How to trade in dealer markets, broker markets and exchanges
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A dealer market operates with a dealer that acts as a counterparty for both buyers and sellers. The dealer sets bid and asks prices for the security in question, and will trade with any investor willing to accept those prices. Securities sold by dealers are sometimes known as traded over-the-counter (OTC).
In doing so, the dealer provides liquidity in the market at the cost of a small premium. In other words, dealers will often set bid prices lower than the market and ask prices higher. The spread between these prices is the profit the dealer makes. In return, the dealer assumes counterparty risk.
Dealer markets are less common in stocks, but more common in bonds and currency. Dealer markets are also appropriate for futures and options, or other standardized contracts and derivatives. Finally, the foreign exchange market is usually operated through dealers, with banks and currency exchanges acting as the dealer intermediary.
Of the three types of markets, the dealer market is usually the most liquid.
A broker market operates by finding a counterparty to both buyers and sellers. When dealers act as the counterparty, the delay with brokers finding an appropriate counterparty results in less liquidity in brokered markets.
Traditionally, stock markets were brokered. Stockbrokers would try to find an appropriate counterparty for their client on the trading floor. This is the stereotypical image that Wall Street used to be known for, with men and women in suits yelling at each other while holding pieces of paper noting their clients’ orders.
Broker markets are used for all manner of securities, especially those with initial issues. An IPO, for example, will usually be launched through an investment bank, who brokers the issue trying to find subscribers. This is also similar for new bond issues. Finally, brokered markets are also appropriate for tailored or custom products.
Of the three types of markets, the exchange is the most automated, however, if no buyers and sellers are able to meet in terms of price, no trades execute.
The stock market is no longer a brokered market, having transitioned to being an automated exchange. Trades are executed based on order books that match buyers with sellers.
The advantage of the exchange is the provision of a central location for buyers and sellers to find their own counterparties. Exchanges are automated, requiring no broker or dealer intermediary.
Exchanges are most appropriate for standardized securities. These include stocks, bonds, futures, contracts, and options. Exchanges will typically specify characteristics for the securities traded on the exchange.
Contract or Lot Size
Contract Execution/Trading Months
Delivery terms and quality are not common in stock exchanges or bond exchanges. In a stock exchange, all that is stated is the contract and tick size, as well as the execution. Execution is mostly immediate. Contract sizes may require a minimum. For example, a stock may only be purchased in lots of 100 on a certain exchange. Tick size is commonly the lowest denomination of a currency. In US stock exchanges, the lowest tick in price is a cent. A contract tick size under this arrangement would then be $1 ($0.01 x 100 shares per lot).
Delivery terms and quality are more appropriately used in commodity exchanges, and with derivatives involving assets that have these characteristics. Gold and diamonds, for example, have qualities and ratings. Additionally, the physical asset has to be in a form deliverable to the buyer or contract holder. These characteristics are specified by the exchange.
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