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Electronic Trading in Financial Markets Terrence Hendershott Electronic Trading in Financial Markets Terrence Hendershott rading financial instruments has histori- impacting financial markets (M. Fan et al., “Elec- cally required face-to-face communica- tronic Commerce and the Revolution in Financial tion at physical locations. The Nasdaq Markets,” South-Western College Pub., 2001). A over-the-counter market for stocks was book by L. Harris offers details on issues relating Tone of the first markets where technology to financial markets’ operations. (L. Harris, replaced physical interaction. Subsequently,most “Trading and Exchanges: Market Microstructure stock exchanges in the world, such as those in for Practitioners,” Oxford University Press, 2002). London, Tokyo, and Frankfurt, moved to elec- The “Definition of Terms”sidebar explains several tronic trading.The largest exchange in the world terms that this article discusses. (by market capitalization), the New York Stock Exchange, still uses OVERVIEW OF ELECTRONIC Technological physical trading, but MARKET STRUCTURES has introduced systems A trading system’s market structure includes innovations such to let retail and institu- the set of rules governing its trade execution as electronic tional investors engage mechanism and the amount of price and quote in electronic trading. data it releases. Many diverse market structures communications Innovations in com- exist.Three generic market structure types are puting and communica- networks bypass tions make possible •a continuous limit order book, human global electronic order •a single-price auction, and routing, broad dissemi- •a trading system with passive pricing. intermediaries, nation of quote and increasing trade information, and In an electronic limit order book, traders con- new types of trading tinuously post bids and offers on the system for competition systems. These innova- other participants to view. A limit order is an and reducing tions eliminate the need order to buy a specified quantity of a security at for direct person-to- or below a specified price, or sell above a speci- transaction costs. person contact via trad- fied price.The order book displays orders and typ- ing floors or telephone ically ranks them by price and then by time. networks.New technol- Figure 1 shows an example of the limit order book ogy reduces the costs of building new trading sys- for Island, which is one of the largest electronic tems, lowering the entry barriers for new trading systems. Limit orders to buy are on the competitors. Finally, improvements in communi- cations technology enable faster order routing and market data transmission to a much larger group Inside of participants.The growth in electronic trade exe- cution systems on an international basis has been Definition of Terms explosive,and new stock markets are almost exclu- sively electronic.A publication by M.Fan et al.pro- Nasdaq’s Communication Network vides a broad overview of how technology is 10 IT Pro July ❘ August 2003 Published by the IEEE Computer Society 1520-9202/03/$17.00 © 2003 IEEE left side, and orders to sell are on the right, with each order’s price Definition of Terms and quantity displayed. The order book lists buy orders by descend- A financial market is a to market participants. ing price and sell orders by ascend- communications system Order routing is the act ing price, with orders at each price facilitating transmission of sending orders from highlighted in a different color.The of pre- and post-trade their originators, prima- highest-price bid is $24.05, and the information, order rout- rily investors and broker- lowest-price offer is $24.06, mean- ing, matching, execution, dealers, to the execution ing the spread between the best trade clearing, settlement, system. buy and sell prices is 1 cent. For and custody. Order matching and each security, the top 15 orders on A trading system’s pro- execution is a transaction each side of the book are continu- gramming instantiates specific rules algorithm that translates orders into ously available on Island’s Web site regarding allowable messages that trades, which consist of transaction (http:// www.island.com). participants can send and receive and prices and quantities. A limit order book does not typ- the type of information displayed. Clearing and settlement is the ically display the user’s identity,the The system transmits pre- and post- process of exchanging the seller’s order’s entry time, or the period for trade data about quotes and trades shares for the buyer’s cash. which the order is good. A partici- pant either initiates a trade with an order already on the order book or places a new limit order in the book. If a bid or offer is in the book and a participant enters an order on the other Figure 