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

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

0:00
Welcome to the Deep Dive. Today, we're pulling
0:02
from this really fascinating stack of educational
0:04
materials, articles and research all about market
0:07
structure. Yeah, there is some seriously eye
0:09
-opening stuff in these sources. Right. And our
0:12
mission today is to demystify something you probably
0:15
interact with all the time, but rarely actually
0:18
think about. We're going to figure out how financial
0:20
markets actually set prices. Exactly. The hidden
0:24
mechanics determining what something is worth
0:26
the exact second you want to buy it. Yeah. And
0:29
to do that, we have to look at a tale of two
0:31
very different trades. So imagine you're logging
0:34
into your brokerage account on your phone. OK.
0:37
We've all been there. You've decided today is
0:39
the day you're putting some cash to work. First,
0:42
you decide to buy a stock. Instantly, the screen
0:44
comes alive. Blinking green and red, numbers
0:47
flashing everywhere. Exactly. You can see the
0:50
price moving in real time. You see the exact
0:52
depth of the market like how many people wanna
0:55
buy, how many wanna sell, the specific price
0:58
tiers they're lined up at. It feels incredibly
1:00
transparent. It really does. It feels like you're
1:04
tapped straight into the heartbeat of the global
1:05
economy. You hit buy, and you just feel totally
1:09
in control. But then, on that exact same afternoon,
1:13
with the exact same amount of money, you decide
1:16
to buy a corporate bond. Ah, and the experience
1:19
is completely different. Completely. You click
1:22
over to the fixed income tab and crickets. Like
1:26
the blinking lights are just gone. Yeah, that
1:29
long list of competing buyers and sellers vanishes.
1:32
Right. You just handed a single static number
1:35
on the screen. Take it or leave it. No context,
1:39
no transparency. It's a jarring psychological
1:42
shift for sure. You go from feeling like this
1:45
ultimate insider in a bustling financial hub
1:48
to feeling like you're buying a used car from
1:51
a guy in a dark alley. Totally. And your immediate
1:54
instinct is usually, is my app broken? Am I looking
1:58
at outdated info or am I just getting ripped
2:00
off here? Because the two experiences do not
2:03
feel like they belong in the same financial system
2:05
at all. Exactly. So what's going on? Well, I
2:08
can assure you right out of the gate that stark
2:10
difference you see on your screen is not a glitch.
2:12
OK. Good to know. Yeah, it's a deliberate structural
2:15
feature of two fundamentally different systems.
2:18
We're talking about auction markets versus dealer
2:21
markets. Auction versus dealer. Right. And once
2:23
you understand the hidden mechanics of how these
2:25
two systems operate, I promise you will never
2:28
look at a price quote on your screen the same
2:29
way again. OK, let's unpack this. Because to
2:32
understand that completely opaque bond trade
2:35
that leaves you in the dark, we first need to
2:37
pull apart that transparent stock trade. Makes
2:39
sense. You called it an auction market. How does
2:42
that actually work under the hood? So the Toronto
2:44
Stock Exchange, or the TSX, is a perfect classic
2:47
example of an auction market. In this system,
2:50
there is no central authority. There's no middleman
2:53
stepping in to tell everyone what a share is
2:55
worth today. Instead, buyers and sellers from
2:58
all over the world just submit their orders to
3:00
a central order book. So when I'm looking at
3:02
my screen and seeing those blinking numbers,
3:04
I'm looking at the actual public order book.
3:07
You are. Yeah, everyone who wants to buy a stock
3:09
posts the maximum price they're willing to pay,
3:11
and we call that the bid. Their bid, right. And
3:14
on the flip side, everyone who wants to sell
3:16
posts the minimum price they're willing to accept,
3:18
which we call the ask. Got it. So the highest
3:21
buyer and the lowest seller are essentially staring
3:24
each other down at the very top of that order
3:26
book. The current price of the stock just emerges
3:28
organically from the sheer competition between
3:30
all those thousands of orders meeting in one
3:33
place. Let's use a real -world example from our
3:36
sources to make this really concrete. Sure. Say
3:39
you're looking at a large, highly traded Canadian
3:42
bank stock. You look at that public order book
3:44
and you see the best bid is $79 .98. There's
3:48
a buyer sitting there who wants 2 ,000 shares
3:50
at that price. Okay. And the best ask is $80
3:53
from a seller who has 1 ,500 shares to offload.
3:57
Right. So the gap between what the highest buyer
3:59
is willing to pay and the lowest seller is willing
4:01
to accept, that's known as the spread. The spread.
