On exchange definition

What is on exchange?

On exchange is a term used to describe a trade that is taking place directly on the order book of an exchange. It differs from trading over-the-counter (OTC), which are contracts exchanged between two parties, away from a centralised exchange.

One way to trade on exchange is through direct market access (DMA). This method of trading provides a host of benefits such as increasing the visibility of other orders on the market. In turn, this creates an even playing field since each order is of equal status in the order book.

Pros and cons of on-exchange trading

Pros of on-exchange trading

When you trade on exchange, the communication of bid and offer prices is centralised, which means that all market participants have access to the information. Anyone can buy or sell at one of the quoted prices or respond with a different quote.

This creates an even playing field, because traders can see market movements clearly and make more accurate predictions of their own – especially as the information supplied by an exchange is available to everyone.

Another positive is that trading on exchange is heavily regulated. Firstly, this means that there is more legitimacy given to the companies that are listed on an exchange. Secondly, this means that there is less counterparty risk, as the exchange acts as the counterparty instead of another independent party.

Cons of on-exchange trading

A potential disadvantage of trading on exchange is that exchanges very often have set open and close times for trading. This is in contrast to OTC markets like forex, which can be traded 24 hours a day.

Trading on exchange can sometimes be more expensive when compared to trading OTC. This is because there are more stringent requirements on companies seeking to be listed on exchanges, which can make their stock more expensive. However, this additional cost also comes with lower counterparty risk.

On exchange vs over-the-counter

On exchange and over-the-counter (OTC) are two popular ways to trade. On-exchange trading offers greater market visibility, which is why it is often referred to as trading on a lit market or into a lit pool. However, the total transparency of lit markets can increase volatility if traders see a large sell-off or buy-in for a particular asset.

Conversely, OTC trading methods allow traders to conceal their movements from each other, which is why the OTC market is sometimes referred to as a dark liquidity market or a dark pool. Dark pools are most often used by large-volume traders, and can have less of an impact on the volatility of financial markets with their large sell-offs or buy-ins.