Third and Fourth Market

A traditional way of organizing the vocabulary numbers the markets. The first market is the trading of listed securities on an exchange. The second market is the over-the-counter trading of securities that are not listed. The third market is the over-the-counter trading of securities that are listed. The fourth market is direct trading between investors. The numbers are labels, not rankings. They do not say that one market is better, larger or more important than another.

The third market label is old. In an address to the American Management Association on November 16, 1966, SEC Chairman Manuel Cohen described transactions that may be executed, in his words, on a principal basis with a non-member of the exchange who trades in listed securities for his own account in the so-called third market. He added that such a firm is often willing, on large transactions, to charge a mark-up that is only a small fraction of an exchange commission. The same address referred to firms in England that operated very much like third market makers. The vocabulary was therefore already in use at the Commission more than half a century ago, and it described firms that were not exchange members trading listed stocks for their own accounts.

The Third Market

A common definition of the third market is the over-the-counter trading of exchange-listed securities. Three features define it. First, the security is listed on an exchange. Second, the trade takes place away from the exchange. Third, the firm on the other side of the customer's trade is usually a dealer, which is a firm that buys and sells securities for its own account, so the customer's order is filled out of that firm's own inventory.

The SEC uses a closely related term in one of its investor publications on trade execution. The publication explains that, for a stock that is listed on an exchange, a broker may direct the order to that exchange, to another exchange such as a regional exchange, or to a firm called a third market maker. It then defines a third market maker as a firm that stands ready to buy or sell a stock listed on an exchange at publicly quoted prices. The third market, in other words, is the activity of firms that stand ready to trade listed stocks away from the exchange.

The same SEC publication describes other places a broker may send an order. A broker may route an order, especially a limit order, to an electronic communications network that automatically matches buy and sell orders at specified prices. For a stock that trades in an over-the-counter market, such as the Nasdaq, the broker may send the order to a market maker in that stock. And a broker may decide to send the order to another division of the broker's own firm, to be filled out of the firm's own inventory, which the SEC calls internalization. In both a market maker's trade and a trade filled from a broker's own inventory, a firm acts as the principal on the other side of the order, which is the feature that the third market label emphasizes.

The SEC's investor education material on executing an order also explains that, as a way to attract orders from brokers, some market makers will pay a broker for routing an order to them, perhaps a penny or more per share, and that this is called payment for order flow. The same material states that a broker has a duty to seek the best execution that is reasonably available for its customers' orders. The two statements belong together. Where a broker sends an order is a decision the broker must be able to defend under its best execution duty.

FINRA's description of where stocks trade uses today's vocabulary for the same kind of activity. FINRA explains that, instead of routing an order to an exchange, a brokerage firm may execute the order itself or may route the order to an execution venue that is not registered as an exchange or as an alternative trading system. FINRA describes a single-dealer platform as an electronic trading platform operated by a broker-dealer where the firm itself acts as the principal counterparty for every transaction. It describes a wholesaler as a broker-dealer that acts as a market maker, a firm that actively quotes two-sided markets in a particular security, for other broker-dealers. The older label third market and the modern words wholesaler and single-dealer platform describe overlapping activity, although the labels do not mean exactly the same thing.

Large orders explain part of the appeal. FINRA notes that when an institutional investor is making a large trade, thinking of thousands of shares, the investor sometimes prefers to trade over the counter for the pre-trade anonymity, and potentially price stability, that an over-the-counter venue can provide.

A hypothetical shows how a third market trade works. A customer of a retail brokerage firm places an order to buy one hundred shares of a stock that is listed on an exchange. The brokerage firm does not send the order to the exchange. It sends the order to a market maker that quotes the stock over the counter. The market maker fills the order from its own inventory, so the market maker is the other side of the customer's trade. The trade has taken place over the counter, in a stock that is listed on an exchange, with a dealer as the counterparty. This is an illustration only and does not describe any actual firm or order.

The Fourth Market

A common definition of the fourth market is direct trading between investors in exchange-listed stocks without using a broker. In the usual description the investors are institutions, and they trade with each other through an electronic system rather than through a broker that stands between them. The central idea is the absence of a broker or dealer taking the other side. In the third market a dealer is the counterparty. In the fourth market the investors are counterparties to each other.

The nearest modern vocabulary for the system that brings such investors together is the alternative trading system. FINRA explains that an alternative trading system is an electronic execution venue that acts much like a stock exchange but is not a self-regulatory organization. Under the SEC's Regulation ATS, FINRA explains, an alternative trading system must be operated by a broker-dealer that is a FINRA member. An alternative trading system therefore matches orders, but the entity that operates it is a regulated broker-dealer.