4:04
And in your example, that spread is incredibly
4:07
small. I mean, it's just 2 cents. 2 cents on
4:09
an $80 stock. So if I decide to buy in and I
4:13
place an order for, say, $8 ,000 worth of this
4:16
bank stock, that 2 -cent spread is going to cost
4:19
me a grand total of about $2. Exactly. It's a
4:23
completely trivial amount. It's nothing. And
4:26
what's fascinating here is how transparency breeds
4:28
competition, right? And competition drives down
4:31
costs. That spread is so tiny because of the
4:34
massive volume of participation. Because everyone
4:36
can see it. Right. You know the fair objective
4:39
price is $80 or within two cents of it because
4:42
hundreds of different algorithms and institutions
4:44
and retail traders are fiercely competing against
4:47
one another to post the most attractive price.
4:50
I like to think of the auction market like a
4:53
massive bustling public flea market. where absolutely
4:56
everyone is walking around with a megaphone.
4:58
Oh, that's a good way to look at it. Right? Yeah.
5:00
Because if someone tries to lowball a bid for
5:02
a vintage lamp, say, shouting that they only
5:04
pay $75. They'll never get it. Exactly. They're
5:07
simply never going to get the item because somebody
5:09
right next to them is already publicly yelling
5:11
into their megaphone that they'll pay $79 .98.
5:15
Competition strictly polices the price. Yeah.
5:17
You really can't get away with a bad deal because
5:19
everyone can hear everyone else. The megaphone
5:21
is a great analogy. It ensures you have the exact
5:24
same pricing information as almost everyone else
5:26
standing in that market. But as you noticed when
5:29
you clicked over to your fixed income tab earlier.
5:31
Right, that bustling flea market is not the only
5:34
way things are bought and sold. Which makes me
5:36
wonder, what happens when you take away the megaphones?
5:39
Like when we look at that bond trade, the mechanics
5:42
seem to completely shift. They do. We're leaving
5:46
the auction market and entering what the sources
5:48
call a dealer market. A dealer market. Yeah.
5:51
Often referred to as an over -the -counter or
5:54
OTC market. In a dealer market, that central
5:57
public order book, it just does not exist. So
6:00
no blinking lights. No blinking lights. There's
6:03
no massive crowd of buyers and sellers organically
6:05
matching with each other. Instead, there are
6:08
dealers. OK, what is a dealer in this context?
6:12
These are specialized financial firms that hold
6:15
their own personal inventory of securities. So
6:18
in this case, bonds. Wait, what does that mean
6:20
in plain English? Are they just, like, matchmaking
6:22
behind the scenes, finding a seller for me? No,
6:24
they're acting as a principal in the trade. They
6:26
are actually using their own wallet. Really?
6:28
Yeah. When you want to buy a corporate bond,
6:31
they sell you one directly out of their own private
6:34
stash. And when you want to sell a bond, they
6:37
buy it from you with their own capital and add
6:39
it to their inventory. Oh, wow. So they aren't
6:41
just facilitating the trade, they're taking on
6:43
the actual risk of owning the asset. Exactly.
6:46
If they buy my bond today and the economy takes
6:49
a hit or interest rates spike tomorrow. The bond
6:51
drops in value while it's sitting right there
6:53
on their balance sheet. They're holding an asset
6:55
that can depreciate at any moment. That's a lot
6:57
of risk. It is. And because they are taking on
7:00
that real inventory risk to accommodate your
7:02
desire to trade, they absolutely expect to be
7:05
compensated for it. Which brings us back to the
7:07
spread. Right. But in a dealer market, the spread
7:10
functions as an entirely different mechanism
7:13
than it does in the auction market. Let's break
7:15
down the math on this, because I really think
7:17
this is where a lot of everyday investors are
7:19
going to have a genuine aha moment. OK, let's
7:22
do it. In a dealer market, the dealer gives you
7:25
two quotes. The bid, which is what they'll pay
7:28
you if you want to sell your bond to them, and
7:30
the ask, which is what they'll charge you if
7:33
you want to buy a bond from their inventory.
7:35
And the ask is invariably higher. Always. Let's
7:38
look at the specific example provided in our
7:40
source material. A dealer quotes a bond. They
7:43
bid 98 and they ask 98 .5. Hang on. If I log
7:47
in and I buy $10 ,000 worth of that bond from
7:51
the dealer at their ask price of 98 .5. OK. And
7:55
then literally 10 seconds later, I instantly
7:58
change my mind. I hit the sell button to give
7:59
it right back to them. They're only going to
8:02
pay you their bid price of 98. Wait. So I just
8:05
lost half a point instantly. on a $10 ,000 trade
8:10
that is $50 gone in 10 seconds. Gone the very
8:14
moment your order executes before the bond has
8:16
even had a chance to move in the broader market.
