Latest / How Canadian Markets Work / Episode 4: Auction Markets and Dealer Markets

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Episode 4: Auction Markets and Dealer Markets · How Canadian Markets Work

0:00
Imagine it's a Tuesday afternoon. You're sitting
0:03
there and you decide to make two trades in your
0:06
brokerage account. Just a quiet afternoon at
0:09
home. Exactly. Yeah. So first you buy a stock
0:11
and instantly you kind of feel like a Wall Street
0:13
insider. Right. You see the price blinking on
0:16
the screen. You watch it tick up and down. You
0:18
see the exact volume of buyers and sellers too.
0:21
Yeah. Lining up right in front of you. You know
0:22
exactly where you stand. But then maybe 10 minutes
0:26
later, you decide to buy a corporate bond. And
0:28
that's when things change. Completely. The screen
0:30
just goes completely dark. All that beautiful
0:32
context, it just vanishes. You are simply handed
0:35
a single number, a take -it -or -leave -it price,
0:39
with absolutely no way to verify if it is actually...
0:43
fair. It is an incredibly common experience for
0:46
retail investors and, well, it almost always
0:48
causes a sense of mild panning. Oh, for sure.
0:50
You assume something is broken or that your brokerage
0:53
platform is somehow hiding information from you,
0:55
but it's not a glitch. Right. It's a fundamental
0:58
difference in the invisible machinery operating
1:00
beneath the surface of the market. Today, we
1:03
are finding out exactly where your money goes
1:04
when those lights go out. Our source material
1:08
is drawn from episode four of the Canadian financial
1:11
series, How Canadian Markets Work. In the original
1:15
text, the hosts, John and Jane, they really break
1:18
down the fascinating, highly structured world
1:21
of... auction markets and dealer markets. And
1:24
while those terms, I mean, they sound like textbook
1:25
jargon, they are really just two completely different
1:28
ways of answering the most basic human question
1:31
in finance. Which is? What is this particular
1:34
asset actually worth right now? OK, let's unpack
1:36
this. Our mission today is to decode that frustrating,
1:41
opaque experience of buying a bond. And along
1:44
the way, we're going to uncover the invisible
1:46
fees that are baked into these everyday transactions.
1:50
It's a very important mission for anyone managing
1:52
their own money. It really is. So to ground all
1:54
of this, let's go back to that opening scenario.
1:57
That is actually pulled directly from Jane, one
1:59
of the hosts in our service material. Right,
2:00
her two trades. Yeah, two trades made on the
2:03
exact same afternoon for the exact same amount
2:06
of money, but yielding two completely different
2:08
user experiences. You have transparency versus
2:11
total opacity. Exactly. When she buys the stock,
2:14
she is participating in an auction market. But
2:17
when she buys the bond, she is participating
2:19
in a dealer market. Two distinct ecosystems.
2:22
Completely different. I want to focus on how
2:24
this actually feels to the investor. Trading
2:27
a stock. It feels like walking into a bustling,
2:33
brightly lit art auction. That's a great way
2:35
to picture it. Right. The auctioneer is at the
2:37
front of the room. Everyone's paddles are visible
2:39
in the air. And you can see exactly what the
2:41
crowd is willing to pay. If the painting is going
2:44
for $5 ,000, you know it's because three other
2:47
people in the room are actively shouting out
2:49
$4 ,900. You see the demand with your own eyes.
2:51
Exactly. But the bond market, that feels like
2:54
walking onto a private, kind of poorly lit used
2:57
car lot. You wander around, you find a sedan,
3:00
and there is just a sticker price on the windshield.
3:03
Just a solitary number. Yeah, and you have absolutely
3:06
no idea what the dealer paid for that car, and
3:09
you have no idea if anyone else would pay that
3:11
sticker price. That used car lot analogy is actually
3:14
perfect, especially if we look at the mechanics
3:16
of why it operates that way. Why is that? Well...
