Introduction

In financial markets, there are many structures within which agents can trade. It is essential to understand two types of structures: quote-driven markets and order-driven markets. A quote-driven market and an order-driven market are two examples of market structure. These structures dictate the ways you will buy and sell assets. Assets can be stocks, commodities or derivatives, among others. Understanding what a quote-driven market or an order-driven market is and what the implications are of each can help you better navigate the trading and broking landscape. Let's explore these markets, their mechanisms, and how they impact your trades.

Understanding Market Structures

When we refer to market structure, we are interested in how buyers and sellers interact based on the landscape that outlines the number of buyers and sellers. The number of competitors in the transactional space, and the number of buyers and sellers entering and leaving the market at any given time. In India, two markets have trading activity on a market scale: commodities and stocks. You must consider multiple locations that may lead to price discovery in a place with many exchanges and brands. Whether you are trading gold futures or equities, quote-driven or order-driven means something to your strategy, costs, and execution speed.

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What Is a Quote-Driven Market?

In a quote-driven market, a market maker (dealer) provides both a bid (purchase) price and an ask (sale) price on an asset. Here, you are buying or selling (fulfilling) your order from the dealer's inventory - they fulfill your order as the middle-person - the market maker provides liquidity even on assets that are not traded frequently. An example of a quote-driven market is, say, you were doing over-the-counter (OTC) contracts for crude oil. The dealer states a price for you to purchase at ₹ 5000 (bid) and a price to sell at ₹ 5050 per barrel (ask). You are dealing directly with the dealer; the dealer's profit comes from the bid-ask spread (in this case, ₹ 50). These markets are often seen in OTC trading of commodities such as oil, physicals such as metals, or any other asset with an identifiable large lot size that produces a liquidity issue.

What is an Order-Driven Market?

In an order-driven market, buyers and sellers (yourself) submit orders directly into a centralized order book. In an order-driven market, the order specifies the price and number of units you want to trade.  The market aggregates - or matches - with supply/demand on your order, say on India's MCX. Otherwise, you put in a buy order for 100 grams of Gold at ₹6000. This order will find a seller who placed an order at the same/lower price level. This process, as seen on synthetic exchanges such as NSE, MCX, etc., is suitable for transparency, but it can sometimes create liquidity problems if there are no matching buy/sell orders to narrow the bid/ask spread.

Key Differences Between Quote-Driven and Order-Driven Markets

Price Discovery

In a quote-driven market, price discovery is personalised or decentralised. The market maker will give a bid and ask price based on the market maker's "flexible" assessment of fair value. The trade is then done at the quoted prices. In an order-driven market, these same buy/sell prices are built at the exchange level from the order book and set prices that reflect buyer demand and seller supply, immediately in real-time. For example, on NSE, the price of a stock is constantly going up and down based on real-time orders being matched.

Transparency

The order-driven market can have greater transparency, as you will see through the liquidity and market depth associated with bidding and asking prices and quantities. This transparency and greater agent-of-budget show you what the market looks like, allowing a better decision-making process. In a quote-driven market, you only respond to whoever the dealer quoted prices; hence, you may not necessarily be exposed to a full market set of operations (including aggregating all perspectives), where transparency may be reduced.

Liquidity

While quote-driven markets are generally better than order-driven regarding liquidity, they rely on the market maker fulfilling your orders from its inventory (which is easier with illiquid assets, like rare metals). However, order-driven markets have liquidity depending on buy orders and sell orders. Therefore, you cannot be sure how quickly you would be able to exit or how wide the bid/offer might be during periods of low liquidity.

Trade executions

You execute trades instantaneously in quote-driven markets since the trade is with the market maker. You must match orders in order-driven markets, which can take longer in illiquid assets or wider spreads.

Costs

Your only cost in a quote-driven market is the bid-ask spread, in which the market maker is profiting. In order-driven markets, you will incur costs for the exchange/brokerage fees that depend on the platform you are using and the size of the trade.

Conclusion

Your objective determines the decision between quote-driven markets and order-driven markets. Quote-driven markets are good if you want liquidity and speed with assets such as OTC commodity contracts. If you wish for transparent pricing and to match the order directly, like MCX or NSE, order-driven markets are good for you, and they are transparent. With support from Motilal Oswal, you can utilise the factors of the above explanation to meet your trading goals and objectives in India's markets.