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Contrast equity trading on an exchange, off an exchange and over the counter

CFA® Level I · Equity Investments · Equity Issuance and Trading · EQ.9.a

The idea

Shares can change hands in three broad kinds of venue. An exchange runs a central, displayed order book, sets listing standards and publishes prices, which makes it the main place where prices are discovered. Off-exchange venues, such as alternative trading systems, dark pools and brokers matching orders internally, trade listed shares away from the exchange; dark pools hide orders before the trade so that large institutions can deal without moving the price against themselves. Over-the-counter trading is negotiated through dealers, usually in securities that are not listed at all, with less transparency and often wider spreads. The trade-off is transparency against market impact: the more volume leaves displayed markets, the more fragmented liquidity becomes and the less information the public price contains.

A practice question

From the question bank, with the reason each wrong option is wrong.

Shares of a company that is not listed on any exchange and trade through negotiation with dealers are traded:

  1. over the counter — correct
  2. in a dark poolWhy not: Dark pools are off-exchange venues that mainly trade listed shares; they are not defined by dealer negotiation.
  3. on an exchangeWhy not: By definition the shares are not listed, so they cannot trade on an exchange's order book.

Over-the-counter trading is conducted through dealer networks rather than a central exchange, typically in unlisted securities, with less transparency than exchange trading.

A harder one

An institution wants to sell a large block of a listed share without moving its price. It would most likely route the order to:

  1. the exchange's displayed limit order bookWhy not: Showing a large sell order in the open signals the institution's intent, and other traders move the price against it.
  2. an over-the-counter dealer in unlisted sharesWhy not: The share is listed. OTC dealer markets are mainly for unlisted securities and add no advantage in hiding a listed-share order.
  3. an off-exchange venue such as a dark pool — correct

Hiding the order before execution reduces market impact, which is the main reason large investors use off-exchange venues for listed shares.

The hardest tier

A regulator notes that the share of trading in listed equities executed off-exchange has risen sharply. The main concern is most likely that:

  1. institutions will face much larger market impact costsWhy not: Off-exchange venues exist to reduce market impact for large orders, so this is the benefit rather than the concern.
  2. unlisted OTC securities will replace listed sharesWhy not: The trading has moved venue, but the shares are still listed; nothing is being delisted.
  3. liquidity fragments and public prices carry less information — correct

Displayed prices on exchanges are formed from displayed orders. If much of the volume trades away from them, the public price reflects less of the demand in the market and liquidity is split across many venues.

In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

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