3:19
When you walk onto that lot, the dealer isn't
3:22
acting as a matchmaker. They aren't finding a
3:24
seller to hand you the keys. Right. The dealer
3:26
actually owns that car. They bought it with their
3:29
own money. It's sitting on their lot taking up
3:31
space and, you know, they need to sell it to
3:34
you for more than they paid for it. Because if
3:36
they don't. If you don't buy it and no one else
3:38
buys it, that car rusts and the dealer takes
3:41
a massive financial loss. So they hold the risk.
3:44
Precisely. What's fascinating here is that this
3:47
immense asymmetry of information This difference
3:50
between the open art auction where everyone is
3:52
competing and the quiet car lot where the dealer
3:55
holds all the inventory. It's the structural
3:57
foundation of our financial system. Well, wait.
4:01
If the open art auction is so efficient and the
4:03
stock trade is so beautifully transparent, how
4:07
does that machinery actually work? You mean under
4:10
the hood? Yeah, exactly. Why do we feel so in
4:13
control when we trade a stock? Because you are
4:16
stepping into the public square. When we talk
4:19
about auction markets, the primary example in
4:21
our Canadian source material is the TSX, the
4:25
Toronto Stock Exchange. Like the TSX. And the
4:28
beating heart of an exchange like the TSX is
4:31
something called a central order book. Let's
4:34
visualize that central order book for a second.
4:36
What does it actually look like behind the screen?
4:38
Imagine a massive, continuously updating digital
4:41
ledger, and it's divided into two columns. OK,
4:44
two columns. On one side, everyone who wants
4:46
to buy the stock publicly posts their bid, which
4:49
is the maximal price they're willing to pay.
4:51
Got it. On the other side, everyone who wants
4:53
to sell publicly posts their ask, which is the
4:56
minimum price they're willing to accept. So you
4:58
basically have a column of buyers and a column
5:00
of sellers all staring across this digital ledger
5:03
at one another. Yes. And a trade only ever happens
5:07
when the highest buyer and the lowest seller
5:09
finally meet in the middle. The crucial element
5:12
here is visibility. You can look at this ledger
5:14
and see that there are, say, 400 shares offered
5:18
at $80 and 900 shares being did at $79 .95. So
5:23
you have the exact same data. as the massive
5:26
institutions. Exactly the same data. So if everyone
5:29
is just shouting out the numbers they want, who
5:31
actually decides what the stock is worth, there's
5:33
no central authority stamping a price tag on
5:36
it. No authority at all. Public competition polices
5:39
the price. Oh, wow. The market itself doesn't
5:42
actually set the value. the crowd does. So the
5:45
market itself doesn't actually set the price
5:47
the crowd does. That is a really elegant system.
5:50
It is incredibly efficient because hundreds sometimes
5:54
thousands of participants are actively competing
5:57
to post the best possible price. Makes sense.
5:59
If someone wanders into the market and posts
6:01
a bid that is completely unreasonable say they
6:05
want to buy shares for seventy five dollars when
6:07
the entire crowd is bidding 80 they don't suddenly
6:10
get a magical bargain. The system just ignores
6:12
them. It just ignores them. They never get to
6:15
trade because someone else in the crowd is always
6:16
willing to offer a better, fairer price. So the
6:19
sheer volume of the crowd protects the individual
6:22
investor from getting ripped off. That's exactly
6:24
right. OK, well, if that central order book is
6:27
so brilliant and it protects the investor so
6:29
well, why on earth did Jane's bond trade happen
6:33
in the dark? That's a great question. Like, why
6:35
don't we just use that exact same public ledger
6:38
for everything? Because sometimes the public
6:40
square is completely empty. Empty. Yeah. And
6:44
this is where we have to look closely at the
6:46
dealer market. It's also known as the over -the
6:48
-counter or OTC market. Right, OTC. In this ecosystem,
6:52
there is no central order book. There is no public
6:55
ledger. There is no crowd. So who is on the other
6:59
side of my trade? Dealers, these are large financial
7:02
institutions, typically the major banks, who
7:04
stand ready to buy from you or sell to you directly
7:08
out of their own private inventory. Just like
7:10
the owner of the used car lot. Exactly like the
7:13
car lot owner. They are not matching your buy
7:16
order with another retail investor's sell order.