8:19
I am genuinely surprised by that because if I
8:21
look at my brokerage statement at the end of
8:23
the month, that $50 loss never appears as a line
8:26
item. It doesn't. It doesn't say dealer convenience
8:28
fee, $50. I could be sitting there using a so
8:32
-called zero commission brokerage app feeling
8:34
really savvy. about saving money. And you are
8:37
silently bleeding $50 on that trade without ever
8:40
even realizing it. That's crazy. The spread in
8:44
a dealer market is, for all intents and purposes,
8:46
a fee. It is a hidden cost baked directly into
8:49
the price of the asset itself, rather than being
8:52
charged as a separate commission. Because there's
8:54
no public order book showing you what the dealer
8:56
paid yesterday. Right. No blinking lights. You
8:58
have no baseline to compare it against. You're
9:00
navigating a massive asymmetry of information.
9:05
Which... naturally makes you wonder, why do we
9:06
use the system at all? It's a fair question.
9:09
If the spread is taking 50 bucks out of my pocket
9:11
in the dark, why can't bonds just trade on a
9:14
public transparent exchange like stocks do? Why
9:16
can't we just have an auction market for everything
9:18
and be done with it? What's fascinating here
9:20
is that it really comes down to one fundamental
9:23
issue, and that is variety. Variety? Yeah. Think
9:27
about a major technology corporation. They generally
9:30
have one single class of common shares. It's
9:33
one standardized uniform item that every single
9:36
equity investor in the world trades. Right. A
9:39
share of the company is just a share of the company.
9:41
But that exact same technology company might
9:44
have 15 or 20 different bonds outstanding simultaneously.
9:49
Wait, why so many? Because companies borrow money
9:51
at different times for different reasons. They
9:53
might have a bond maturing in 2025, another in
9:56
2030, another in 2050. I see. And they all have
10:01
different maturity dates and they pay different
10:03
interest coupons, meaning the actual percentage
10:05
of interest they pay out varies depending on
10:07
what the economy looked like on the day that
10:09
specific bond was issued. So instead of one massive
10:12
unified pool of stock, you have 15 fractured,
10:17
highly specific pools of bonds for just one single
10:20
company. Exactly. Now multiply those 15 different
10:23
bonds by every single corporate borrower, municipality,
10:27
and government entity in the entire country.
10:30
You're suddenly looking at a staggering, almost
10:33
incomprehensible number of distinct, unique securities.
10:37
And the harsh reality is most of them trade very
10:40
rarely. Okay, so going back to my flea market
10:42
analogy, an auction market only works if you
10:45
have a massive crowd all trying to trade the
10:47
exact same item at the exact same time. Right.
10:51
You need the noise. You need the megaphones to
10:54
force the spread down to two cents. And bonds
10:56
simply do not have that crowd. They don't. If
11:00
you tried to put a somewhat obscure corporate
11:02
bond on a public order book like the TSX, you
11:04
might sit there for three weeks waiting for a
11:06
buyer to randomly show up who wants that exact
11:09
maturity date and that exact interest rate. Wow.
11:12
The dealer market exists out of necessity. The
11:15
dealer steps in, uses their own capital, and
11:17
basically says, I will trade with you right now.
11:20
providing you instant liquidity, even though
11:23
literally nobody else in the world currently
11:25
wants this bond. OK, so the $50 hidden fee isn't
11:28
just like malice or Wall Street greed. It's a
11:32
convenience fee for instant liquidity. It is
11:35
the necessary cost of transferring the risk of
11:38
holding a highly illiquid asset from you onto
11:41
the dealer's balance sheet. That makes a lot
11:43
of sense. In fact, that's one of the most vital
11:45
takeaways from our sources. The spread is the
11:48
ultimate pure measure of an asset's liquidity.
11:51
So a widespread like that $100 cost on a retail
11:54
bond trade? Is just the market mathematically
11:57
expressing to you that there are very few participants
12:00
around. OK, so you've painted these as two separate
12:02
universes. We have the transparent bustling auction
12:05
markets for stocks on one side and the opaque
12:08
hidden fee dealer markets for bonds on the other.
12:11
Right. But surely real life is messier than that,
12:14
right? Does an auction market ever break down
12:17
if a stock becomes as unpopular as a rare bond?
