Different Types of Markets for Securities Trading

BROKER MARKET and DEALER MARKET

On the basis of the way the securities are traded in secondary market, they are classified into two segments called broker market and dealer market. The broker market consists of organized securities exchanges and dealer markets consist of the OTC market. These two markets are different in terms of techniques of executing trades. In a broker market, the buyer and seller of the securities are brought together through a broker. In other words, the buyers buy the securities from the seller through the broker and the sellers sell the securities to the buyers through the broker. Thus, the securities change the hands effectively in the broker market with the help of brokers. However, in the dealer markets, the orders of buyers and sellers are never brought together. Instead, the sellers sell their securities to securities dealers and the buyers buys their securities from the same dealer or different ones. Thus, one side of transactions in dealer market always consist of securities dealers. Securities dealers are the market makers who are ready to buy and sell the securities they invested at quoted price. 

These two types of secondary markets are discussed below:

1. Broker Market

Broker markets consist of the organized market where buy and sell orders of the investors are executed through licensed brokers. The organized exchanges may be stock exchanges, future exchanges, and option exchanges. In case of Nepal, NEPSE is the only one national stock exchange. Particularly, it is the only one dominant broker market in Nepal. This section deals with the following types of broker markets.

A. Organized Stock Exchanges:

An organized stock exchange is the physical location where securities are traded under some established rules and regulations through licensed brokers. It is one of the important secondary markets where the investors buy and sell securities among themselves. Organized stock exchanges provide floor for trading securities. Every buy and sell order of investors is executed in floor of organized exchanges. No trade is allowed outside the floor of exchanges. Organized stock exchanges appoint their members, known as brokers, to assist trading of securities. All investors must place their buying and selling orders through brokers. Only listed securities are traded in organized stock exchanges. They set criteria for listing of securities. Only those securities which meet the criteria are listed in the exchange and qualified for trading.

There are many organized stock exchanges in the world. One of the best known is NEW YORK STOCK EXCHANGE (NYSE), which deals with trading of majority of total shares traded in the United States. Other well known exchanges are London Stock Exchange, Tokyo Stock Exchange, Hong Kong Stock Exchange. There can be more than one stock exchange in a country. For example, Bombay Stock Exchange, Calcutta Stock Exchange, Delhi Stock Exchange in India. But in case of Nepal, Nepal Stock Exchange is the only one stock exchange in the country.

B. Futures Exchanges

A future contract is an agreement to buy and sell a standard quantity and quality of a specified commodity or financial instruments on a specified future date at a predetermined price. Future contracts are executed in a futures exchange. Future exchanges allow investors to hedge the risk of adverse price movements. The standardized nature of futures contracts also leads to lower transaction and information costs. The world’s oldest and largest futures exchange, The Chicago Board of Trade (CBOT), was founded in 1848 by 82 Chicago merchants. In 2007, Chicago Mercantile Exchange (CME) and CBOT officially merged, and are now collectively known as CME Group Inc., the world’s largest and most diverse futures exchange.

Initially, future exchanges were developed to help agricultural producers and consumers manage the price risks that they face during harvesting, marketing and processing food crops every year. Today, Futures exist not only in agricultural products, but also on wide varieties of financial instruments and foreign exchange markets. These days online commodity trading has become increasingly popular, and commodity brokers offer front-end interfaces to trade these electronic-based markets. A commodities broker may also continue to offer access to traditional open-outcry, markets that established the futures exchanges.

In the context of Nepal, Commodities and Metal Exchange Nepal Limited (COMEN), Mercantile Exchange Nepal Limited (MEX) and Nepal Derivative Exchange (NDE) are in operation as future exchanges. The majority of  transaction in these exchanges include gold and crude oil. COMEN deals with trade services of agricultural products. MEX has also made immense contribution in raising awareness about and catalyzing implementation of policy reforms in the commodity sector. MEX is the first exchange to enroll participation of high net worth corporate securities member in commodity derivatives market. NDEX is a public limited company incorporated on November 20, 2008 under the company act, 2063. It is a professionally managed multi commodities and derivatives exchange which provide online platform for traders to buy and sell commodities efficiently at a fair price. It aims to facilitate trading on commodities, metals, energies, currencies and others. It contains tools and information that a trader needs to successfully engage trading and investment. People can trade in the products at NDEX through its software and fulfill their respective needs.

C. Options Exchanges

An option is a contract that gives its holder a right, but not obligation, to buy or sell underlying securities at pre-specified exercise price and within stipulated time period. Options exchanges only deal with the trading of options on the securities. They do not trade the underlying securities. However, there are some stock exchanges which also deals with the trading of options along with the underlying securities. For example, New York Stock Exchange (NYSE), American Stock Exchange (AMEX), Philadelphia Stock Exchange. There is no separate options exchange in Nepal and NEPSE as well doesn’t allow the options exchanges. In the case of USA, the Chicago Board of Options Exchange (CBOE) is the dominant options exchange.