Some alternative trading systems are called dark pools. FINRA explains that dark pool is a term often used to refer to an alternative trading system that is not lit, meaning it does not publicly display the buy or sell price or the number of shares traded. Not displaying orders before a trade is the feature that distinguishes a dark pool from a lit venue.

A hypothetical illustrates the fourth market. A large pension fund wants to sell a very large position in a stock, and a mutual fund wants to buy a large position in the same stock. If an electronic system matches the two funds directly, with neither a broker nor a dealer taking the other side, the trade is of the kind the fourth market label describes. The funds deal with each other and the system provides the matching. This is an illustration only and does not describe any actual funds or system.

The fourth market label and the alternative trading system are not identical. The label describes a pattern of trading, which is investors dealing directly with each other. The alternative trading system is a regulated type of venue, and trading on one does not by itself tell a reader which label applies. Whether a given trade is a fourth market trade depends on whether the investors are dealing with each other directly, and the venue label does not settle that question.

Comparing the Two Markets

The two markets share two features. In both, the security is listed on an exchange, and in both, the trade takes place away from the exchange. The difference is the counterparty. In the third market the investor trades with a dealer that fills the order from its own account. In the fourth market the investor trades with another investor through an electronic system.

The difference in counterparty leads to a difference in what regulation focuses on. A third market trade is a principal trade by a broker-dealer, so the rules that govern principal trading and the handling of customer orders, including the fair price and best execution rules, are central. A fourth market trade is a matched trade between investors on a venue, so the rules for the venue and for its operator are central. In both cases the trade still has to be reported, as the section on reporting below explains.

The typical descriptions also differ in who uses each market. The usual description of the fourth market centers on institutions trading large positions. The third market is described more broadly as over-the-counter trading of listed stocks through dealers, and the SEC publication shows that an ordinary customer's order can be directed to a third market maker.

Where These Markets Fit Among Market Segments

The third and fourth markets are parts of the secondary market, which is where securities trade after they have been issued. The primary market is the place where an issuer first sells securities and receives the proceeds. In neither the third market nor the fourth market does the issuer receive money from the trade, because both involve securities that already exist and are trading between holders.

The labels describe where in the secondary market a trade takes place. A trade on an exchange is one kind of secondary market trade. A third market trade and a fourth market trade are other kinds. All of them are trades in the same stocks, and the exchange, the dealers and the matching systems all contribute to the prices that investors see.

How Firms in These Markets Are Regulated

The firms that operate in these markets are broker-dealers. Section 15 of the Securities Exchange Act of 1934 governs the registration of brokers and dealers, and Section 15(b)(8) generally requires a registered broker-dealer to be a member of a national securities association. FINRA is a national securities association registered with the SEC. A firm that acts as a market maker in the third market is therefore generally subject to FINRA's rules as well as the SEC's.

Several FINRA rules apply whether a firm routes a customer's order to an exchange, to a market maker or to another venue.

FINRA Rule 2121, titled Fair Prices and Commissions, applies to a member that deals with a customer as a principal. Its opening sentence provides that, in securities transactions, whether in listed or unlisted securities, if a member buys for its own account from its customer, or sells for its own account to its customer, it shall buy or sell at a price that is fair, taking into consideration all relevant circumstances, including market conditions with respect to the security at the time of the transaction, the expense involved, and the fact that the member is entitled to a profit. The rule's reference to listed securities matters in the third market, where a dealer sells a listed stock to a customer from its own inventory.

FINRA Rule 5310, titled Best Execution and Interpositioning, applies to a member that handles a customer's order. Paragraph (a)(1) provides that, in any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in that market so that the resulting price to the customer is as favorable as possible under prevailing market conditions. The rule identifies factors that bear on whether reasonable diligence was used, including the character of the market for the security, the size and type of transaction, the number of markets checked, the accessibility of quotations, and the terms and conditions of the order. The rule is framed as a standard of reasonable diligence and not as a list of approved venues, so routing an order to a market maker, an alternative trading system or an exchange is a decision that the firm must be able to support under the standard.

FINRA Rule 5320, titled Prohibition Against Trading Ahead of Customer Orders, addresses a conflict that exists when a firm both holds customer orders and trades for itself. It provides that a member that accepts and holds an order in an equity security from its own customer or from a customer of another broker-dealer, without immediately executing the order, is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account. The rule contains exceptions, including a large order and institutional account exception, a no-knowledge exception, a riskless principal exception, and exceptions for odd lot and bona fide error transactions. The rule matters for firms that both handle customer orders and trade for their own accounts.