12:20
Real markets are almost always hybrids. They
12:23
borrow mechanics from each other all the time.
12:25
How so? Well, let's take the TSX again. It is
12:28
an auction market, but it actively uses designated
12:31
market makers. Market makers? Yeah, these are
12:34
specialized firms that are contractually obligated
12:37
by the exchange to post two -sided quotes, a
12:39
bid and an ask, in certain assigned stocks at
12:42
all times. So even in the pure auction market,
12:45
there's a dealer standing by just in case the
12:47
crowd goes completely quiet. Exactly. It ensures
12:50
the flea market never truly empties out. The
12:53
market maker is getting paid by the exchange
12:54
to stand there and provide a dealer style backstop
12:57
to the public auction, ensuring you can always
13:00
buy or sell even in a thinly traded stock. That's
13:04
fascinating. But the complications go deeper
13:06
than that, don't they? They do. Because our sources
13:10
mentioned that not everything in an auction market
13:13
is actually visible to the public, which sounds
13:16
completely contradictory to the whole megaphone
13:18
concept we were just talking about. Ah, you're
13:20
referring to dark pools. Honestly, it sounds
13:23
like a villain's lair in a comic book. What are
13:25
dark pools? They sound sinister, but they serve
13:27
a very practical, albeit highly debated purpose.
13:32
Okay. Imagine a massive institutional investor,
13:35
say a national pension fund managing billions
13:38
of dollars. They decide they need to sell two
13:41
million shares of a company to rebalance their
13:43
portfolio. Two million shares. If they dump a
13:46
two million share sell order directly onto the
13:49
public TSX order book, what do you think happens?
13:52
Absolute panic. Every algorithmic trader and
13:55
day trader sees that massive wall of selling
13:57
supply looming and they instantly start selling
14:00
too. Exactly. The price of the stock would plummet
14:03
before the pension fund even finished executing
14:05
their trade. The market would move aggressively
14:07
against them just because they announced their
14:09
intentions. So what's the solution? Dark pools.
14:13
They're private alternative trading systems that
14:15
allow these massive institutions to place large
14:17
orders without displaying them to the public
14:19
market beforehand. Oh, I see. They often match
14:22
buyers and sellers at the midpoint of the public
14:24
bid and ask. The trade executes in the shadows,
14:27
protecting the pension fund from causing a panic
14:29
and getting a terrible execution price. Hold
14:31
on though, I need to push back on this. Go ahead.
14:34
If a pension fund gets to hide their massive
14:36
trades in a dark pool so they don't spook the
14:39
market, isn't that just a legalized unfair advantage?
14:42
That is the big question. Like, why do massive
14:45
institutions get to play by a different set of
14:47
rules, completely hidden, while retail investors
14:49
have to show their hands on the public order
14:51
book? You're hitting on the absolute core of
14:53
the controversy. Critics of dark pools make the
14:56
exact same argument. They rightly point out that
14:58
dark pools remove vital supply and demand information
15:01
from the public price discovery process. Because
15:03
if two million shares just traded hands in secret.
15:06
The public price you're seeing on your screen
15:08
isn't factoring in that massive shift in ownership.
15:11
Yeah. The pension fund saves money by avoiding
15:13
market impact. But critics argue the public market
15:16
becomes slightly less accurate as a result. It's
15:19
a heavy debate between the need for institutional
15:21
liquidity and the demand for public transparency.
15:24
We don't take sides here, but it's important
15:25
to understand both arguments. It really is. And
15:28
what about bonds? Are they stuck in the completely
15:31
dark ages forever, or is transparency improving
15:33
there, too? Sources are clear that it's improving
15:36
significantly. We now have systems like Trace,
15:38
which provide post -trade reporting in the bond
15:40
market. Post -trade. So after the fact. Right.
15:43
You still don't get a live blinking pre -trade
15:46
order book like you do with equities, but regulators
15:48
mandate that dealers report their trades shortly
15:50
after they happen. Okay, so you can at least
15:53
look at historical data and see what others recently
15:55
paid for that same bond. Exactly. If you read
15:58
older textbooks, they paint a much bleaker picture
16:00
of bond opacity than the reality of today's market.
16:04
So what does this all mean for you, the listener?
