Trading Mechanisms

What are Trading Mechanisms?

Trading mechanisms refer to the logistics behind trading assets and securities, regardless of the type of market. These markets can be exchanges, dealers or OTC markets. The mechanisms are the operations by which buyers of an asset are matched with sellers.

There are two main types of trading mechanisms:

• Order driven markets
• Quote driven markets

Trading Mechanisms: Quote Driven

In a quote driven market, continuous prices or “quotes” are provided to buyers and sellers. These prices are provided by market makers, which mean these types of systems are better suited for dealer or OTC markets. For a buyer, the price provided is the price a dealer is willing to sell at. For a seller, the price provided is the price a dealer is willing to buy at. Typically, the quoted buy price will be lower than the sell price. The spread is the profit that the market maker, the dealer, makes.

Trading Mechanisms: Order Driven

In an order driven market, buyers and sellers of assets are able to place orders for assets they wish to purchase or sell. They can list at market price, which executes a market order instantaneously at the best available price. Alternatively, they can list a fixed/limit price, which executes either a limit or stop order, not to be executed until certain pricing conditions are met.

In an order driven market, counterparties are not necessarily available immediately, depending on the listed price. Because this is so, order driven trading mechanisms are more suited for exchanges. Orders will execute once a suitable counterparty is found for each buyer or seller. In other words, a buy order will only execute if a seller is found who is willing to sell at the specified limit price.

Order driven trading mechanisms are often supported by an order book.

Order Book

An order book is the system or database that operates behind an order driven trading mechanism. The book lists all buyers and sellers, as well as their intended bid or ask prices.

In the above shown order book, we see sell orders listed in ascending order and buy orders listed in descending order, sorted by list price. Orders in an order driven trading mechanism execute when the lowest sell order and the highest buy order match, or exceed each other. In the case of the Ethereum order book above (courtesy of CEX.io), no order will execute as the lowest sell order price is higher than the highest buy order price.

Order books will typically continue updating as new orders are added in real-time.

Disadvantages of the Order Driven Market

As demonstrated by the order book above, the order driven style of trading mechanisms will have lower liquidity than the quote driven market. In a quote driven market, a market maker is always readily available to sell or buy, as long as the trader is willing to meet the slightly higher premiums of quoted price. In an order driven market, trades can stagnate if buyers are not willing to meet seller prices, or vice versa.

Because of this automated matching system, order driven market trading mechanisms are most suitable for assets that are frequently traded and naturally very liquid. These markets include stocks, options, bonds and some currencies, among others.

Trading Mechanisms: Order Types

In order driven trading mechanisms, there are several different order types that a trader can take advantage of. These are briefly described above, but are further described in one of our other articles.

The presence of the real-time order book allows traders to take advantage of limit and stop pricing that will not fulfill until their conditions are met. This differs from market pricing, which executes immediately, and may be unfavorable for traders.

Trading Mechanisms: Order Timing

Additionally, order driven trading mechanisms allow traders to specify the shelf life of a specific order. Orders, for example, can be kept indefinitely until executed, set to last only a day, or set to last until a specific time.

The Bottom Line

Knowing the different trading mechanisms is important know-how for traders. Understanding the game allows the trader to play it better. Certain markets, for example, will use algorithms in conjunction with order driven markets, and knowing this will allow a trader to make the most out of their trades. As such, knowing the difference between the quote and order driven trading mechanisms is definitely profitable information.

More Resources:

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Direct Market Access (DMA)
• Equities Trader
• ECM
• Not-Held Order
• Payoff Graphs vs Profit & Loss Diagrams
• See all capital markets resources
• See all wealth management resources