Fourth Market

Fourth market trading is direct institution-to-institution trading without using the service of broker-dealers, thus avoiding both commissions, and the bid–ask spread. Trades are usually done in blocks. It is impossible to estimate the volume of fourth market activity because trades are not subject to reporting requirements. Studies have suggested that several million shares are traded per day.

What Is the Fourth Market?

The fourth market refers to a market where securities trade directly between institutions on a private, over-the-counter (OTC) computer network, rather than over a recognized exchange such as the New York Stock Exchange (NYSE) or Nasdaq. It is similar to the third market, which involves exchange-listed securities that are being traded over-the-counter between broker-dealers and large institutional investors. Fourth market trading differs from third market trading in that there is no intermediary or broker facilitating the trade. Institutions directly trade with each other without brokers or dark pools.

Institutions can trade various types of securities and derivatives contracts on the fourth market, often to increase anonymity or to effect large trades without moving the market.

Key Takeaways

The fourth market is an over-the-counter marketplace for the direct exchange of securities between private institutions.
The fourth market lacks a broker or exchange intermediary, and so provides little transparency to the public or regulators.
Institutions utilize the fourth market in order to keep trading activities private, reduce transaction costs, and to transact large volumes without moving markets.

Understanding the Fourth Market

The fourth market is utilized solely by institutions only, and can be contrasted with the primary market, secondary market, third market and dark pools. While primary, secondary, and third markets have similar trading mechanisms and utilize similar technologies as the fourth market, these markets are exchanges of publicly offered shares for all investors including retail and institutional.

Often the fourth market is used for trading securities that involve a company’s risk management strategy. For example, swap options are one type of derivative that can be traded through the fourth market directly with a willing counterparty to manage interest rate risk. With a put swaption, an institution can enter a contract to pay a fixed rate of interest and receive a floating rate of interest pertaining to credit debt on its balance sheet.

In other cases, companies may choose to exchange securities privately to prevent moving markets. This could occur if a mutual fund and a pension fund enter into a large block trade with each other. The two companies could transact over an electronic communication network (ECN). By executing the transaction in this way, they avoid the possibility of distorting the market price or the volume traded on an exchange. Both parties may also avoid brokerage and exchange transaction fees.

Primary, Secondary, Third, & Fourth

Market exchanges are a significant aspect of the financial industry’s infrastructure globally. In the U.S., primary, secondary and third markets are all viable parts of the financial system. Primary markets include the first issuance of a security and its initial public offering (IPO). Secondary markets are markets such as the New York Stock Exchange and Nasdaq which trade actively throughout the day, five days a week. Third markets also trade actively with a five-day week and are known as the over-the-counter markets. All of these markets provide access for all types of investors to publicly traded securities that must be registered with the Securities and Exchange Commission (SEC) for public sale.1

The Fourth Market and Dark Pools

Fourth markets are generally more closely comparable to dark pools, with the two phrases often used interchangeably. These markets are private exchanges that trade exclusively between institutional investors. A wide range of securities and structured products can trade on the fourth market with little transparency to the broad public market.

Fourth market trades are transacted between institutions. These trades are typically placed directly from each institution with low transaction costs. The fourth market can encompass a broad array of securities including publicly offered securities traded privately as well as derivatives and structured products tailored to the needs of corporate institutions.

These trading platforms can be set up by independent companies or they may be formed by institutions themselves. Liquidity and trading volume can vary extensively with this type of trading.