16:06
You're sitting there with your brokerage app
16:08
trying to navigate these hybrid markets, invisible
16:11
dealer fees and wide spreads. How do you actually
16:14
protect yourself? Well, our sources offer one
16:17
incredibly powerful practical tool. And it is
16:20
called the limit order. Yes. This is perhaps
16:24
the most crucial defensive tactic an investor
16:27
can utilize. Think about what happens when you
16:29
use a standard market order, right? A market
16:32
order is you telling your broker, I don't care
16:34
about the price. Just fill my order immediately
16:36
at whatever the best available price happens
16:38
to be right now. Right. And in a highly liquid
16:41
stock like a major bank, that's generally fine
16:43
because the spread is only two cents. But what
16:46
if you throw a market order into a thinly traded
16:48
stock or a volatile market where the crowd is
16:50
small and the spread is wide? You are essentially
16:53
handing a blank check to the market. Literally.
16:56
If the nearest willing seller on the order book
16:57
is demanding a price that is three, four, or
17:00
five percent higher than the last traded price,
17:02
your market order will simply execute at that
17:05
terrible price. Ouch. Yeah. You'll feel several
17:07
percent away from where you expected, instantly
17:10
destroying your own value just to get the trade
17:12
done quickly. It is genuinely dangerous. That
17:15
is exactly why the limit order is your best friend.
17:18
A limit order says to your broker, fill my trade
17:21
at this specific price or do not fill it at all.
17:24
You are drawing a hard line in the sand. Right.
17:27
And mechanically, by placing a limit order, you're
17:29
not just consuming whatever liquidity is available.
17:32
You are actually posting your intention to the
17:34
order book. That's the key. By placing a limit
17:36
order, I am basically grabbing my own megaphone
17:39
and stepping into the flea market. I become a
17:41
visible part of the order book. forcing the market
17:44
to come to my terms. Exactly. Now, you might
17:47
not end up making the trade if the market price
17:49
never reaches your specified limit. True. But
17:51
you will never, ever be surprised by a devastatingly
17:54
widespread executing against your capital. And
17:57
it costs absolutely nothing to use a limit order
17:59
on your app. It's the single easiest way to stop
18:02
a widespread from silently draining your portfolio.
18:05
Honestly, if you take nothing else away from
18:07
this deep dive, take that limit orders are your
18:10
shield. A very sound rule of thumb for any investor.
18:14
OK, let's synthesize everything we've uncovered
18:16
today. We started with the mystery of why two
18:19
identically sized trades, one stock, one bond,
18:22
felt so vastly different on the screen. And we
18:24
found that it fundamentally comes down to market
18:26
structure. First, auction markets pool public
18:29
orders centrally, allowing organic competition
18:32
to transparently set the price. That's where
18:35
you find tight spreads and high pre -trade visibility.
18:38
Second, dealer markets rely on middlemen who
18:40
trade directly out of their own private inventory,
18:43
mostly because the assets are too varied to sustain
18:46
a massive crowd. Right. They take on real risk,
18:49
and they charge you for that risk by baking a
18:52
hidden fee directly into the price. And third,
18:55
that hidden fee, the spread, is the ultimate
18:58
measure of an asset's liquidity. A widespread
19:01
is just the market mathematically expressing
19:03
that there are very few participants willing
19:05
to trade. which forces you to pay a premium to
19:08
whoever is willing to step up. So the next time
19:10
you log into your account, you aren't just looking
19:12
at blanking numbers or static quotes anymore.
19:15
You have x -ray vision. You can look at the spread
19:17
on the stock or a bond and instantly understand
19:20
the hidden mechanics operating behind your screen.
19:23
You know exactly what it means when a quote is
19:25
flashing live from an order book, and you know
19:27
exactly what it means when a dealer hands you
19:29
a static number from their own inventory. You're
19:32
no longer flying blind. No more silent fees draining
19:34
the account. You'll never blindly accept an opaque
19:37
quote without understanding the inventory risk
19:39
the dealer is managing. And you will certainly
19:42
never throw a careless market order into a thinly
19:44
traded asset again. You are in control of the
19:47
mechanics now. But before we wrap up this deep
19:50
dive, this raises an important question. Something
19:53
I'd like you to just maul over the next time
19:55
you're looking at your seemingly transparent
19:57
stock portfolio. Lid on us. We talked earlier
20:00
about dark pools, right? and how massive institutional
20:03
players like pension funds and hedge funds use
20:05
them to cross huge multi -million share trades
20:08
away from the public order book. Right. Hidden
20:10
from the public eye. So if a truly massive chunk
20:14
of the actual buying and selling in the market
20:16
is happening completely in the shadows, what
20:19
does that mean for the true accuracy of that
20:21
transparent price blinking on your screen? Oh,
20:24
wow. If the biggest players with the most money
20:27
are playing off the board? Are everyday retail
20:30
investors simply trading based on an illusion
20:33
of transparency?