Dealing Systems

Order driven
Quote driven
Brokered Systems
Hybrid mix of two

Order Driven
A broker is used to match buy and sell orders at a given price. The broker charges a small commission. Orders are entered with a price limit, for example a buyer is prepared to buy 500 shares up to a limit of £1.54 or a seller will sell 400 shares but at a price no lower than £1.51. These orders are feed into the system. The system then calculates the opening price at which the largest number of bids and offers can be matched.

Lets imagine we have the following buy and sell orders:
buy 500 - market price
buy 200 - 156
buy 250 - 155
buy 500 - 154
buy 750 - 153
buy 1000 - 152
buy 3000 - 151

sell 400 - market price
sell 250 - 150
sell 400 - 151
sell 500 - 152
sell 600 - 153
sell 1250 - 154
sell 1700 - 155

In this example, the market reaches equilibrium at 153 with 1700 shares at the offer rate (200 + 250 + 500 + 750) prepared to pay at least 153
and 1750 shares at the bid rate (250 + 400 + 500 + 600) prepared to sell at 153 (?)
All the orders are now filled at the market price and any unfilled orders are carried forward with a limit price of 153.
Trading is continuous and the arrival of new orders will trigger a match if any exist.
Very large orders present a problem. They may wait quite a long time until they can be matched and its presence will raise or lower the price.

Quote Driven

A market maker is used to continuosly quote a bid and offer price.
The difference between the bid and offer is called the spread and that is the market makers profit margin.
Market Makers buy shares (or bonds) not knowing who they will sell them to. They also agree from time to time to sell short (sell stock they don;t own) This involves risk and capital. The market maker can change his bid and offer at any time.

The main quote driven systems are the NASDAQ (US) and the SEATS (UK)

In this situation the broker will approach the market maker on behalf of their clients
In this situation the broker is often referred to as a broker dealer.
Large institutions don't have to use a broker buy may approach a market marker directly
If they do use a broker it is often because the client receive free equity research reports from them.

The market is very competitive and there could be as many as 15 or 20 market makers competing in a particular share.

Hybrid

SEATS - An electronic notice board onto which orders can be logged. This is a hybrid system.

For stocks where there is not much liquidity a single market maker is appointed who is obliged to continuously quote a spread.
When market makers trade they must fulfil orders than are posted first if they are at the same price or better than a proposed trade.

Hybrid systems - Each share is allocated to a specialist
The specialist acts as a broker, executing orders for other brokers on a commission basis, or may buy and sell for their own account.
They match the buyers and sellers when there is plenty of liquidity and buy on their own account when there is a shortage.
At the start of the day, the specialist is faced with many order, some at closing market price, some at limit prices.
His duty is to set a price as near to the close as possible (to maintain an orderly market) and yet also match as many orders as possible.