What is Quote-Driven Market?
A quote-driven market refers to a type of financial market structure in which market participants trade through market makers who quote bid and ask prices for securities. Market makers play a crucial role in markets, especially quote-driven markets. In this blog, we will explore what quote-driven markets are, the role of market makers, and how these markets differ from order-driven markets.
What is a Quote-Driven Market?
A quote-driven market, also known as a dealer market, refers to a market in which the market maker acts as an intermediary between buyers and sellers, facilitating transactions. The market maker or dealer quotes the bid and ask prices. In a quote-driven market, the market maker facilitates the trade of securities by matching and filling orders from their own inventory. The market maker purchases securities from sellers and sells them to buyers at a higher price, thereby earning a profit.
A quote-driven market and a price-driven market are often used interchangeably. Both refer to markets where market makers provide bid and ask prices for securities.
Quote-Driven Market in Commodities
The commodities market is integral to the global trade scenario. Along with hedging and speculation, the commodities market facilitates the physical transfer of commodities, allowing producers and consumers to meet the physical demand.
As we discussed earlier, a quote-driven market is one in which the dealer or market maker quotes the bid and ask prices. This allows the market maker to fulfil orders from their inventory, reducing liquidity constraints.
In the commodity market, quote-driven markets are primarily seen in over-the-counter (OTC) oil derivatives or the trade of physical metals. OTC derivatives are contracts that are not traded on an exchange, where market makers or dealers typically come into play. Market makers are crucial in such markets, as they provide the necessary liquidity to fill orders from buyers and sellers.
Let’s look at how a quote-driven market works with the help of an example:
Trader A wants to purchase 100 lots of OTC oil contracts, while Trader B wants to sell 100 lots of OTC oil contracts. Since OTC oil contracts are traded in a quote-driven market, the market maker will quote the bid and ask price.
The market maker quotes a bid price of ₹5,000 and an ask price of ₹5,010.
Since Trader B wants to sell 100 lots of OTC oil contracts, the market maker will purchase the quantity from Trader B at the bid price of ₹5,000 and match it to Trader A, who wants to purchase 100 lots at the ask price of ₹5,010.
The market maker profits from the difference between the bid and ask price
Profit = (₹5,010 – ₹5,000) x 100 = ₹1,000
The quote-driven market fulfils the buyer and seller's requirements by providing the necessary liquidity, which is extremely beneficial in the commodities market.
Advantages of Quote-Driven Markets
Quote-Driven Markets have the following benefits:
Provides Liquidity
Quote-driven markets provide liquidity as market makers and dealers fill orders from their own inventory. This is especially helpful in the commodity markets where large lot-size trades are executed. Since one seller might not always be able to fulfil the entire quantity for the trade, a market maker steps in to provide the necessary liquidity.
Price Continuity
Market makers in a quote-driven market quote the bid and ask price. To ensure liquidity and fair price discovery, the bid-ask spreads are relatively narrow, allowing buyers and sellers to fulfil their orders at desirable bid and ask prices.
Quick Execution
In a quote-driven market, the market maker or dealer commits to fulfilling the order of the buyer and seller through their own inventory. This results in speedy execution, as it does not depend on the exact quantities of a buyer and seller being matched.
Drawbacks and Risks of Quote-Driven Markets
Less Transparency
One of the key drawbacks of a quote-driven market is the lack of transparency. The depth of the market, such as the size of orders at each price level, may not be as transparent as in an order-driven market, where this information is available along with the bid and ask prices quoted by individual investors.
Possibility of Wide Bid-Ask Spreads
During periods of lower volume, demand and supply may be skewed. When such a situation arises, there can be significant discrepancies between the bid and ask prices, which results in price volatility. Furthermore, lower volume can also lead to liquidity issues.
Dealer Concentration
Dealer concentration is a key risk in quote-driven markets. If there is one dealer or market maker, reliance on the market maker increases. Concentration exposes the market to significant risks in case the market maker fails to provide the necessary liquidity. Additionally, a concentration on the market maker side can also lead to asymmetric information, as the dealer or market maker may possess more information than other market participants.