Where shares trade: exchanges, off-exchange and over the counter

How does an exchange work?

An equity exchange is a rules-based venue where shares trade regularly. Its rules aim at liquidity and transparency: scheduled trading hours every business day and an order matching system that pairs buy and sell orders.

Investors do not reach the exchange themselves. A broker-dealer that is an exchange member brings their orders. It can act as an agent or principal : as agent it trades on the client’s behalf, and as principal it trades against the client from its own book. For exchange-traded shares it acts as agent.

Orders are entered in standardized lots, typically of at least 100 shares. That size is the standard lot .

Each listed share usually has one designated market maker : a dealer that buys, sells or holds shares to keep trading orderly, especially at the open and close and when orders are out of balance or prices swing.

To trade on an exchange a share must be listed and keep meeting listing requirements . Typical ones are a minimum number of shareholders and minimum holdings, minimum book equity or net worth or profitability, and a minimum percentage of shares in public hands. Many exchange groups run a junior market with lighter requirements for early-stage companies, which can move up to the main market as they grow. (Learning Module 1 introduced listing: see public vs private equity.)

Because orders meet in a central book, an exchange is an order-driven market .

Market orders, limit orders and the order book

A market order buys or sells a set number of shares at the best price available now. A limit order sets a price boundary: a buy limit gives the most you will pay, a sell limit the least you will accept. If the market does not reach that price, the order does not execute.

Unfilled limit orders wait in the limit order book . Buy limits sit on the bid side at lower prices and sell limits on the ask side at higher prices. Market depth is the size of orders posted at or very near the best bid and ask. A book with roughly equal size on both sides shows supply and demand in balance.

Here is the book for Halden Foods, used for the rest of the lesson.

Bid size	Bid price	Ask price	Ask size
600	47.95	48.05	300
400	47.90	48.10	700
900	47.85	48.15	500
500	47.80	48.20	800

What is the bid-ask spread, and what is the mid-market price?

The bid price is what a buyer will pay for a stated quantity, and the ask (offer) price is what a seller will accept. The bid-ask spread (or bid-offer spread) is the lowest ask minus the highest bid. It is the round-trip cost of buying and selling straight away.

$$\text{Bid-ask spread} = \text{Lowest ask} - \text{Highest bid}$$

The percentage bid-ask spread divides that by the lowest ask.

$$\text{Bid-ask spread (\%)} = \dfrac{\text{Lowest ask} - \text{Highest bid}}{\text{Lowest ask}}$$

The mid-market price is halfway between them, and it is the usual stand-in for “the current price” and the benchmark for execution costs.

$$\text{Mid-market price} = \dfrac{\text{Lowest ask} + \text{Highest bid}}{2}$$

Exam tip Divide the spread by the lowest ask, not by the mid-market price. For a tight spread the two barely differ (0.2081% against 0.2083% here), but for a thinly traded share they do: bid 4.50 and ask 5.00 give 10.00% over the ask and 10.53% over the mid.

Trading costs come in two kinds. explicit costs are out-of-pocket fees and commissions. implicit costs are indirect. The spread is one of them, and it is the only one you can see in the order book. Market impact, delay and opportunity costs (below) cannot be observed in advance.

What does a market order really pay?

A market order fills against the best ask first, then the next level, and so on. A large order “walks the book”, so its average execution price is worse than the best quote.

$$\bar{P} = \dfrac{\sum_i q_i P_i}{\sum_i q_i}$$

The mirror image holds for sellers. A market sell for 1,000 shares fills 600 at 47.95 and 400 at 47.90, an average of 47,930 ÷ 1,000 = 47.93, which is 0.07 below the mid.

What is VWAP?

The volume-weighted average price (VWAP) averages the prices of trades over a period, weighting each by the number of shares traded. Traders use it to follow a share’s performance and momentum through the day and to judge their own fills.

$$\text{VWAP} = \dfrac{\sum_{i=1}^{n} \text{Price}_i \times \text{Volume}_i}{\sum_{i=1}^{n} \text{Volume}_i}$$

Build a book and walk it on the first tab, then try the trades on the second.

