Order-driven markets operate on the principles of supply and demand, where orders from buyers and sellers dictate the prices of securities. This system contrasts with quote-driven markets, where market makers provide bid and ask prices to facilitate trading. In an order-driven market, buyers and sellers interact directly with each other through the exchange’s order book.
How Order-Driven Markets Work
In an order-driven market, buyers and sellers submit their buy and sell orders, respectively, to the exchange’s order book. These orders contain details such as the security being traded, the quantity, and the price at which the trader is willing to transact. The order book displays all these orders, allowing market participants to see the current market depth and liquidity.
Market Orders vs. Limit Orders
There are two main types of orders in order-driven markets: market orders and limit orders. A market order is an instruction to buy or sell a security at the best available price in the market. Market orders are executed immediately at the prevailing market price.
On the other hand, a limit order is an instruction to buy or sell a security at a specific price or better. Unlike market orders, limit orders are not executed immediately. Instead, they are added to the order book and executed only when a matching order from the counterparty is found.
Price Discovery in Order-Driven Markets
Price discovery in order-driven markets occurs through the continuous matching of buy and sell orders. As buyers and sellers submit their orders to the order book, the exchange’s trading system matches compatible orders, leading to transactions at specific prices. The continuous flow of orders and transactions results in the formation of market prices that reflect the collective wisdom of market participants.
Advantages and Disadvantages of Order-Driven Markets
Order-driven markets offer several advantages, including transparency, as all orders and transactions are visible to market participants. Additionally, order-driven markets often have lower trading costs compared to quote-driven markets, as there are no intermediary spreads. However, order-driven markets may also suffer from liquidity issues, especially for less actively traded securities, as there may not always be a matching counterparty for a given order.
