Key Differences between Quote-Driven vs. Order-Driven Markets

One of the key features of any market is facilitating trade by connecting buyers and sellers. For a market to work efficiently, it is important for it to enable buyers and sellers to exchange goods and services at a fair price. Quote-driven and order-driven markets are two common types of markets seen in the financial world that enable the trading of assets like commodities. For any investor or trader, it is important to know what these two market types are and how they differ from each other. Read on to learn more about quote-driven and order-driven markets.

Market Structures

Before we dive into the world of quote-driven and order-driven markets, we must understand what a market structure is and why it is important.

A market structure has three main elements: the number of buyers and sellers, the number of different brands or competition, and the ease with which one can enter or exit the market. By looking at a market structure, we can understand how competitive a market is. It can also allow one to determine whether a market is dominated by one player or if it contains several competitors.

In commodity trading, market structure is important because buyers and sellers can ascertain if they can easily enter or exit a market. Moreover, by understanding the competition present in the market, they can get an idea about how fair the pricing is or how much information will be available to the market participants.

What is a Quote-Driven Market?

Now that we have taken a look at market structures and their importance in commodity markets, let’s see what a quote-driven market is.

A quote-driven market is a market where the market maker or dealer quotes both, the bid and ask price. The market maker acts as an intermediary, connecting buyers and sellers. In a quote-driven market, the market maker fulfills the order from their own inventory.

By quoting a bid and ask price, the dealer purchases a security from the seller and sells the security to a buyer. In such a market, the trades take place between the clients and the dealers. The difference between the bid and ask price is the profit of the dealer.

Quote-driven markets are commonly seen in over-the-counter (OTC) derivative contracts for oil or the trading of physical metals. Since these commodities may be traded in large-lot sizes, they may pose liquidity issues. This is where a market maker comes in and provides the liquidity by fulfilling the order from their inventory.

Read more about: Quote-Driven Market

What is an Order-Driven Market?

An order-driven market is a market where individual buyers and sellers display the quotes at which they want to buy or sell a security along with the quantity that they wish to trade.

In an order-driven market, these orders are recorded in a centralised order book and the prices are determined by matching the demand and supply of the underlying asset. These markets are highly transparent as market participants get a clear picture of the bid and ask prices. However, these markets can tend to be illiquid if the demand and supply are skewed. Further, it can also result in volatile bid-ask spreads.

Order-driven markets are commonly seen in commodities and commodity derivatives traded on exchanges. The Multi Commodity Exchange (MCX), Chicago Mercantile Exchange (CME), and the London Metal Exchange (LME) are key examples of order-driven markets.

Key Differences between Quote-Driven and Order-Driven Markets

Price Discovery

The price discovery in a quote-driven market is decentralised. Since these markets have no central exchange, the trades are executed between the clients and the market maker or dealer.

On the contrary, an order-driven market has a centralised mechanism for price discovery. The orders of buyers and sellers are recorded in a centralised order book through which a fair trading price is set.

Transparency

In a quote-driven market, the market maker or dealer quotes the bid and ask price. The buyers and sellers are unable to see the quoted prices by each other, leading to lower transparency. Moreover, the market maker or dealer in a quote-driven market may have more information compared to the buyers and sellers.

An order-driven market is more transparent as the bid and quote prices are recorded in a centralised order book. Buyers and sellers can view this order book and make informed trading decisions by studying the quoted prices and the quantities being traded.

Liquidity

Quote-driven markets are more liquid since the dealer or market maker commits to providing the liquidity from their inventory. This makes quote-driven markets especially useful for illiquid commodities or commodities that are traded in large lots.

Compared to a quote-driven market, an order-driven market is less liquid. The liquidity in an order-driven market depends on the buyers and sellers whereas the market maker provides the necessary liquidity in a quote-driven market.

Trade Execution

Trades in a quote-driven market are executed by the dealer resulting in speedy execution of trades. The market maker fulfills the order from their inventory allowing trades to be executed quickly.

In an order-driven market, the trades are auction-based and are executed if the buyers and sellers match. In some cases, the bid-ask spreads may be wide resulting in delayed execution of trades.

Cost Structure

The primary cost in a quote-driven market comes from the spread between the bid and ask prices. The difference between the spread is the profit of the market maker or dealer.

In an order-driven market, the costs are associated with the order and include fees such as brokerage and exchange fees.

Pros and Cons of Quote-Driven and Order-Driven Markets