest price at which a seller will accept the sale of an asset.

In this type of market, the dealer provides the liquidity, and after the trade between the buyer and the seller, they generate profit from the bid-ask spread.

Though the presence of a market maker makes a quote-driven market highly liquid, scepticism remains in terms of transparency compared to an order-driven market, as traders do not have access to the order book to view the prices at which an asset is traded.

Special Considerations

There are, however, special considerations where the rules about the function of a quote-driven market can be overridden:

• Traders can accept the price quoted by the dealer or attempt to negotiate for a much more acceptable price through their own agents or brokers.
• Dealers can choose not to trade with a certain trader.
• Traders may encounter situations where they may find more than one dealer for the trade of a specific security; in that case, they can choose their preferred market maker.

Quote-Driven Market in Commodities

Traders can trade commodity-based assets in the commodity markets just like equity-based markets in a quote-driven market.

The dealer in such markets sets the ask price and quotes the bid price, after which the trade between the buyer and the seller is brokered, allowing the former to fulfil the order from their own inventory.

For example, Trader A wants to buy 100 lots of an over-the-counter (OTC) oil contract, and Trader B wants to sell 100 lots of an OTC oil contract. The dealer will now execute the trade by quoting the bid price and setting the ask price.

Let's assume that the dealer quotes a bid of ₹5,000 and an ask price of ₹5,100. Trader B can now sell their 100 lots of the oil contract to the dealer for ₹5,000, after which Trader A can buy the same volume for ₹5,100 from the market maker.

The dealer makes a profit of: (₹5,100 - ₹5,000) x 100 = ₹10,000.

The quote-driven market aims to fulfil trade demands by offering liquidity, which is an essential requirement in the commodities markets.

READ MORE: Square Off Process in the Commodity Market

Advantages of Quote-Driven Market

Given below are some of the advantages of trading in a quote-driven market:

• Offers Liquidity: This market offers liquidity as the dealer fulfils the order from their own inventory. This is highly beneficial for traders in commodity markets, where a large volume of commodities is traded, as one seller may not be able to execute a massive order on their own.
• Price Continuity: The ask price and the bid are set by the dealer, allowing price continuity. A tighter bid-ask spread helps in ensuring liquidity and price discovery, enabling traders to efficiently execute orders at their desired prices.
• Quick Execution: In this market, since the market maker fulfils the order from their own inventory, the order execution is smooth and quick. Once the trader meets the order requirement, the execution happens immediately.

Disadvantages of a Quote-Driven Market

Given below are the disadvantages of trading in a quote-driven market:

• Lack of Transparency: Quote-driven markets are known to lack transparency as traders are unable to view the order volumes and the price at which other traders want to execute their trades. This is unlike the order-driven market, where they can view the order book and trade accordingly.
• Bid-Ask Spread May Widen: Demand and supply may get skewed during periods of low volume, leading to discrepancies in the bid-ask spread. This may result in price volatility and liquidity issues.
• Dealer Concentration: The presence of only one market maker or dealer maximises performance risk. A singular dealer may cause asymmetric trading conditions if they fail to provide liquidity or possess an additional information advantage, which would be unfair to other market players.

Conclusion

A quote-driven market offers higher liquidity and fast execution of orders, especially for large volumes and assets that are illiquid. However, traders entering this market should also be aware of its drawbacks, such as low transparency regarding order books and wider spreads.

Knowing the pros and cons of a quote-driven market can help traders ensure that they make better decisions in alignment with their trading goals.