Understanding Market Types: Dealers, Exchanges & Brokers

In the exchange of assets, there are several different types of markets to facilitate trade. Each market operates under different trading mechanisms,Trading MechanismsTrading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms which affect liquidity and control.

These three are the main types of markets:

1. Dealers (Over-the-counter)
2. Exchanges
3. Brokers

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Dealer Markets

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 securityPublic SecuritiesPublic securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based. in question, and will trade with any investor willing to accept those prices. SecuritiesMarketable SecuritiesMarketable securities are unrestricted short-term financial instruments that are issued either for equity securities or for debt securities of a publicly listed company. The issuing company creates these instruments for the express purpose of raising funds to further finance business activities and expansion. 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 premiumMarket Risk PremiumThe market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets.. 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 stocksStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably., but more common in bondsBond PricingBond pricing is the science of calculating a bond's issue price based on the coupon, par value, yield and term to maturity. Bond pricing allows investors and currencyCryptocurrencyCryptocurrency is a form of digital currency that is based on blockchain networking. Cryptocurrency like Bitcoin and Ethereum are becoming widely accepted.. Dealer markets are also appropriate for futures and options, or other standardized contracts and derivatives. Finally, the foreign exchange marketForex Trading - How to Trade the Forex MarketForex trading allows users to capitalize on appreciation and depreciation of different currencies. Forex trading involves buying and selling currency pairs based on each currency's relative value to the other currency that makes up the pair. 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.

Broker Markets

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 floorThree Best Stock SimulatorsThe best stock simulators allow the user to practice and refine their investment techniques. Stock trading simulators allow trading fake cash with real time data, enabling traders to test out various trading strategies prior to risking any real money on them.. 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 bankWhat Do Investment Bankers Do?What do Investment Bankers do? Investment bankers can work 100 hours a week performing research, financial modeling & building presentations. Although it features some of the most coveted and financially rewarding positions in the banking industry, investment banking is also one of the most challenging and difficult career paths, Guide to IB, 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.

Exchanges

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 optionsStock OptionA stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period. A seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the stock option buyer.. Exchanges will typically specify characteristics for the securities traded on the exchange.

Exchange Characteristics

• Contract or Lot Size
• Contract Execution/Trading Months
• Tick Size
• Delivery Terms
• Quality

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 executionTrade Orders - TradingTrade orders refer to the different types of orders that can be placed on trading exchanges for financial assets, such as stocks or futures contracts.. 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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CFI offers the Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! 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:

• Technical AnalysisTechnical Analysis - A Beginner's GuideTechnical analysis is a form of investment valuation that analyses past prices to predict future price action. Technical analysts believe that the collective actions of all the participants in the market accurately reflect all relevant information, and therefore, continually assign a fair market value to securities.
• Trade Order TimingTrade Order Timing - TradingTrade order timing refers to the shelf-life of a specific trade order. The most common types of trade order timing are market orders, GTC orders,
• Bond IssuersBond IssuersThere are different types of bond issuers. These bond issuers create bonds to borrow funds from bondholders, to be repaid at maturity.
• The Trading FloorTrading FloorA trading floor refers to a literal floor in a building where equity, fixed income, futures, options, commodities, or foreign exchange traders buy and sell securities.