Financial markets: Exchange or Over the Counter

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Financial markets’ economic and institutional structures critically determine how prices are established (“discovered”) and shape the orderliness and stability of the marketplace.
Some market arrangements can quickly become disorderly, dysfunctional, or otherwise unstable, as experienced following the August 2007 onset of the financial turmoil that led to the global economic crisis.
Two basic ways to organize financial markets: exchange and over the counter (OTC), although some recent electronic facilities blur traditional distinctions.

Exchanges originated as physical places (examples in the source):
- New York Stock Exchange (NYSE) formed in 1792.
- Chicago Board of Trade (now part of the CME Group) has been trading futures contracts since 1851.
Today there are "more than a hundred" stock and derivatives exchanges throughout the developed and developing world.
Exchanges:
- Set institutional rules that govern trading and information flows.
- Are closely linked to clearing facilities for post-trade completion.
- Centralize communication of bid and offer prices to all direct market participants; execution prices are communicated throughout the market.
- Produce a level playing field allowing any participant to buy as low or sell as high as anyone else who follows exchange rules.
Communication media on exchanges: voice, hand signal, discrete electronic message, or computer-generated electronic commands.
Electronic trading developments:
- Eliminated the need for physical trading floors; many traditional floors are closing.
- London Stock Exchange, NASDAQ, and Eurex are completely electronic.
- Many exchanges offer both floor and electronic trading.
- NYSE bought the electronic trading platform Archipelago and is moving increasingly toward electronic trading.
- CME Group maintains both open-outcry and electronic trading.
- Brazil’s BM&F maintained both until 2009.

OTC markets are networks of trading relationships centered around one or more dealers rather than a physical place.
Dealers act as market makers by quoting ask (offer) and bid prices to other dealers and to their clients/customers.
Key distinctions of OTC:
- Dealers do not necessarily quote the same prices to other dealers as to customers, nor to all customers.
- Dealers can withdraw from market making at any time, potentially causing liquidity to dry up.
- OTC markets are less transparent and have fewer rules than exchanges.
- All securities and derivatives involved in the financial turmoil that began with a 2007 breakdown in the US mortgage market were traded in OTC markets.
Communication methods in OTC trading: telephone, mass e-mail messages, text messaging, and electronic bulletin boards.
Bilateral trading:
- Negotiation by phone or electronic message between two market participants (customer-dealer or dealer-dealer).
- Only the two participants directly observe quotes or execution.
- Some brokered markets post execution prices and trade size after the fact, but access may be limited.

Customer market:
- Bilateral trading between dealers and their customers (individuals, hedge funds).
- Dealers initiate contact through high-volume electronic messages called “dealer-runs” listing securities/derivatives and prices.
Interdealer market:
- Dealers quote prices to each other and can lay off risk to other dealers.
- Dealers can quickly survey multiple counterparties for quotes; customers generally cannot access the interdealer market.

Interdealer brokers:
- Help market participants access a deeper view of the market by broadcasting dealers’ quotes.
- Provide trading platforms such as dark pools enabling dealers to post quotes to every other dealer in the broker’s network.
- Broker screens typically show bid, ask, and sometimes execution prices, and are normally not available to end-customers.
Electronic trading in OTC:
- Some electronic brokering platforms allow dealers and some nondealers to submit quotes and execute trades directly, replicating multilateral exchange-like trading for direct participants.
- Such electronic arrangements can treat participants differently (e.g., by size or credit rating).
- Clearing and settlement in OTC remain the responsibility of buyer and seller, unlike exchange trades matched and guaranteed by the exchange.
- Dealers resist participation of nondealers, arguing nondealers “take liquidity without exposing themselves to the risks of providing it”; critics say dealers try to prevent competition that would compress bid-ask spreads.

OTC market architecture contributed to problems for structured securities, credit derivatives, commercial paper, municipal bonds, and securitized student loans during the recent crisis.
Two serious complications emerged:
- Inability to value holdings:
- Without liquid and orderly markets, price discovery failed and there was no easy definitive way to value securities.
- Lack of benchmark prices forced reliance on models that were sometimes not adequately informed by benchmark prices, further depressing affected securities’ prices.
- Inability to sell holdings:
- Dealers, facing funding crunches and holding excessive illiquid assets, withdrew from markets.
- Increased volatility made market making dangerous and expensive, removing buyers for instruments such as collateralized debt obligations, certain municipal securities, and credit derivatives.
- Investors could not reduce losses by trading or meet margin/collateral calls, contributing to the depth and breadth of the financial crisis.

Major regulatory reform underway in the United States, European Union, and other developed financial markets address OTC market issues.
Reform measures include:
- Shifting some trading from OTC to exchange markets.
- Moving post-trade clearing of OTC trades to clearinghouses (central clearing counterparties).
- Improving trade reporting for OTC transactions.
The role of the dealer in OTC markets is not being explicitly addressed in most reforms except possibly through higher capital requirements.