7:20
They are taking the opposite side of your trade
7:22
themselves. Using their own capital. Using their
7:25
own capital, yes. And because they are using
7:27
their own capital, They are taking on that inventory
7:30
risk we talked about earlier. A very severe risk,
7:33
honestly. They might buy a massive block of corporate
7:35
bonds from you today, but what if inflation data
7:38
comes out tomorrow, interest rates spike, and
7:41
the value of those bonds plummets? Then they're
7:43
stuck. They are stuck holding an asset that is
7:46
losing value, and they might be unable to find
7:49
anyone to take it off their hands. Wow. Because
7:51
they are absorbing that heavy risk, they require
7:54
compensation. Here's where it gets really interesting.
7:58
How exactly are they taking their compensation?
8:00
Because when I log into my brokerage account
8:02
and buy a bond, I don't see a massive invoice
8:05
for dealer risk services. No, you don't. You
8:08
don't see it because it's baked directly into
8:10
the price. OK. Let's break down the mechanics
8:12
of the bid ask spread. This is the core engine
8:15
of the dealer market. I'm listening. A dealer
8:17
always quotes two prices. The bid is the price
8:21
the dealer is willing to pay you if you want
8:23
to sell your bond to them. And the ask. The ask,
8:26
sometimes called the offer, is the higher price
8:29
they will charge you if you want to buy that
8:31
bond from them. The mathematical gap between
8:33
those two numbers is the spread. Let's run the
8:37
exact numbers from our source material so we
8:39
can see what this looks like in practice. Yeah.
8:41
Because I think this is crucial. Definitely.
8:43
Imagine a dealer. is quoting a specific corporate
8:47
bond. They post a bid of 98, and they post an
8:51
ask of 98 .5. Now, follow the sequence of events
8:56
here. You decide to buy a $10 ,000 position in
8:59
that bond. You pay the dealer's asking price
9:02
of 98 .5. Right. The transaction goes through.
9:05
But the very next second before the market has
9:07
moved at all, you realize you made a mistake.
9:10
You need that cash back. So I decided to sell
9:12
the bond instantly back to the exact same dealer.
9:15
But they won't pay you 98 .5. Right. They will
9:18
only pay you their bid price, which is 98. Ah.
9:22
So I bought it 98 .5, and I instantly sold back
9:25
at 98. I've just lost half a point. Exactly.
9:28
You lost half a point. And on a $10 ,000 position,
9:32
that means the simple act of buying and instantly
9:34
selling back costs you $50 immediately. Wait.
9:37
I need to push back on this. $50. Yes. They just
9:42
pocketed my $50 for doing absolutely nothing
9:45
but acting as a toll booth. I mean, that sounds
9:49
like a legally sanctioned scam. It can certainly
9:52
feel that way. How is that fair to the retail
9:54
investor? Especially when my brokerage statement
9:57
probably says my trading commission was zero
9:59
dollars. It feels like a hidden penalty, I agree.
10:01
Yeah. But it is not a scam. That $50 is essentially
10:04
an insurance premium you are paying to the dealer
10:06
for providing liquidity. An insurance premium.
10:09
Yeah. You have to remember, the dealer did not
10:12
know you were going to sell it right back to
10:13
them. When they sold it to you at 98 .5, they
10:16
took it out of their inventory. When they bought
10:18
it back at 98, they put it back onto their balance
10:20
sheet, reassuming all the risk that the bond
10:23
might drop to 95. tomorrow. Right they're holding
10:26
the bag again. Exactly. The spread is the required
10:30
cost of forcing a massive financial institution
10:34
to trade with you on your schedule rather than
10:36
waiting for a natural buyer to show up. Okay
10:39
that makes sense logically but $50 is still a
10:42
steep hidden fee. Auction markets have spreads
10:44
too don't they? They do yes. How do they compare?
