Navigating Market Structures: A Comparison of Call and Continuous Markets
For financial markets to operate efficiently, rules are necessary to bring order to the process of buying, selling, and processing investors’ orders. There are two main types of markets: call markets and continuous markets.
Call Markets (Call Auction)
Call markets have one or two short trading sessions daily. Based on the incoming buy and sell orders (both market and limit orders), a clearing price is determined. This is the price at which the highest trading volume can be cleared.
Consider the following orders for trading shares of company XYZ:
- Buy 100 shares at $50
- Buy 200 shares at $55
- Buy 1000 shares at $60
- Sell 50 shares at $55
- Sell 1000 shares at $60
- Sell 50 shares at $70
At a clearing price of $60, the highest trading volumes can be achieved. Since transactions for a given investment instrument are executed simultaneously at the same price, trading volumes are significant. This makes call markets very liquid (and suitable for trading less liquid securities).
One of the main drawbacks of call markets is that the clearing price is unknown in advance. Therefore, some limit orders may not be executed, and some market orders may be executed at an unexpectedly unfavorable price.
Continuous Markets
Continuous markets, by contrast, stay open during extended trading sessions. However, this flexibility often results in reduced liquidity, making it harder for buyers and sellers to match trades efficiently. As a result, continuous markets are well-suited for securities with active trading, where there are many buyers and sellers.
Many markets start as call market auctions and then continue to operate as continuous markets. Some of them end the day with another auction.
Execution Mechanisms in Financial Markets
Financial markets rely on specific rules to ensure efficient processing of investors’ orders. There are three main market systems: quote-driven markets, order-driven markets, and broker-mediated trading.
Quote-Driven Markets
In quote-driven markets, dealers (usually a network of banks) provide quotes at which they are willing to buy or sell. These dealers “make a market” for the financial instruments they offer. This type of market is also referred to as an OTC (over-the-counter), as trades are conducted outside of a regulated exchange.
A significant portion of trading in currencies, bonds, and spot commodities occurs in quote-driven markets.
Order-Driven Markets
Order-driven markets match buy and sell orders through a specific mechanism. These rules are necessary because the parties involved in the trade typically do not know each other. Almost all exchanges and alternative trading systems operate as order-driven markets.
Matching Rules
These rules determine the order in which trades are processed. The primary criterion is price priority—orders with the highest buy prices and lowest sell prices are executed first. Displayed orders take precedence over hidden ones. When orders are at the same price, time precedence comes into play, with earlier orders being processed first.
Trade Pricing Rules
After matching, the execution price is determined by specific trade pricing rules. There are three main types of pricing rules in order-driven markets:
- Uniform Pricing Rule: Common in call markets, this rule sets a single price that maximizes the trading volume.
- Discriminatory Pricing Rule: In continuous markets, the standing order determines the price, ensuring that new trades clear the most aggressively placed orders first. For example, if Trader A places a standing buy order at $100 and Trader B places one at $99, and a seller later offers shares at $99, Trader A’s order will be filled first, followed by Trader B’s.
- Derivative Pricing Rule: The price is based on trading in another market. Often, the execution price is set at the average between the bid and ask prices from the primary market for the instrument, hence the term “derivative pricing.”
Broker-Mediated Trading
In broker-mediated markets, a broker arranges a deal between their clients. This approach is more commonly used for trading less liquid assets, such as real estate, art, intellectual property, and more.
Conclusion
Call markets, with their single trading session and uniform pricing, are ideal for trading illiquid securities, ensuring efficient price discovery through periodic matching. On the other hand, continuous markets provide flexibility with ongoing trading throughout the session, making them better suited for highly liquid assets.
