6.2 Characteristics of bonds and equities

trading arrangements in place at the moment still show the legacy of those reforms.

The buying and selling of equities is done largely through market-makers who act

in a dual capacity. They quote continuous two-way prices for the shares in which

they deal. Market-makers in the London Stock Exchange are usually divisions of

major banking groups. Buying and selling prices are displayed on computer screens

using the London Stock Exchange’s SEAQ system. Because market-makers hold

their own inventories of stock and quote continuous prices, the London Exchange

is said to be a ‘quote-driven’ rather than an ‘order-driven’ (also called ‘matching’ or

‘auction’) market.

In this respect, London is unusual. Most stock exchanges – including those of

continental Europe, many of which have recently undergone drastic modernisation

– are order-driven markets. Tokyo and New York mix both systems. In an order-driven

market, buyers and sellers submit orders to the market-maker specifying respectively

an upper and lower limit at which they are prepared to trade. Buy orders are then

matched to sell orders, so far as possible, by computer and a price is struck and

declared. Any offers which cannot be executed at that price are kept until the price

moves within their limit or the instruction to buy or sell is withdrawn. Compared

with the quote-driven or dealer system it is immediately apparent that the order-

driven system distributes the risk associated with holding shares rather differently.

In a dealer system, the dealer holds inventories of stocks on his own behalf, to which

he adds the sell stocks that he receives and from which he executes buy orders.

Clearly the price of this inventory will uctuate with changes in the market price

of stocks. Meanwhile, the buyer/seller has the advantage of knowing with certainty

the price at which his order will be executed. In an auction system, the market-

maker holds no signicant inventories and accepts no stocks except in so far as he

matches them instantly with a buyer. The counterparties to the transaction, how-

ever, cannot know in advance the exact price at which their order will be carried

out. The risk to the latter is moderated by the setting of price limits and by the

fact that auction markets, just like dealer markets, display continuous and detailed

trading information on screen which enables potential buyers and sellers to see the

price at which the last trade was carried out and any trend that might be developing.

Partly because the market-maker faces less risk, while the shareholder faces more,

order-driven markets are generally cheaper to operate. Commissions and spreads

between the bid and offer prices are lower in Frankfurt and Paris than in London,

for example.

In October 1997, the London Stock Exchange launched a limited order-driven deal-

ing facility. Known as ‘SETS’ (Stock Exchange Electronic Dealing System), it covered

the shares of 126 larger companies (most of them included in the FTSE-100 index).

The results so far have been mixed, especially for small investors. On average, the

bid–offer spread has fallen from around 0.6 per cent to 0.4, but there have been

cases where such spreads (normally less than 1 per cent) have jumped to nearly

10 per cent. The problem, it seems, lies with insufcient orders. Clearly, if orders

are few, there is a chance that the only matching order is at a very disadvantageous

price. Part of the problem may well be that with two systems running side by side,

not enough people were attracted to the order-driven system and once it emerged

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Chapter 6 • The capital markets

that prices could behave erratically, fewer still were attracted by low dealing costs.

Problems seem to have been worst at the beginning and end of the day. (There

were even rumours that some investors were putting in ‘buy’ orders at absurdly low

prices at the end of the day, hoping to pick up a bargain from some unsuspecting

investor who placed a ‘sell’ order early the following morning when there might be

no buyers for the shares.) It remains to be seen whether London will move to order-

driven trading as the norm. The main lesson may be that running the two systems

in parallel is the worst of all possible options.