2. Dealer Markets

A dealer market is a security market mechanism wherein multiple dealers post prices at which they are agreed to buy or sell a specific security. In a dealer market, securities dealers are designated as market makers. They provide liquidity and transparency by electronically displaying the prices at which they are willing to make a market in a security. A security dealer posts both the price at which it will buy the security, which is called bid price, and the price at which it will sell the security, known as ask price. In other words, the investors should pay the ask price. In other words, an investor should pay the ask price to buy securities and receive bid price from selling securities in a dealer market. The ask price is always higher than the bid price and the difference is called bid-ask spread. A market maker in a dealer market invests its own capital to provide liquidity to investors The primary mechanism of controlling risk for the market maker in a dealer market is therefore the use of bid-ask spread, which represents a tangible cost to investors.

A dealer market differs from a broker market primarily in ease of multiple market maker aspect. In a broker market, a single specialist in a centralized location, such as the trading floor of NEPSE,  facilitates trading and liquidity by matching buyers and sellers for listed securities. However, A dealer market requires no compulsory listing of Securities. Any security can be traded on this market as long as a registered dealer is willing for make a market in the security(willing to buy and sell the security), It is not a central physical place like an organized stock exchange; it is rather the network of securities dealers scattered across the country. Buy and sell trades in a dealer market are conducted in the form of negotiated bidding through a network of communication line and computer system, which links the securities dealers to their clients. The securities dealers in a dealer market can compete with both investment bankers and the organized stock exchanges because they can operate in both primary and well as secondary market. There is an effective link of communication system used by the dealers in a dealer market, which facilitates the investors for selection of the most competitive market makers as opposed to being forced to trade with one monopolistic market maker.

A. Over-the-counter (OTC) market is one of the most common examples of dealer markets. Besides, National Association of Securities Dealers Automated Quotation System (NASDAQ) in the United States and Over-the counter Exchange India (OTCEI) in India are the other examples of dealer markets and foreign exchange trade primarily in dealer markets

The stock trading on the NASDAQ is a prime example of an equity dealer market, OTC markets were traditionally concerned with trading of securities which were not listed in the organized stock exchange However, today the securities listed in organized stock exchanges ate also traded in OTC.

One significant advantage of OTC market in the past was that it required less financial discloses. However, many OTC markets, such as NASQAD, today requires furnishing some information  as the organized exchanges provide to the investors.

OTC MARKET IN NEPAL

Previously, OTC markets didn’t exist for corporate securities, but did for government securities in Nepal. However, the Nepal Stock Exchange now has been operating OTC market since Jestha 2065 B.S. According to the OTC Bylaws, 2065, shares of companies that have been de-listed or failed to get listed on NEPSE, public companies which have not yet been listed and government owned enterprises can be trade OTC Market. The trade of securities in OTC market doesn’t require involvement of broker to trade securities.

As on Ashwin 02, 2072 B.S., NEPSE published notice regarding OTC market registration. NEPSE has invited qualified organizations to register their securities in NEPSE OTC market. As per the notice, following securities can be registered for OTC market;

• Securities that has been de-listed from the market.
• Securities of companies that have not been able to be listed in NEPSE as they are unable to meet the minimum requirement set forth.
• Securities of public companies that have not been listed.
• Publicly offered securities of government agencies.

The OTC market had been rarely used to trade shares in Nepal. In 2068 BS, 71982 shares of Nepal Bank Limited were traded in the OTC market for the first time. But now it is getting momentum. In the year 2072/73, 12.92 million shares were traded in the market.

ALTERNATIVE TRADING SYSTEM

Third market and fourth market transactions are the alternative trading systems of securities which take place outside the broker and dealer market. They are described below:

1. The Third Market

The third-market transactions are the over the counter market transactions executed for exchange of listed securities. The market makes in OTC markets, they are not the members in organized exchanges, handle the third market transactions. These market makers help in bringing together the buyers and sellers of securities and work on lower commission basis than the organized exchanges. Mutual funds, pension funds, insurance companies and other institutional investors are interested to exchange the securities in the third market due to large savings in brokerage commissions.

2. The Fourth Market

The fourth market consists of transactions that are directly executed between large institutional buyers and sellers through well-established electronic communication networks. The orders are executed automatically by the electronic networks if they are matched. If any order remains unmatched, the system will post the order on an exchange or with the market makers. The order will be executed immediately as soon as the other traders are ready to trade at the given price. The cost of executing transactions using electronic networks is typically lower because it involves only a nominal transaction fee. Similarly, this system of trading is more efficient to discover the best prices for investors’ orders.