10:47
Well they do have spreads but because of the
10:49
massive crowd they are microscopic. How microscopic.
10:53
If you trade a highly liquid Canadian bank stock
10:57
on the TSX, the spread might just be one or two
11:00
cents. Wow. So if you buy $8 ,000 worth of that
11:04
stock, the spread might cost you a grand total
11:06
of $2. $2 versus $50. That is a staggering difference.
11:10
It really is. The spread is the ultimate measure
11:13
of liquidity. A narrow spread, those two cents
11:16
on the bank stock, tells you that there is heavy
11:19
competition, a massive crowd, and almost zero
11:22
risk for anyone taking the other side of the
11:24
trade. A widespread. A widespread, like that
11:27
big gap on a corporate bond, is the market's
11:29
way of telling you that you are entirely alone.
11:33
There is no crowd. The dealer is the only game
11:37
in town, and they are charging you a premium
11:39
for their solitary service. OK, this raises a
11:41
massive structural question for me. What's that?
11:44
If auction markets are so much cheaper for the
11:46
investor and the spreads are so tiny, why not
11:49
just force bonds onto the TSX? Why let dealers
11:53
take that cut at all? Why do bonds have to live
11:55
in the dark? The answer is something called the
11:57
variety problem. The variety problem. Let's explore
12:00
that. Let's picture a single major Canadian telecom
12:03
company. That company typically issues only one
12:06
single class of common stock. It is one uniform
12:10
asset. Right. Millions of shares exist, but they're
12:13
all identical. So it is very easy to gather a
12:16
massive crowd around that one single item. Exactly.
12:19
Everyone who wants to invest in the company's
12:21
equity is trading the exact same ticker symbol.
12:24
But that exact same telecom company might have
12:28
15 or 20 different bonds outstanding at the exact
12:31
same time. Wait, really? 20 different bonds for
12:34
one company? Yes. Because they borrow money at
12:37
different times for different projects. I hope
12:39
that makes sense. They might have a bond issued
12:41
in 2018 that matures in 2028, paying 4%. They
12:45
might have another bond issued in 2020. that
12:47
matures in 2035 paying 5%. And those are completely
12:51
separate. They are entirely distinct legal contracts.
12:54
Now take those 20 bonds and multiply them by
12:57
every single corporate and government borrower
13:00
in the entire country. You're talking about tens
13:02
of thousands of completely different products.
13:05
Exactly. The bond market isn't a single highway.
13:08
It is a sprawling map of thousands of tiny dirt
13:11
roads. Oh, I love that analogy. Because there
13:13
is so much variety, most of these specific bonds
13:16
rarely trade. You might go an entire month without
13:19
a single person in the country wanting to buy
13:21
the exact 20, 35, 5 % corporate bond that you
13:25
suddenly need to sell on a Tuesday morning. Wow.
13:28
So this isn't a sinister plot by dealers to hide
13:31
fees, just that there aren't enough people trading
13:34
the exact same bond to form a crowd. If we connect
13:36
this to the bigger picture, the dealer isn't
13:39
extracting a widespread because the market is
13:41
maliciously designed. The spread is simply the
13:44
required cost of having someone, anyone willing
13:46
to answer the phone when the public square is
13:48
empty. That is deeply sobering. Are retail investors
13:52
just stuck paying these massive hidden fees if
13:54
they want to hold bonds? Not necessarily. Our
13:56
source material notes a very common workaround.
