Exploring the workings of dealer markets, including the over-the-counter trading of bonds, debentures, and unlisted equities. The guide illuminates the methods and advantages of trading in dealer markets and synthesizes regulatory nuances in Canada.
Dealer markets, also known as over-the-counter (OTC) markets, consist of a network of banks and investment dealers. Unlike auction markets, where orders from buyers and sellers are collated in a centralized marketplace, dealer markets operate as negotiated markets. Market makers in these environments post bid-and-ask quotations through electronic platforms and computer networks. Investment dealers typically act as principals in the OTC market.
Almost all bonds and debentures are transacted through dealer markets. Despite being less visible than auction markets for equities, the volume of trading (in dollar terms) for debt securities is significantly larger in dealer markets.
Dealer markets are often referred to as unlisted markets because the securities traded there are not listed on an organized exchange, as is customary in auction markets.
In dealer markets, transactions do not occur in a central marketplace. Instead, they are typically carried out on the OTC market. Trades are facilitated by the computer systems of inter-dealer brokers that enable transactions between investment dealers.
The volume of unlisted equity business in dealer markets is much smaller than what transpires on stock exchanges. Despite many junior issues trading OTC, shares of some industrial companies also trade in this market. These companies’ boards might choose not to list one or more of their equity issues on a stock exchange for numerous reasons. The unlisted market does not impose minimum listing requirements nor attempts to regulate companies.
Many of the stocks traded in the unlisted market are more speculative and generally offer lower liquidity than those on listed markets.
Visual Representation—Example Snapshot of Dealer Markets Transaction: Non-Centralized Trading
graph TD
A[Investment Dealer A] -->|Quote Bid/Ask Prices| B((OTC Market))
A[Investment Dealer A] --> C[Market Maker X]
A[Investment Dealer A] --> D[Market Maker Y]
D[Market Maker Y] --> E[Investor Order]
C[Market Maker X] --> E[Investor Order]
B((OTC Market)) --> |Facilitates| E[Investor Order]
Over-the-counter trading of equities takes place similarly to bond trading. No centralized and public market exists for individual investors’ orders. Instead, market makers quote their own bid and ask prices. Market makers maintain inventories of the securities they commit to trading, selling them to interested buyers against quoted prices.
The ability of market makers to offer bid and ask prices provides necessary liquidity to the system, albeit with the discretionary right to refuse to trade at these prices. Investors looking to buy or sell an unlisted security have their dealer consult multiple market makers’ quotations to find the best price before completing the transaction. This service incurs a commission charge by the dealer.
The OTC derivatives market is largely handled by major international financial institutions, including banks and investment dealers who trade with corporate clients and other financial entities. Traders conduct their negotiations asynchronously, ensuring the market operates incessantly, 24 hours a day.
One of the appealing features of OTC derivative products is their customizability by buyer and seller to include special features beyond the fundamental properties of options and forwards, introducing higher complexity.
Reporting requirements for unlisted trades differ by jurisdiction. Notably, in Ontario, investment dealers must report unlisted and unquoted equity trades via the Canadian Unlisted Board Inc.’s web-based system, as mandated by the Ontario Securities Act. Conversely, the rest of Canada lacks obligatory trade reporting for unlisted securities.