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This is in by no means a duplicate. I've found similar questions that didn't clarify.

I'm simply wondering if there is a relationship between quote driven markets (market making) and order driven markets (market taking) . I've been reading a lot and it seems the lines are blurred, in that you can make money from either market.

My understanding of quote driven market: The trader observes the interests of other trades in a particular security. The traders quotes on a security and every participating trader can view all the quotes. This provides liquidity as the prices don't move a lot.

My understanding of order driven market: You watch the order book and send orders. You may not look at the quotes. And it helps liquidity.

Question one: What security does the trader quote? Is it the security that the trading firm itself owns?

Question two: What I don't get is how a trader can make money from simply sending a quote. And I think this is where my confusion stems. Maybe the trader doesn't make money from quoting. Is it an auction for traders to decide on the best price, and when they are happy they send an order?

Except I don't think that's right because it seems you can send an order without quoting, or you can quote but not send an order.

So why quote? How do you make money from quoting? Is there any correlation between quoting and sending orders? If you can execute a quote like you can execute an order, what is the real difference between quotes and orders? How does order driven market help liquidity?

So many questions.. However, if you can explain as to a noob (which is what I am at this game) that'd be awesome.

  • 2
    Why was this downvoted? Usually the downvoter gives a reason... – Lews Therin Dec 5 '13 at 6:00
  • 2
    I suspect it's been downvoted for lack of a personal finance angle, which is the topic for this site. The activities you are referring to would be performed by professionals doing this for a living and not retail individual investors. – Chris W. Rea Dec 5 '13 at 14:16
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Quote driven markets are the predecessors to the modern securities market.

Before electronic trading and HFTs specifically, trading was thin and onerous. Today, the average investor can open up a web page, type in a security, and buy at the narrowest spread permitted by regulators with anyone else who wants to take the other side.

Before the lines between market maker and speculator became blurred to indistinction, a market maker was one who was contractually obligated to an exchange to provide a bid and ask for a given security on said exchange even though at heart a market maker is still simply a trader despite the obligation. A market maker would simultaneously buy a large amount of securities privately and short the same amount to have no directional bias, exposure to the direction of the security, and commence to making the market. The market maker would estimate its cost basis for the security based upon those initial trades and provide a bid and ask appropriate for the given level of volume. If volumes were high, the spread would be low and vice versa.

Market makers who survived crashes and spikes would forgo the potential profit in always providing a steady price and spread, ie increased volume otherwise known as revenue, to maintain no directional bias. In other words, if there were suddenly many buyers and no sellers, hitting the market maker's ask, the MM would raise the ask rapidly in proportion to the increased exposure while leaving the bid somewhere below the cost basis. Eventually, a seller would arise and hit the MM's bid, bringing the market maker's inventory back into balance, and narrowing the spread that particular MM could provide since a responsible MM's ask could rise very high very quickly if a lack of its volume relative to its inventory made inventory too costly. This was temporarily extremely costly to the trader if there were few market makers on the security the trader was trading or already exposed to.

Market makers prefer to profit from the spread, bidding below some predetermined price, based upon the cost basis of the market maker's inventory, while asking above that same predetermined cost basis. Traders profit from taking exposure to a security's direction or lack thereof in the case of some options traders.

Because of electronic trading, liquidity rebates offered by exchanges not only to contractually obligated official market makers but also to any trader who posts a limit order that another trader hits, and algorithms that become better by the day, market making HFTs have supplanted the traditional market maker, and there are many HFTs where there previously were few official market makers. This speed and diversification of risk across many many algorithmically market making HFTs have kept spreads to the minimum on large equities and have reduced the same for the smallest equities on major exchanges.

Orders and quotes are essentially identical. Both are double sided auction markets with impermenant bids and asks. The difference lies in that non-market makers, specialists, etc. orders are not shown to the rest of the market, providing an informational advantage to MMs and an informational disadvantage to the trader. Before electronic trading, this construct was of no consequence since trader orders were infrequent. With the prevalence of HFTs, the informational disadvantage has become more costly, so order driven markets now prevail with much lower spreads and accelerated volumes even though market share for the major exchanges has dropped rapidly and hyperaccelerated number of trades even though the size of individual trades have fallen.

The worst aspect of the quote driven market was that traders could not directly trade with each other, so all trades had to go between a market maker, specialist, etc. While this may seem to have increased cost to a trader who could only trade with another trader by being arbitraged by a MM et al, paying more than what another trader was willing to sell, these costs were dwarfed by the potential absence of those market makers. Without a bid or ask at any given time, there could be no trade, so the costs were momentarily infinite.

In essence, a quote driven market protects market makers from the competition of traders. While necessary in the days where paper receipts were carted from brokerage to brokerage, and the trader did not dedicate itself to round the clock trading, it has no place in a computerized market. It is more costly to the trader to use such a market, explaining quote driven markets' rapid exit.

  • Detailed answer, but I'm still confused. Are MMs not traders as well? – Lews Therin Dec 5 '13 at 9:20
  • @LewsTherin It's like quantycuenta explained the rules of a sports game and you're asking which team the grounds crew is on. They are traders in that they trade, but in the simpler way that the trading world used to operate, (which your question focuses on), they were an important part of the infrastructure to make transactions possible. – THEAO Dec 5 '13 at 10:25
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This is too lengthy for a comment. The following quoted passages are excerpted from this Money SE post.

Before electronic trading and HFTs specifically, trading was thin and onerous.

No. The NYSE and AMEX were deep, liquid and transparent for nearly 75 years prior to high frequency trading (HFT), in 2000 or so. The same is true for NASDAQ, but not for as many years, as NASDAQ is newer, being an electronic market. The point is that it existed, and thrived, prior to HFT. The NASDAQ can be active and functional, WITH or WITHOUT high frequency trading.

This is not historically true, nor is it true now:

Without a bid or ask at any given time, there could be no trade...

Market makers, also known as specialists, were responsible for hitting the bid and taking the offer on whatever security they covered. They had a responsibility assigned to them by the exchange. Yes, it was lucrative! There was risk, and they were rewarded for bearing it. There is a trade-off though. Specialists provided greater stability on a systemic level, although other market participants paid for that cost. Prior to HFT, traders who were not market makers were often bounded by, boxed in, by the toll paid to market makers. Market makers had different, much higher capital and solvency requirements than other traders. Most specialists/market makers had seats, or shared a seat on the NYSE or AMEX. Remember that market makers/specialists are specific to stock markets, whereas HFT is not.

If this is true, then we are in trouble:

HFTs have supplanted the traditional market maker

Why? Because trading volume is LOWER now than it was in the 1990's!

EDIT
In the comments, I noticed that OP was asking about the difference between

  • traders and market makers.

I suggest reading this very accurate, well-written answer to a related question, The spread goes to the market maker, is the market maker the exchange? That explains the difference between

  • market makers and the exchange.

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