Market microstructure: who is on the other side of a trade

On an exchange, all orders for an instrument meet in one place under one rulebook. Shares and futures are mostly traded this way. Everyone sees the same prices, and the exchange publishes what was dealt and how much.

In an over-the-counter market there is no central place. Dealers quote prices to their customers and to one another, by screen and by electronic link. Spot foreign exchange, most bonds and CFDs are traded like this. It follows that there is no single official price for a currency pair and no complete record of volume: the price is the quote of whoever is being dealt with.

An order book is the list of limit orders waiting to be filled. Orders to buy, the bids, are ranked from the highest price down; orders to sell, the asks or offers, from the lowest price up. Within a price, the earliest order comes first.

The highest bid and the lowest ask are the top of the book, and the difference between them is the spread. The quantities waiting at each price are the depth.

A limit order joins the book and waits, and is said to provide liquidity. A market order is matched at once against orders already waiting, and is said to take it. A market order larger than the quantity at the top works down through the levels, so the price paid depends on the size of the order as well as on the quote.

A market maker quotes a price at which it will buy and a higher one at which it will sell, continuously, and deals with whoever comes. It earns the spread, and in return carries stock that may fall in value before it can be passed on.

In foreign exchange the large liquidity providers are banks and specialist trading firms. They quote to one another, to trading platforms and to brokers.

The spread pays for three things: the cost of handling the trade, the risk of holding the position, and the risk that the person on the other side knows something the market maker does not. When any of the three rises, the spread widens.

There are two broad models, and neither is good or bad in itself.

In the dealing-desk model, also called market making or dealing as principal, the broker is the other side of the client’s trade. It sets its own quotes, taken from the wider market, and may set one client’s position against another’s, keep the remaining risk or hedge it elsewhere. Such a broker can offer small sizes, steady quotes and immediate fills. Where it keeps the risk, a client’s loss is the broker’s gain and the reverse: a conflict of interest that rules and disclosure are meant to manage, and do not remove.

In the agency model the broker passes the order on and earns a commission or a mark-up on the spread, so its income depends on how much is traded and not on whether the client wins or loses. Several labels are used. Straight-through processing, STP, means the order is sent on to one or more liquidity providers without a dealer intervening. An electronic communication network, ECN, is a system in which the quotes and orders of many participants meet. Non-dealing desk is the general term. A client of such a broker typically sees spreads that vary, and may meet slippage and partial fills, because the prices are those of the providers at that moment.

The labels are used loosely. Many firms combine the models, passing some orders on and keeping others. And a broker working as an agent in the economic sense is often still, in law, the client’s counterparty to the CFD, with a matching trade of its own elsewhere. The dependable source is not the label but the firm’s order execution policy and its regulatory disclosures, which say how orders are handled and where conflicts lie.

In over-the-counter foreign exchange, a liquidity provider that receives a request to deal at a price it has quoted may keep a brief moment in which to accept or refuse it. This is last look.

Its stated purpose is to protect the provider against requests that arrive after the price has moved. It is criticised because a provider could refuse the trades that have turned against it and accept the others. The FX Global Code, the set of principles of good practice agreed by central banks and market participants, says how last look should be used and disclosed.

For the person trading, last look shows itself as an order rejected, requoted or filled at a different price. Quotes that carry no last look are called firm.

A spread widens when fewer firms are quoting or when quoting has become riskier. The usual occasions are well known.

• Scheduled releases and central bank decisions. In the moments around them, providers quote wider or withdraw, because the next price is unusually uncertain.
• The daily rollover, around the close of business in New York, when the value date changes and few are dealing.
• The open after a weekend, public holidays and the quiet hours between sessions.
• Stress: when prices are moving quickly, holding a position for even a moment costs more.
• Less-traded instruments, which have fewer providers at any hour, and instruments quoted while their underlying market is closed.
• A wider spread can itself set off a stop, because buy orders and sell orders are triggered by different sides of the quote.