Saturday, August 13, 2011

quote-drive ^ order-driven markets (my take

Many practitioners classify each market into either quote-driven or order-driven.
- Futures, Listed options, listed stocks are Order-Driven.
- FX, Bonds, IRS, CDS are Quote-driven

---- In Quote-Driven markets, dealers (loosely known as "market makers") publish quotes on
- interdealer broker systems
- 3rd-party dealer-to-client markets known as ECN's
- their own private markets (like MLBM or CitiVelocity, or perhaps Rediplus)

Clients can also send RFQ to get customized quotes.

Here's a key feature of the quote -- at execution time, the dealer has a last look and can reject the order. Therefore the quote is an indication, not a legal promise.

FX spot/forward is Quote-driven. In some markets (such as Hotspot), non-dealers can also publish quotes, and probably can reject orders too.

Q: How about limit orders in FX spot market?
A: Remember FX spot is QD. When an ECN lets you (a retail trader) submit a limit order, the ECN will hit/lift the quotes on your behalf but still the dealer has the last look.

---- In Order-Driven markets, participants submit market orders, and "limit orders" like irreversible quotes. The exchange performs order matching [1] among market orders and limit orders. At time of execution, there's no (easy) way for either side to reject the trade. Only the exchange can cancel trades, as they did to a lot of trades on a few special occasions.

To the exchange, there's no dealer vs. client. If the trade happens be an individual vs GS, then GS is perhaps a dealer, perhaps a market-maker (not the same thing), or perhaps just a regular player. The exchange treats both sides as equals.

[1] Note stop market orders and stop limit orders are not part of the matching until they "activate" to become live market/limit orders.
----
In FX, even the executable quotes are subject to dealer's "last look". When a small investor Ken hits a Citi offer on an ECN, the ECN dare not book the trade right away because it can't guarantee to Ken that Citi's last look would pass. Ultimately, the ECN doesn't take position.

Q: In stock exchanges (or other listed markets), dealers can't cancel a trade. Only the exchange can. Exchange executes trades and they are final, because the exchange takes position. Why is the stock exchange so powerful? Why is the exchange able to guarantee to Ken that no matter what Citi does, Ken's trade is confirmed?
%%A: because the exchange's clearing fund is contributed by the big dealers
%%A: because the exchange is counterparty of every trade and takes positions. If a member bank (Citi in this case) fails to deliver, the exchange takes the loss, using the clearing fund.

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