Secondary Security Markets: Trade Pricing Rules
Trade pricing rules are used in order-driven markets to control the second part of the order matching process. Preceding trading rules establish trading matches through a hierarchy using price and time priorities. Once matches are formed, trade pricing comes into play to finally set the transaction price.
Knowing that most exchanges, including electronic networks, are order-driven markets, why do you suppose such detailed rules and processes exist?
Yes. Market participants are not sure who their trade requests will be matched with, and credit quality information is not available. The rules keep trading parties fair and honest.
No. While it might seem that a better structure would make a market more attractive than one without, order-driven markets do not increase in volume based on the matching and sequencing structure that is provided, and most markets are order-driven.
No. Ordering rules use time stamps to set the order when two prices are the same—the first one in is first. Rules also set the highest buy price request to the lowest sales price request. Trade pricing rules set the resultant trade prices. No side fees are imposed.
For example, consider the following orders and ponder a new buy order from Scott for quantity 11 with a limit price of USD 2.04:
| Buyer | Bid Quantity | Limit Price in USD |
|-------|--------------|----------------------|
| Joe | 5 | 2.00 |
| John | 3 | 2.01 |
| Jack | 6 | 2.02 |
| Seller | Offer Quantity | Limit Price in USD |
|--------|----------------|----------------------|
| Adam | 3 | 2.03 |
| Alex | 7 | 2.04 |
| Albert | 10 | 2.05 |
Based on discriminatory pricing rules, which is likely the correct scenario?
No. Scott does not initially trade with Alex because Adam's limit price is less than Alex's.
Yes. Scott's limit order is USD 2.04, so he does not agree to purchase shares from Albert because the offer price is above his limit.
No. Scott's order is the only one that is marketable, as Joe's, John's, and Jack's limit orders are too low and their orders will wait in the book for a match.
__Crossing networks__ match buyers and sellers that will trade at prices from other markets. They use the __derivative pricing__ rule, which determines the crossover price that trades will take place at. The price does not depend on the orders submitted to the crossing network.
To summarize:
[[summary]]
One type of trade pricing rule is __uniform pricing__. This is found in a call market, where an entire order would trade at the same price, the market clearing price, at the call time. This price is determined by the last feasible trade where maximum quantities are traded.
A second type is widely used in continuous markets. The __discriminatory pricing__ rule establishes trade pricing as the limit price that is associated with the first arriving order, the standing limit order. Larger orders benefit from getting better prices on parts of orders.
Rules enable more participants to trade each trading session
Rules keep participants honest
Rules allow for markets to collect side fees on trades
Scott trades with Alex and purchases 7 shares at USD 2.04 each
Scott only completes a trade for 10 shares and purchases three shares from Adam at $2.03 each and 7 shares from Alex at USD 2.04 each
Scott's order is not considered because of his limit price
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