Market Structure and Trading Mechanisms Notes

Market Structure and Trading Mechanisms

Overview of Market Structure

  • Definition: Market structure refers to the organization and characteristics of a market, influencing the exchange of goods and services and competition levels.

  • Key Influences on Market Dynamics:

    • How goods/services are exchanged.

    • The level of competition present.

Types of Market Structures

  1. Perfect Competition:

    • Characteristics:

      • Many buyers and sellers.

      • Homogenous products.

      • Price takers due to no individual influence on market.

      • Free entry and exit for firms.

    • Real-World Examples: Rare in practice; agricultural markets sometimes represent this structure.

  2. Monopolistic Competition:

    • Features:

      • Many firms selling differentiated products.

      • Some pricing power due to product variation.

      • Heavy use of advertising and branding.

    • Example: Restaurant industry.

  3. Oligopoly:

    • Description: Market dominated by a few large firms.

    • Strategic Behavior: Firms may collude, influencing market prices.

    • Examples: Automobile manufacturers, airlines.

  4. Monopoly:

    • Key Traits:

      • Single seller with significant market power.

      • High barriers to entry; prices can be set without competitor fear.

    • Examples: Local utility companies; certain patented drugs.

  5. Duopoly:

    • Definition: Market with two major firms competing intensely.

    • Example: Telecommunications firms (e.g., PLDT & Globe Telecom).

Trading Mechanisms

  • Definition: Methods and processes for buying and selling financial instruments (stocks, bonds, etc.).

Common Trading Mechanisms

  1. Auction Markets:

    • Buyers and sellers interact directly.

    • Types include: English, Dutch, and sealed-bid auctions.

    • Example: NYSE mainly operates as an auction market.

  2. Dealer Markets:

    • Involves intermediaries (dealers) who buy/sell from their inventory.

    • Offer liquidity through bid/ask prices.

    • Example: OTC markets for certain stocks and bonds.

  3. Electronic Trading Platforms:

    • Enable electronic matching of buy and sell orders.

    • Example: Nasdaq, which operates primarily on an electronic market model.

  4. OTC Markets:

    • Decentralized platforms where parties trade directly.

    • Allow for flexibility and customization but may lack transparency.

    • Examples: Trading of bonds, derivatives, and currencies.

  5. Hybrid Markets:

    • Combine features of auction and dealer markets.

    • Example: Chicago Mercantile Exchange (CME).

  6. Continuous vs. Periodic Auctions:

    • Continuous: Trades occur throughout the day.

    • Periodic: Trades occur at set intervals.

Interplay Between Market Structure and Trading Mechanisms

  • Liquidity: Level of liquidity can be influenced by the market structure.

  • Price Discovery: Auction markets are generally viewed as more efficient for price discovery.

  • Transparency: Varies by structure; auction markets typically provide greater transparency than dealer markets.

  • Market Manipulation Risks: Auction markets are less prone to manipulation than dealer markets.

  • Regulatory Considerations: Regulators shape both market structures and trading mechanisms to enhance market efficiency and integrity.

Role of Stock Exchanges

  • Function and Purpose: Facilitate buying/selling securities and ensure transparent trading platforms.

  • Capital Formation: Help companies raise funds by issuing stocks/bonds.

  • Market Regulation: Subject to strict regulations ensuring fair practices.

  • Liquidity and Price Discovery: Stock exchanges enhance market liquidity resulting in better price discovery.

Philippine Stock Exchange (PSE)

  • Significance: Main exchange, crucial for capital raising.

  • Role: Offers transparency and investor confidence.; provides investment opportunities.

  • Challenges: Low public participation, lower liquidity compared to mature markets.

International Stock Exchanges

  1. Size and Importance: Major exchanges impact global financial markets; NYSE, LSE, TSE as key players.

  2. Listing Requirements: Specific criteria for companies to trade shares.

  3. Market Structure and Efficiency: Centralized vs. decentralized marketplaces influence efficiency.

  4. Technology Impact: Electronic platforms enhance liquidity and transaction speed.

Over-the-Counter (OTC) Markets

  • Characteristics: Decentralized; allow trading without formal exchanges. Lower transparency and higher counterparty risk.

  • Types of OTC Markets: Equities (Pink Sheets), Debt, FX, Derivatives, Commodities, and Cryptocurrencies.

Auction Systems

  • Definition: Competitive bidding process for buying/selling goods.

  • Types:

    • English Auction: Open bidding.

    • Dutch Auction: Prices decrease until accepted.

    • Sealed-Bid Auction: Confidential bidding.

  • Advantages: Efficient pricing, transparency, and quick sales.

  • Limitations: Limited participation, potential for fraud, risk of overpayment.

Clearing and Settlement

  • Definition and Importance: Processes ensuring secure transfer of assets post-trade execution.

  • Clearinghouses' Role: Validate trades, reduce counterparty risk through novation.

  • Settlement Types: Physical delivery, book-entry, cash settlement, DVP (Delivery versus Payment).

Clearing and Settlement in the Philippines

  • Entities Involved: Philippine Stock Exchange, PDTC (Philippine Depository & Trust Corporation).

  • T+2 Trading System: Trades settled two days post-execution, ensuring efficiency and risk mitigation.

  • Challenges: Need for continued technology upgrades and cyber risk management.

Conclusion

Understanding market structures and trading mechanisms is essential for investors and policymakers to navigate financial markets effectively. These concepts play critical roles in ensuring fair, efficient, and transparent market operations.