8.2 Over the counter market, third market, and the fourth market

The over-the-counter market (OTC)

• is another market center

• continues to be the market center for smaller companies

• Securities that trade OTC are called non-listed or unlisted securities.

• There is no floor. The OTC is a decentralized market.

• Trades in the OTC are between specialized broker-dealers called market makers.

• There are multiple market makers for a given stock. The market makers compete for business.

Market makers

• A dealer willing to accept the risk of holding a particular security in its own account to facilitate trading in that security.

• operated as a decentralized venue

• facilitates trading by: providing liquidity, reducing spreads, absorbing volatility

Market makers

• There are multiple market makers for a given stock. The market makers compete for business.

• Market makers maintain an inventory of the securities they make a market in.

• Market makers post their prices (quotes) in an electronic system so investors can see them.

• When an investor buys an OTC security, they are buying from a market maker.

• When an investor sells an OTC security, they are selling to a market maker.

• A broker-dealer may assist a customer in a trade by identifying a market maker that will be able to provide the trade the customer needs.

• A broker-dealer that assists the customer is acting as an agent, representing the customer in the trade. They will charge a commission for this service.

• A market maker makes a profit on the difference between what they pay to buy the security and what they sell it for. This is called the spread; it may also be referred to as a markup or markdown.

• A broker-dealer may not act as both the agent and a market maker on the same trade.

Risk of Market makers

• inventory risk

• market risk

• operational cost

The Third Market (Nasdaq Intermarket)

• A system that facilitates Nasqad trades in the NYSE floor.

• When exchange-listed securities are traded OTC, the trade is said to be in the third market.

The Fourth Market (The ECNs)

• A market for institutional investors

• no assistance of broker dealer

• transactions take place through electronic communication networks (ECNs)

• are open 24h a day

• protect institutional investors from revealing their trades.

• protects the marker from orders that might be disruptive because they are so large

• orders in the fourth market are not made public until after the trade is complete. That is why they are sometimes called dark pools, because these trades are less transparent than exchange or OTC trades.

NYSE trading window

9:30 am and 4:pm ET

market makers trading window

remain open until 6:30 p.m. in extended hours trading.