13:59
Many retail investors choose to bypass the individual
14:02
dealer market entirely by purchasing bond ETFs
14:05
exchange traded funds. How does an ETF solve
14:08
the variety problem? An ETF pools hundreds of
14:11
millions of dollars from thousands of everyday
14:13
retail investors. The fund managers take that
14:17
massive pool of capital and buy the bonds in
14:19
institutional sizes because they are trading
14:22
in blocks of 50 or 100 million dollars. The dealers
14:26
give them razor -thin highly competitive institutional
14:29
strides. And then the retail investor just buys
14:32
the ETF. Exactly. They buy the ETF on the stock
14:35
exchange enjoying the transparency of the auction
14:38
market. But there is always a catch, right? Of
14:41
course there is. The trade -off is that while
14:43
you avoid the wide dealer spread, you are now
14:46
paying a transparent ongoing management fee to
14:49
the company that runs the ETF. So you trade an
14:52
invisible one -time execution fee for a visible
14:56
recurring management fee. Precisely. For most
14:58
retail investors, the transparency is worth the
15:01
trade -off. That makes perfect sense. So we've
15:03
established the difference between the transparent
15:05
auction and the opaque dealer market. Right.
15:08
I know our sources mentioned that real markets
15:10
are actually complex hybrids, like the TSX uses
15:13
designated market makers to provide a backstop.
15:16
just in case the crowd ever vanishes from a stock.
15:18
Yes, that's a great point. And bond transparency
15:21
is slowly getting better with post -trade reporting.
15:24
But I want to move away from the theory and get
15:26
into the defense. The practical side. Yeah. How
15:29
does an investor protect themselves from these
15:31
hidden fees when they are forced to trade in
15:33
a thin market? We defend ourselves with order
15:36
types. This is the most practical tool a retail
15:38
investor has, and Jane emphasizes it strongly
15:41
in our source material. We need to contrast the
15:44
market order with the limit order. Let's start
15:47
with the market order. It sounds completely standard.
15:49
It is standard. A market order is an instruction
15:51
you give your broker that simply says, fill my
15:54
order right now, immediately, at whatever the
15:56
best available price happens to be. Just get
15:59
it done. Right. In a highly liquid market like
16:01
buying shares of a massive national bank, a market
16:04
order is totally fine. The spread is two cents.
16:07
The crowd is enormous. You get exactly the price
16:10
you see on your screen. But what if I use a market
16:12
order in a thinly traded market? What if I am
16:15
trying to buy a small of cap stock on a junior
16:17
exchange where there's almost no crowd. That
16:20
is where a market order becomes incredibly dangerous.
16:24
How so? To understand why, you have to picture
16:26
the order book as a ladder. OK, a ladder. Let's
16:29
say you want to buy 1 ,000 shares of a small
16:32
mining company. You look at your screen, and
16:35
the quoted price is $4. So you hit buy with a
16:40
market order. Assuming I'm going to pay $4 ,000.
16:43
Right. But because the market is thin, the first
16:46
rung of the ladder only has 100 shares available
16:49
at $4. OK. Your market order buys those 100 shares
16:53
instantly, but you still need 900 more. Uh -oh.
16:58
Because it is a market order, the computer is
17:01
programmed to blindly climb the ladder to find
17:04
the next seller. And where is the next seller?
17:06
The next seller might not be sitting until $4
17:09
.50. Wow. The computer buys their shares, then
17:13
it climbs again. The next seller is at $5, it
17:16
buys those. So it just keeps going. By the time
17:19
your order is completely filled, you might have
17:21
paid an average of $4 .75 for a stock you thought
17:24
cost $4. That's terrible. The computer just reached
17:28
higher and higher up an empty order book, pulling
17:31
money out of your account at every step. That
17:33
is literally handing the exchange a blank check.
17:35
You are prioritizing the speed of the transaction
17:39
over the cost of the transaction. That's exactly
17:41
what you are doing. You are giving up all control
17:43
over the final price just to ensure the trade
17:46
happens right this second. Which is bad. In a
17:49
market with widespread, that is financial suicide.
17:52
Which brings us to our ultimate defense mechanism,
17:55
the limit order. How does that change the dynamic?
17:58
A limit order takes your control back from the
18:01
computer. It is a firm non -negotiable instruction
18:04
that says, fill my order at this exact price
18:07
or do not fill me at all. So if I am looking
18:10
at that same small mining sock and I place a
18:13
limit order to buy 1 ,000 shares at $4 .10, what
18:17
happens? The computer will buy whatever shares
18:19
are available up to $4 .10, and then it stops.
