What is prearranged trading?
Prearranged trading is, as its name suggests, a trade that happens at a specified price that both parties already agreed upon before execution. Can an investor really set his preferred price for execution? These types of orders are conditional, and they depend on prearranged price concepts. If we are to name one classic example, we can say that most over-the-counter orders are most likely prearranged.
Prearranged trading is used by traders who want to execute trades at a specific price in the open market. We mentioned conditional orders earlier, and they refer to orders that follow the concept of prearranged trading, where an investor can customize the risks depending on his tolerance. Hence, he can choose his preferred prices when he buys and sells. If you have heard of prearranged orders, then you must also be aware of block orders. They are also similar, and one can encounter them on regional exchanges or ECNs, which is legal. So, if there is something like this, why would others still get exposed to risks?
Prearranged trading is prohibited. Be it stocks, commodities, futures, options, or anything else. It should not happen among market makers because stock exchanges mostly have rules. For example, the Commodity Exchange Act strongly prohibits this regarding prearranged trading in the commodities market.
There are many market exchanges. They are all different, but they all want the orders to be executed using a bid-ask process that market makers use to match the suitable buyers and sellers. Now that we mention what market makers can do, we say they can use different entities and trading systems. On the other hand, investors can place different orders from several types of securities available to trade. Market or limit orders execution is done through the bid-ask process that market makers facilitate.
Why is it illegal?
You may already have an idea why but let us elaborate more. It is an illegal activity if it involves the securities exchange among market makers at prearranged prices. Why? Market makers are the facilitators of security exchanges in an open market. They make sure that the process is in order by matching the buyers and sellers who can trade. Prearranging the trade somehow defeats their purpose. It is unfair to people like brokers, investors, traders, and other market participants. These trades do not see what happens in the market pricing. Aside from that, there is no exposure to the risks that come with the standard exchange trades.
Let us cite an example before we end today’s topic.
Let us that market makers trade among each other in the equity market. They may make a sell offer that comes with a buy-back offer. They may also do the opposite and make a buy order with a sell offer to another market maker with the same price or another that will benefit them both. It can also happen in commodities. Dealers may execute trades without risks if they set prices instead of market prices. These are only some ways market makers can make prearranged trading, and now we understand why it’s illegal.