Auction Market

An auction market is a market in which buyers enter competing bids and sellers enter competing offers, and trades are made when the two meet. Prices come from the interaction of orders submitted by participants, not from quotations set by an intermediary. Most stock and futures exchanges are auction markets, as are the sales through which governments issue debt.

The contrasting model is the dealer or quote-driven market, in which a market maker stands between buyers and sellers, quoting a bid price at which it will buy and an ask price at which it will sell. Auction markets are also called order-driven markets. Many modern venues combine the two, with an order book supplemented by firms that have agreed to quote. The design of these mechanisms is studied under market microstructure.

Auction markets take two main forms. In a continuous auction, orders can arrive at any moment and are matched as soon as a buy order and a sell order are compatible. This is the normal daytime mode of an exchange, described under continuous trading. Orders rest in an order book and are executed according to priority rules, usually best price first and, at the same price, earliest order first.

In a call auction, orders are collected over a period without being matched. At a set moment, the system calculates the single price at which the largest quantity can trade and executes all eligible orders at that price. Exchanges use call auctions at the start and end of the day, as the opening auction and the closing auction, and to restart trading after a halt or a volatility interruption. Some less liquid securities trade only by periodic call auctions.

A continuous auction is sometimes called a double auction, because both buyers and sellers compete at once. This distinguishes it from a one-sided auction, in which a single seller faces many bidders.

In a continuous market, the highest bid and the lowest offer in the book define the bid-ask spread. A trade occurs when a participant is willing to cross the spread, by buying at the best offer or selling at the best bid, or when a new limit order overlaps with one already resting. The exchange's matching engine applies the rules automatically, and the combined book is generally known as a central limit order book (CLOB).

Because all orders compete in one place and trades are published, an auction market supports price discovery: the process by which information held by many participants is brought into a single price. A call auction concentrates this process at one moment, which tends to produce a price that reflects more orders than any single continuous trade.

The following are common cases:

• Stock exchanges. Shares on a stock exchange trade in electronic order books during the day, with call auctions at the open and close. The New York Stock Exchange grew from a floor-based auction in which brokers gathered around a specialist.
• Futures and options exchanges. Historically these used open outcry, in which traders in a pit shouted and signalled bids and offers. Most have moved to electronic books.
• Government debt. Treasuries sell bills and bonds by auction, often through a primary dealer system. Bidders state a price or yield, and securities are awarded either at one clearing price for everyone or at the price each bidder offered.
• Share offerings and buybacks. A Dutch auction, in which the price is set at the level that clears the quantity on offer, is sometimes used for new issues and tender offers.

Central banks also use auctions to lend to or borrow from banks in their market operations.

An auction market lets investors trade directly with each other, so a patient investor can earn the spread instead of paying it. Prices and order flow are visible, and no single intermediary controls access. These features work well for standardised, actively traded instruments.

Dealer markets suit instruments that trade rarely or in many varieties, such as most corporate bonds and customised derivatives. There may be no matching order in a book at the moment an investor wants to trade, so a dealer supplies immediacy by using its own inventory. The cost is a wider spread and less transparency. Foreign exchange and bond markets remain largely dealer-based, though electronic platforms have introduced auction-like features such as requests for quotes sent to several dealers at once.

Auction markets depend on enough orders being present. When liquidity is thin, the book has gaps, and a large order can move the price sharply. Displaying a large order reveals the trader's intention, which encourages institutions to split orders or use non-displayed venues. Continuous matching rewards speed, which has led to heavy investment in fast trading technology and to a debate about whether frequent batch auctions would be fairer. Exchanges manage disorderly conditions with price limits, trading halts and auction-based restarts.