18:22
It just stops. It will absolutely not climb the
18:25
ladder to $4 .11. It will not touch the shares
18:29
sitting at $4 .50. It hits your ceiling, and
18:32
it halts. But what if I only get 200 shares at
18:35
my price, and the rest of my order just sits
18:37
there? What if the market moves away and the
18:39
trade never finishes? Then the trade never finishes.
18:42
The order sits there unfilled. I mean, that feels
18:45
like a failure. It feels like a failure, but
18:47
it is actually a massive victory. Really? Yes.
18:51
An unfilled limit order is an outcome you specifically
18:54
deliberately chose. Right, because I set the
18:57
boundary. You drew a boundary to protect yourself
18:59
from a punishing spread. You can always evaluate
19:02
the situation tomorrow and decide to raise your
19:04
limit order if you really want the stock. That's
19:06
true. But you can never ever unbuy a stock that
19:10
you accidentally paid five dollars for because
19:12
a market order ran away from you. Wow. The limit
19:15
order is your shield against the dark. So what
19:17
does this all mean? Let's synthesize what we've
19:19
unpacked today. We started by looking at the
19:22
structural difference between the open crowdsourced
19:26
auction prices of the stock exchange, and the
19:29
completely opaque inventory -driven quotes of
19:32
the dealer bond market. We uncovered the mechanics
19:34
of the bid ask spread. Right. We learned that
19:37
the gap between the buying price and the selling
19:40
price is not a scam, but a mathematically certain
19:43
fee charged by dealers for taking on the terrifying
19:47
risk of holding inventory in a lonely market.
19:50
And finally, we armed ourselves with the limit
19:52
order. the ability to physically cap the amount
19:55
of money a thin market can pull from your account.
19:58
A vital tool. It really is. This matters directly
20:01
to you listening right now. The next time you
20:04
log into your brokerage app and see a big flashy
20:06
advertisement for zero commission trades, you
20:09
don't need to wonder how the brokerage is keeping
20:11
the lights on. No, you don't. You know exactly
20:13
where to look to find the actual cost of your
20:15
transaction. You look at the spread. You step
20:17
past the marketing and you look at the spread.
20:19
Exactly. And as we close today's deep dive, I
20:22
want to leave you with a final thought to mull
20:24
over. A scenario that pushes just a bit beyond
20:27
our source material. I'd love to hear it. We
20:30
have firmly established that the bid ask spread
20:32
is essentially the price a dealer charges for
20:35
taking on the risk of holding inventory. Right.
20:38
It's the cost of providing liquidity when things
20:40
are quiet. They charge a premium to be the buyer
20:42
of last resort. Exactly. So what happens to that
20:46
opaque dealer driven market during a massive
20:49
systemic financial panic? Like 2008. Imagine
20:53
a scenario exactly like 2008. Absolutely everyone
20:56
is terrified. Everyone is trying to sell their
20:58
bonds for cash. And absolutely no dealer wants
21:01
to take on the risk of holding an asset that
21:03
might be worthless tomorrow. Oh, wow. Does the
21:05
dealer simply widen the spread out to infinity
21:08
to protect themselves? Or does the entire invisible
21:11
system just freeze completely, leaving investors
21:13
trapped in the dark? That's a terrifying thought.
21:17
We started today by talking about stepping onto
21:19
that poorly lit used car lot. It is comforting
21:22
to know the dealer is always there. waiting to
21:25
buy your car, even if they give you a bad price.
21:28
Yes. But it is quite another thing to wonder
21:30
what happens when a hurricane hits. You pull
21:33
it to that lot desperately needing to sell, and
21:36
you find that the dealer has simply locked the
21:38
gates and abandoned the property. It is definitely
21:41
something to consider the next time the market
21:42
starts to tremble. Thank you so much for joining
21:44
us on this deep dive. Take your time, process
21:47
what you've learned about the hidden machinery
21:49
of your money, and we will be here when you are
21:52
ready to look beneath the surface again. goodbye
21:54
for now farewell and thank you for listening