Market Structures: Quote-Driven vs Order-Driven Markets (Chapter 5)
Not all markets work the same way. The rules, the systems, and the structure of a market determine who can trade, what information they can see, and who actually makes money. Chapter 5 of “Trading and Exchanges” lays out a framework for understanding market structures. And once you understand this framework, you can look at any market in the world and quickly figure out how it works.
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Why Market Structure Matters
Market structure is power. It determines what people can know and what they can do. The trading strategies that work brilliantly in one market might be totally useless in another. If you trade in multiple markets and you don’t understand how each one is structured, you’re flying blind.
Here’s the practical takeaway: your best order submission strategy depends on the structure of the market you’re trading in. So understanding structure isn’t abstract theory. It’s a prerequisite for trading well.
Trading Sessions: Continuous vs Call Markets
Markets organize trading into sessions. There are two basic types.
In continuous markets, you can try to trade anytime the market is open. Most major stock, bond, futures, options, and forex markets work this way. Trading is “continuous” in the sense that traders can always attempt to arrange trades, though in practice most trades happen when someone demands liquidity.
In call markets, everyone trades at the same time when the market is “called.” Think of it like an auction with a fixed end time. All the bids and offers get collected, then everything gets matched at once. Government bond auctions work this way. Some stock exchanges use calls for their least active securities.
Many continuous markets actually use both. They open with a call auction, switch to continuous trading, and sometimes use calls to restart trading after a halt. The opening auction helps establish fair prices by concentrating everyone’s attention at the same time.
The advantage of call markets is that they focus all buyers and sellers on the same place at the same time, making it easy to find counterparties. The advantage of continuous markets is that you can trade whenever you want without waiting for the next call.
The Three Execution Systems
This is the core of market structure. Every market uses one of three basic execution systems, or some combination of them.
Quote-Driven (Dealer) Markets
In a quote-driven market, dealers are at the center of everything. Anyone who wants to trade must trade with a dealer. Buyers can’t trade directly with sellers. Instead, both sides trade through dealer intermediaries.
Dealers quote the prices at which they’ll buy and sell. They profit from the spread between their bid and ask prices. Harris makes a fun comparison: sports bookies are essentially dealers. They maintain a “balanced book” and profit from the vigorish (the spread). A typical football point spread bet has a vigorish of 1 dollar for every 10 bet.
Most bond and currency markets are quote-driven. The old Nasdaq was a classic dealer market. These markets tend to be informal networks where dealers communicate with clients by phone. The key thing to know: dealers choose their customers. They avoid traders who seem well-informed because those traders tend to win, and the dealers tend to lose.
Order-Driven Markets
In order-driven markets, buyers and sellers trade directly with each other. The market has formal trading rules: order precedence rules determine who trades with whom, and trade pricing rules determine the price.
These are essentially auction markets. The rules formalize how buyers seek low prices and sellers seek high prices. This process reveals the prices that best match supply and demand, which economists call price discovery.
Dealers can trade in order-driven markets too, but they trade on equal terms with everyone else. They can’t pick and choose their counterparties.
Order-driven markets include everything from open-outcry futures pits to electronic stock exchanges. Almost all major futures exchanges and most stock exchanges around the world are order-driven.
Brokered Markets
In brokered markets, brokers actively search for counterparties. This is different from order-driven markets where traders post public orders, and from dealer markets where dealers always stand ready to trade.
Brokered markets exist where items are unique, where dealers won’t hold inventory, and where nobody wants to post public orders. Think large block trades in stocks and bonds, real estate, and mergers and acquisitions. The broker’s special skill is knowing who might want to trade and presenting opportunities to them.
There are two types of liquidity providers in brokered markets. Concealed traders know they want to trade but won’t expose orders publicly. Latent traders don’t even know they want to trade until a broker presents them with an attractive opportunity.
Hybrid Markets
Most real-world markets are hybrids. The NYSE is primarily order-driven but requires specialist dealers to provide liquidity when nobody else will. The old Nasdaq was primarily quote-driven but required dealers to display public limit orders. Both markets also had brokers arranging large block trades. So most markets blend elements of all three systems.
Market Information: What You Can and Can’t See
A market’s information systems determine who knows what and when they know it. This matters enormously.
Transparent markets quickly report complete information to the public. Opaque markets keep traders in the dark. There are two types of transparency: pre-trade (can you see current orders and quotes?) and post-trade (can you see completed trades?).
U.S. equity and equity options markets are quite transparent. U.S. futures markets are post-trade transparent but not really pre-trade transparent because in oral auctions, quotes don’t stand long enough to be reported. Over-the-counter bond markets are generally opaque.
Here’s an interesting tension: traders want to see what others are doing, but they don’t want others to see what they’re doing. Those who know the least about market conditions tend to favor more transparency. Those who know the most prefer opacity because they don’t want to give up their informational edge.
As Harris puts it: “The first half of market information is much more important than the second half.” Being able to see just a little of what’s going on is hugely valuable to someone who would otherwise be completely in the dark.
Order Routing: Getting Your Order to the Market
How orders travel from trader to broker to exchange matters. Speed and accuracy are everything. The strategies you can profitably use depend heavily on the order-routing systems available to you. Short-term, high-frequency strategies require submitting and canceling orders quickly and reliably.
Electronic order-routing systems are faster, more accurate, and cheaper than phones and runners. But they can only handle standardized orders. For special instructions, traders still pick up the phone.
Floor traders historically had a huge advantage over off-floor traders because they could see and react to market developments much faster. Even with electronic systems, there are delays of several seconds for off-floor traders. Those seconds can be worth a lot of money.
Order Books: Where Secrets Are Kept
Order books hold all the open orders that haven’t been filled yet. They’re incredibly valuable because they reveal the conditions under which traders are willing to trade. Knowing what other traders intend to do can help you trade ahead of them profitably.
Open book markets show the full book to all traders. Closed book markets keep it hidden. There’s a real tension here. Markets work best when traders submit standing limit orders to the book, but many traders don’t want others to see their orders. Some exchanges let traders submit hidden orders to balance these competing interests.
Telecommunications Changed Everything
Every major innovation in communications technology has reshaped markets. Before the telegraph, every city had its own exchange and prices for the same thing could differ wildly across regions. The telegraph let traders see prices elsewhere and send orders to wherever the best deals were. Markets that got a reputation for being liquid attracted more orders and got even more liquid. Smaller markets started failing.
This consolidation process continues today. Each new technology increases competition among traders and leads to further market consolidation. Electronic trading systems now dominate, and physically convened markets with traders yelling at each other are increasingly rare.
So Which Structure Is Best?
Harris doesn’t give a simple answer, and for good reason. The best structure depends on the instrument, why people want to trade it, and what technologies are available. The great diversity in existing market structures suggests there’s no one-size-fits-all solution.
But understanding these structures lets you make informed decisions about where to trade, how to trade, and what strategies will work. And that understanding starts with knowing the three execution systems, the two types of trading sessions, and the role that information plays in all of it.
This post is part of a series on Larry Harris’s “Trading and Exchanges: Market Microstructure for Practitioners” (Oxford University Press, 2003). Chapter 5 covers market structures.