When do trades happen off-exchange?

When a trade gets a better result directly with a broker-dealer than on the exchange. Off-exchange trading usually covers one of three cases: shares that trade rarely (illiquid shares), very small trades by retail investors, often in low-priced shares, and very large orders, called block trades.

A block trade is usually an order of 10,000 shares or more in one company, and it is the main source of off-exchange activity. The broker-dealer either splits the block into smaller orders worked over time, or sends pieces to several counterparties at once, to avoid moving the price. Asset managers such as mutual funds may also agree to swap shares with each other at the market’s closing price, outside the exchange’s order system.

The aim is to cut implicit costs, the indirect and mostly unobservable costs of trading.

• Market impact (price impact) is the cost of trading immediately. A large buyer must push the price up to find sellers.
• Delay costs (slippage) arise when the order fills late, after the price has already moved as the trader expected.
• Opportunity costs (the unrealized profit or loss) arise when the order never fills, and the price moves as expected without you.

Trading costs

• Explicit Know the idea fees and commissions
• Implicit Memorize indirect costs
  • Bid-ask spread Memorize the one you can see in the book
  • Market impact Memorize moving the price to fill now
  • Delay (slippage) Memorize filled after the move
  • Opportunity cost Memorize never filled

Suppose a fund decides to buy 300,000 shares of a company whose mid-market price is 20.00. Three things could happen.

• Buying it all at once walks the book to an average of 20.12. That is market impact of 0.12 a share, or 300,000 × 0.12 = 36,000 in total.
• Working the order over three days avoids most of that, but the price drifts up as the fund expected, and the fills average 20.30. The extra 0.30 a share paid for waiting is delay cost.
• If 100,000 shares are never bought before the price reaches 21.00, the gain missed on them, about 1.00 a share or 100,000 in total, is opportunity cost.

Exam tip Blocks are split to limit price impact, not to shrink the bid-ask spread. The spread is set by the whole book. One large order only changes how far into it you reach.

How does over-the-counter trading differ?

The over-the-counter (OTC) market is a network of broker-dealers that buy and sell among themselves, with no central matching system. It is a quote-driven market : several competing market makers keep posting bid and ask prices, and fill orders from their own inventory or by finding an offsetting order from another dealer or investor.

Mostly smaller companies trade this way, either because they choose not to pay for a listing on a larger exchange or because they do not meet its listing requirements.

Its strength is the highest likelihood of execution in most conditions, because a market maker must trade at the prices it posts. Its weaknesses are less transparency (trades and orders are not readily visible), no assurance of the best price at a given moment (although competition keeps dealers’ quotes close), and less liquidity from dealers under stress.

	Exchange	Off-exchange	Over the counter (OTC)
How trades happen	Broker-dealer members send orders to a central matching system	Directly with a broker-dealer	Broker-dealers trade among themselves
How prices form	Order-driven: the limit order book	Negotiated, worked in pieces, or at the closing price	Quote-driven: market makers’ bids and asks
Market makers	One designated market maker per share	Not used; the broker-dealer handles the order	Several competing market makers
Typical trades	Standard lots (at least 100 shares) in regular hours	Blocks of 10,000+ shares, illiquid shares, very small retail trades	Shares of smaller companies that are not listed
Main strength	Generally the highest liquidity; transparent	Less price impact for large orders	Highest likelihood of execution
Main weakness	A large order moves the price	Fills can take time (delay, opportunity costs)	Less transparency; no best-price assurance; liquidity can dry up in stress

Secondary equity trading

• Exchange Memorize rules-based, order-driven; broker-dealer members; designated market maker
• Off-exchange Memorize directly with a broker-dealer
  • Block trades 10,000 shares or more, split to limit price impact
  • Illiquid shares
  • Very small retail trades
• Over the counter Memorize quote-driven dealer network; several market makers