The Difference Between The Third and Fourth Markets
While the primary and secondary markets are the chief markets in terms of size and trading volume, they’re not the only options for investors. There are also third and fourth markets. These markets are over-the-counter markets. They open up a broad scope of opportunities between broker-dealers and between institutions.
These markets are generally bypass exchanges to trade securities without the need to dabble in the secondary market. It’s where hedge funds and other institutional investors typically exchange large volumes of shares. Without exchange commissions, it’s much easier to move shares at low costs between parties. Here’s a look at how these markets function.
What is The Third Market?
The third market can be difficult for new investors to understand. It functions as a combination between the secondary market and the OTC market. That is to say, exchange-listed securities trade over-the-counter. Why? To cut out the middle man.
These traders have the means and motive to trade directly amongst themselves for cash and immediate delivery. This typically occurs between hedge funds or pension fund managers. Securities are available at lower cost and trades are relatively anonymous. This creates an environment where trades are more efficient and less subject to scrutiny. For example:
A pension fund manager wants to rebalance the fund. This involves selling $20M in shares of XYZ company. Rather than pay exchange and broker fees, the fund manager sells these shares to a hedge fund. The manager then uses the $20M to purchase $10M in different debt and equity securities OTC, again bypassing fees.
Fund managers and other institutional investors have access to the capital and systems to facilitate trades. They don’t require the liquidity or security offered by an exchange or broker. Trading in this market is much more efficient and lucrative for them. It also opens the door to securities outside of exchange-traded products, which can diversify a fund’s holdings.
Note that some definitions of this market lumps all OTC trades into this category—including retail. While retail investors can make OTC purchases, this market generally refers to institutional trades of exchange-traded securities OTC.
What is The Fourth Market?
The fourth market is one retail investors will never participate in. It’s reserved specifically for institutional investors, used for trading huge blocks directly between funds. These trades happen via the Electronic Communications Network (ECN). This is an Alternative Trading System (ATS), where each transaction comes with a fee. These transactions are immediate.
Institutional investors use ECNs to trade high volumes—both of shares and in dollar amounts. Because there’s no third party, there’s also no middle man to go through. Moreover, trading can happen after market hours, when exchanges close. There are also no reporting requirements for these trades, which makes it difficult to determine the volume of shares. For example:
Fund A and Fund B want to make a trade. Fund A offers 4,000 shares of AWS and 12,000 shares of FTG to Fund B for 8,000 shares of BNM. This trade occurs over the ECN after hours, instantly. The share prices of all securities involved show after-hours activity, but don’t count against daily trading volume.
Fourth market trading encompasses both exchange-traded and OTC securities, as well as derivatives. Most often, these trades occur after hours, to obfuscate the nature of trades. Doing so safeguards the market from any volatility that might come from incorrect assessment of large volume trades.
What Are ‘Dark Pools?’
When dealing with these markets, the term ‘dark pools’ often comes into play. Despite an ominous name, these pools are an important part in keeping other markets from impacting primary and secondary markets.
Dark pools are private exchanges between institutions. They’re where large block transactions take place. An estimated 15% of total stock trading volume happens in dark pools. While this might sound unfair to retail investors, it’s actually a safeguard against volatility. Institutions exchange millions of shares at a time. Therefore, these trades would trigger massive movement in the secondary market. Large trades in dark pools give retail investors more power of pricing in secondary markets.
Not all third and fourth market trades happen in dark pools. But the convenience of dark pools in facilitating huge trades makes them useful for block trading.
Capital Markets Work Together
Both markets are very similar in terms of how they function. Both involve OTC trades of exchange-listed securities without the need for an exchange. Moreover, both revolve around large volumes of shares changing hands. And both are low-cost. Where they differ is in the mode of exchange: broker-dealer vs. ECN.
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The third and fourth markets are arguably types of secondary markets, but their niche purposes make them appealing to larger institutional investors. They’re used to make moves without moving the market.