1. Island’s limit order book. side of the market at the same price or better, the limit order book automatically and immediately matches the refresh island home disclaimer help orders, and a trade occurs. The book can match incoming GET STOCK orders against more than one existing order. In a single-price auction system, participants may sub- MSFT go mit bids and offers over a period of time, but the system executes all trades together at one price, at a single point SYMBOL SEARCH of time. The system normally calculates the transaction price to maximize the total volume traded, given the bids LAST MATCH TODAY’S ACTIVITY and offers residing in the system. Bids and offers with Price 24.0510 Orders 37,864 prices at least as good as the system-calculated price are Time 13:15:23.745 Volume 6,972,147 processed into trades, subject to a set of priority rules.This BUY ORDERS SELL ORDERS structure has variations, depending on order type and SHARES PRICE SHARES PRICE order information display. 1,000 24.0500 5,000 24.0600 Some electronic trading systems determine trade prices 100 24.0500 2,000 24.0700 by explicitly referring to other markets’ pricing and sales 2,100 24.0320 4,000 24.0700 activity. We refer to such trading systems, which have no independent price discovery mechanism and whose prices 2,650 24.0240 500 24.0770 are taken directly from a primary market, as passive or 2,500 24.0240 300 24.0780 derivative pricing systems.Some systems allow for the pos- 1,000 24.0220 700 24.0790 sibility of price improvement by assessing market condi- 4,500 24.0210 1,000 24.0800 tions in the underlying market and then pricing their trades 2,000 24.0200 2,600 24.0900 at a price better than the best quote on the underlying mar- 2,500 24.0200 3,000 24.0900 ket available at the time of the order entry.Prices may vary 300 24.0100 2,000 24.0900 through the trading session—if the system operates at the 1,000 24.1000 1,000 24.0900 same time as its associated primary market—or may be 200 24.1000 750 24.0900 fixed at a single level, such as the closing price for an after- 200 24.1000 1,200 24.0990 hours trading session.A system may base trade execution 45 24.1000 5,400 24.0990 on different secondary priorities than those present in the 6,000 24.1000 100 24.1000 primary market.The brokerage and trading services com- pany ITG operates the largest passive pricing system— (498 more) (587 more) called POSIT—which traded 7.7 billion shares in 2002 and July ❘ August 2003 IT Pro 11 ELECTRONIC TRADING has been growing at an annual rate of about 50 percent. cussed earlier. Several ECNs are currently registered in the POSIT prices its trades at the midpoint of the bid/offer NASDAQ system: Attain, Archipelago, Brass Utility, spread (the difference between the lowest asking price by Bloomberg Tradebook,Instinet,Island,NexTrade,and Track. a seller and the highest bid from a buyer) in the stock’s pri- ECNs’ automated communication and matching systems mary market at the moment the match is run. Eight times have led to lower trading costs. By matching buyers and daily—at 9:40 a.m.,10 a.m.,and 10:30 a.m.,and on the hour sellers directly,ECNs bypass human intermediaries such as from 11 a.m. to 3 p.m.—POSIT compares and matches all dealers, reducing their profits. Dealers on the New York buy and sell orders confidentially. If an imbalance exists Stock Exchange and the Nasdaq have average operating between buy and sell orders, the system randomly selects margins of approximately 50 percent and 25 percent, orders on the excess side to match the number of orders on respectively. ECNs offer other traders the opportunity to the smaller side. Orders that the system does not select do undercut these margins, increasing competition and reduc- not execute. ing transaction costs. ECNs also offer faster trade execution.Their leading-edge THE GROWTH OF ELECTRONIC technology allows significantly faster order execution than COMMUNICATIONS NETWORKS established market centers’ trading systems.For example,the The Securities and Exchange Commission (SEC) defines average execution time for an ECN is two to three seconds, the biggest electronic trading systems, electronic communi- compared with more than 20 seconds for an order through cations networks (ECNs),as “electronic trading systems that an exchange.Furthermore,ECNs typically provide investors automatically match buy and sell orders at specified prices” with more complete price information than traditional mar- (http://www.sec.gov/answers/ecn.htm). The SEC describes ket centers by allowing them to see the ECN’s limit order ECNs as integral to the modern securities markets, and in books.This information allows investors to better assess mar- August 2002 ECNs accounted for approximately 40 percent ket conditions and optimize their trading strategy.
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