Quote-Driven Market: Meaning, Features, Benefits and Limitations

The financial markets make use of several processes to help enable buying and selling of securities. The Quote-Driven Markets are among the processes used, whereby the market makers offer continuous bid-offer quotations for the securities. In the Quote-Driven Markets, the prices are established by the dealers or market makers and not through direct interaction between buyers and sellers.

What is a Quote-Driven Market?

Quote Driven Market refers to the kind of financial market where securities are traded with the help of the dealer or market makers providing continuous quotes to buy and sell. The buyers and sellers are not matched in such a market; rather, market makers serve as an intermediary quoting prices for the transaction of securities.

The main purpose of the quote-driven market is to maintain liquidity and ease the trading process, particularly in cases where there are fewer buyers and sellers in the market.

How Does a Quote-Driven Market Work?

In a Quote-Driven Market, market makers continuously display two prices:

• Bid Price: The price at which they are willing to buy a security.
• Ask Price: The price at which they are willing to sell a security.

When an investor wishes to buy a security, the transaction takes place at the ask price. Similarly, when an investor wants to sell, the trade is executed at the bid price.

For example:

The difference between the bid and ask price is known as the spread, which compensates the market maker for providing liquidity and taking on inventory risk.

In a quote-driven market, market makers always quote two prices:

• Bid Price: This is the price at which they are ready to buy the security.
• Ask Price: This is the price at which they are ready to sell the security.

If the investor wants to purchase a security, the deal will be completed according to the ask price. Likewise, if he intends to sell, then the deal will be done at the bid price.

Example:

Type of Quotes   Price

Bid Price            ₹990

Ask Price          ₹1,000

The spread refers to the gap between bid and ask prices and pays back the market maker for their liquidity and inventory services.

Key Features of a Quote-Driven Market

A quote-driven market has a number of unique features, which make it different from other types of markets.

• Continuous Quotation of Prices

Price quotes are continuously provided by market makers during the trading period.

• Trading through Dealers

Deals are made through dealers and not by the traders themselves.

• Providing Liquidity

Market makers guarantee liquidity in the event of little trading.

• Spread in Bid and Ask

A price always comes with a spread, which compensates market makers.

• Fits for Illiquid Securities

The quote-driven system works best for securities with little order flow.

It ensures that the market is efficient and trading continues uninterrupted.

Role of Market Makers

Market makers serve as the linchpin of the Quote-Driven Market system. Their key function lies in providing liquidity through constant quotations and willingness to either buy or sell securities.

These duties entail:

• Provision of two-way quotations
• Execution of trades
• Maintenance of market liquidity
• Mitigation of the effects of supply and demand disequilibrium
• Aiding in the smooth operation of the market under turbulent conditions

The maintenance of inventory of securities by market makers ensures that trading can take place even in the absence of an immediate counterparty. In today's electronic markets, many market makers use advanced trading systems to continuously update bid and ask prices. Technologies such as High-Frequency Trading (HFT) enable firms to execute large numbers of trades within fractions of a second, helping improve liquidity and support efficient price discovery in a Quote-Driven Market.

Quote-Driven vs Order-Driven Market

While both markets make trading possible, there are major differences between a quote-driven market and an order-driven market.

Unlike the price formation process of an order-driven market where prices are formed from buyer and seller orders, those of the quote-driven market are dependent on the dealers.

Advantages and Disadvantages

Advantages 

Here are some of the advantages of  a quote-driven market:

• Enhanced Liquidity

Market makers guarantee that the securities are always available for trading regardless of low activity within the market.

• Speedy Order Execution

Quotes enable fast order execution.

• Market Stability

Dealers assist in balancing out any temporary imbalance in the number of buyers and sellers.

• Easy Trade in Illiquid Securities

Investors can trade securities that may otherwise have limited participation.

Disadvantages

Here are some of the disadvantages of  a quote-driven market:

• Increased Trading Costs

Quotes may sometimes widen the bid-ask spread and increase trading costs.

• Reliance on Quotes

Securities can only be liquid if market makers decide to offer quotes.

• Inadequate Transparency

Investors may lack access to some orders on the market.

• Possibility of Inaccurate Pricing

There might be times when quoted prices do not correspond with the market price.

An understanding of these advantages and disadvantages enables traders to know if their trading conditions need quotes or not.

Examples of Quote-Driven Markets

There exist many financial markets in the world that run on the basis of the Quote-Driven Market model.

They include:

• Foreign Exchange (Forex) Markets
• Bond Markets of Governments
• Bond Markets of Corporations
• Over-The-Counter (OTC) Markets
• Specific Derivatives Markets

In these markets, liquidity is ensured through the activities of market makers and dealers. The importance of quote-driven markets in ensuring financial operations in the world lies in the provision of continuous buying and selling quotes. 

Foreign exchange market is an example of a quote-driven market. In the foreign exchange market, banks and other financial institutions make the market by offering buy and sell quotes, which ensure that trading takes place at any time within the trading session.