FINRA Rule 5220, titled Offers at Stated Prices, applies to the quotations that market makers publish. It provides that no member shall make an offer to buy from or sell to any person any security at a stated price unless the member is prepared to purchase or sell, as the case may be, at that price and under the conditions stated at the time of the offer. A third market maker that publishes a quotation in a listed stock therefore stands behind it.

Reporting of Trades Made Away From an Exchange

Trading away from an exchange is not trading in secret. FINRA explains that over-the-counter trades in exchange-listed stocks must be reported to a FINRA Trade Reporting Facility. FINRA also explains that all trade data for listed stock transactions occurring on alternative trading systems, including dark pools, must be submitted to a FINRA Trade Reporting Facility. A dark pool does not display its prices before a trade, but the trade itself is reported.

FINRA's rules set the timing. FINRA Rule 6380A, which applies to participants in the FINRA and Nasdaq Trade Reporting Facility, requires a participant to transmit last sale reports as soon as practicable but no later than ten seconds after execution. FINRA Rule 6282, which applies to transactions reported to the Alternative Display Facility, uses the same ten-second outer limit. Those rules also define the hours to which the deadline applies.

The Terms in Exam Preparation

FINRA's content outline for the Securities Industry Essentials examination lists both the third market and the fourth market among its topics. A learner preparing for that examination can review the course overview for the Securities Industry Essentials examination to see how these topics fit with the rest of the content outline.

A Worked Comparison

Consider the same exchange-listed stock traded three ways on the same day. In the first trade, a customer's order is routed to the exchange where the stock is listed, and it is matched there with another investor's order. That is an exchange trade.

In the second trade, another customer's order is routed to a market maker, which fills the order from its own inventory. That is a third market trade. The market maker is a principal, the trade takes place over the counter, and the stock is exchange-listed. The broker that routed the order is subject to the best execution requirement, and the market maker's published quotation is subject to the stated price requirement.

In the third trade, two institutions are matched through an electronic system that does not take the other side, and they trade directly with each other. That is a fourth market trade.

All three trades are in the same stock and all three are secondary market trades. They differ in where they take place and who is on the other side. The second and third trades must be reported to FINRA. This example is an illustration only and does not describe any actual trades.

Common Misunderstandings

One misunderstanding is that trading away from an exchange is unregulated. It is not. The firms that operate in these markets are broker-dealers regulated by the SEC and by FINRA, an alternative trading system must be operated by a broker-dealer that is a FINRA member, and the trades must be reported.

A second misunderstanding is that a dark pool does not report its trades. A dark pool does not publicly display the price or the number of shares before the trade, which is why it is called dark. After the trade, the trade data must be submitted to a FINRA Trade Reporting Facility.

A third misunderstanding is that the numbers in the labels are rankings. The first, second, third and fourth markets are a numbering convention. The third market is not third in importance and the fourth market is not fourth in size.

A fourth misunderstanding is that the labels are legal definitions. They are industry and educational shorthand. FINRA now describes trading venues in terms of exchanges, alternative trading systems, wholesalers, single-dealer platforms and other execution venues, and the rules apply according to what a firm does.

A fifth misunderstanding is that the third market trades only unlisted stocks. The definition is the reverse. The third market is the over-the-counter trading of securities that are listed on an exchange. Unlisted equities also trade over the counter, but that activity is not what the third market label describes.

A sixth misunderstanding is that every off-exchange trade is a third market trade. An off-exchange trade in a listed stock may be a third market trade, a fourth market trade or something else, depending on who the counterparties are and how the trade is arranged.

Key Points

The third market is the over-the-counter trading of exchange-listed securities, usually with a dealer that fills the order from its own account. The SEC describes a third market maker as a firm that stands ready to buy or sell a stock listed on an exchange at publicly quoted prices.

The fourth market is direct trading between investors in exchange-listed stocks without using a broker. FINRA describes the alternative trading system as an electronic execution venue that acts much like a stock exchange but is not a self-regulatory organization, and it describes a dark pool as an alternative trading system that does not publicly display the price or the number of shares before a trade.

Both markets are parts of the secondary market. Both are regulated. An alternative trading system must be operated by a broker-dealer that is a FINRA member, and over-the-counter trades in exchange-listed stocks, including those on dark pools, must be reported to FINRA.

FINRA Rules 2121, 5220, 5310 and 5320 govern fair pricing, stated quotations, best execution and trading ahead of customer orders, and FINRA's content outline for the Securities Industry Essentials examination lists both markets as topics.