What is Auction Market? how does it work?
An auction market is a market where the price is determined by the highest price the buyer is willing to pay (bids), and the lowest price the seller is willing to take (offers). Bids and offers are matched for a trade to occur.
How Auction Markets Work
Auction markets are an efficient way to connect buyers and sellers. The New York Stock Exchange (NYSE) is an example of an auction market. Trades on the exchange will be executed when an offer and bid is matched – think of it as an agreed-upon price between the buyer and seller. While negotiations are made in OTC markets, no negotiations are made in auction markets.
Historically, auction markets trades were executed via open outcry, where buyers and sellers would call out prices on the trading floor. Currently, trades in an auction market will be matched simultaneously and instantly and are executed electronically. If the bid is unable to be matched to an offer price, the order will remain pending until a corresponding bid and ask can be matched. In exchange, the process is spread across many buyers and sellers.
Auction Market vs. Dealer Market
As formerly mentioned, an auction market trades directly between a buyer and a seller. A dealer market uses a middleman or “market maker,” who buys and sells securities to create liquidity in the market. The market makers are typically referred to as brokers and profit from the bid-ask spread.
Example of Auction Market
Imagine three buyers are looking to buy shares in Company XYZ, placing bids of Rs100, Rs101, and Rs102, respectively. There are also three sellers with offers of Rs102, Rs103, and Rs104. Here, only the buyer and seller with offers/bids of Rs102 will get their shares traded. The price of the stock at such a point in time will be Rs102.
Now, imagine a scenario where bids are Rs100, Rs101, and Rs102, and asks are Rs103, Rs104, and Rs105. In such a situation, all the trade orders will remain as pending until a bid and ask can be matched.