Electronic trading

Not to be confused with E-Trade.

Electronic trading, sometimes called etrading, is a method of trading securities (such as stocks, and bonds), foreign exchange or financial derivatives electronically. Information technology is used to bring together buyers and sellers through an electronic trading platform and network to create virtual market places. They can include various exchange-based systems, such as NASDAQ, NYSE Arca and Globex, as well as other types of trading platforms, such as electronic communication networks (ECNs), alternative trading systems, crossing networks and "dark pools".^[1] Electronic trading is rapidly replacing human trading in global securities markets.

Electronic trading is in contrast to older floor trading and phone trading and has a number of advantages, but glitches and cancelled trades do still occur.^[2]

History

For many years stock exchanges were physical locations where buyers and sellers met and negotiated. Exchange trading would typically happen on the floor of an exchange, where traders in brightly colored jackets (to identify which firm they worked for) would shout and gesticulate at one another – a process known as open outcry or pit trading (the exchange floors were often pit-shaped – circular, sloping downwards to the centre, so that the traders could see one another). With the improvement in communications technology in the late 20th century, the need for a physical location became less important and traders started to transact from remote locations in what became known as electronic trading.^[3] Electronic trading made transactions easier to complete, monitor, clear, and settle and this helped spur on its development.

One of the earliest examples of widespread electronic trading was on Globex, the CME Group’s electronic trading platform conceived in 1987 and launched fully in 1992.^[4] This allowed access to a variety of financial markets such as treasuries, foreign exchange and commodities. The Chicago Board of Trade (CBOT) produced a rival system that was based on Oak Trading Systems’ Oak platform branded ‘E Open Outcry,’ an electronic trading platform that allowed for trading to take place alongside that took place in the CBOT pits.

Set up in 1971, NASDAQ was the world's first electronic stock market, though it originally operated as an electronic bulletin board, rather than offering straight-through processing (STP).

By 2011 investment firms on both the buy side and sell side were increasing their spending on technology for electronic trading.^[5] With the result that many floor traders and brokers were removed from the trading process. Traders also increasingly started to rely on algorithms to analyze market conditions and then execute their orders automatically.^[6]

The move to electronic trading compared to floor trading continued to increase with many of the major exchanges around the world moving from floor trading to completely electronic trading.^[7]

Trading in the financial markets can broadly be split into two groups:

Business-to-business (B2B) trading, often conducted on exchanges, where large investment banks and brokers trade directly with one another, transacting large amounts of securities, and
Business-to-consumer (B2C) trading, where retail (e.g. individuals buying and selling relatively small amounts of stocks and shares) and institutional clients (e.g. hedge funds, fund managers or insurance companies, trading far larger amounts of securities) buy and sell from brokers or "dealers", who act as middle-men between the clients and the B2B markets.

While the majority of retail trading in the United States happens over the Internet, retail trading volumes are dwarfed by institutional, inter-dealer and exchange trading. However, in developing economies, especially in Asia, retail trading constitutes a significant portion of overall trading volume.

For instruments which are not exchange-traded (e.g. US treasury bonds), the inter-dealer market substitutes for the exchange. This is where dealers trade directly with one another or through inter-dealer brokers (i.e. companies like GFI Group, ICAP and BGC Partners. They acted as middle-men between dealers such as investment banks). This type of trading traditionally took place over the phone but brokers moved to offering electronic trading services instead.

Similarly, B2C trading traditionally happened over the phone and, while some still does, more brokers are allowing their clients to place orders using electronic systems. Many retail (or "discount") brokers (e.g. Charles Schwab, E-Trade) went online during the late 1990s and most retail stock-broking probably takes place over the web now.^[3]

Larger institutional clients, however, will generally place electronic orders via proprietary electronic trading platforms such as Bloomberg Terminal, Reuters 3000 Xtra, Thomson Reuters Eikon, BondsPro, Thomson TradeWeb or CanDeal (which connect institutional clients to several dealers), or using their brokers' proprietary software.

For stock trading, the process of connecting counterparties through electronic trading is supported by the Financial Information eXchange (FIX) Protocol. Used by the vast majority of exchanges and traders, the FIX Protocol is the industry standard for pre-trade messaging and trade execution. While the FIX Protocol was developed for trading stocks, it has been further developed to accommodate commodities,^[8] foreign exchange,^[9] derivatives,^[10] and fixed income^[11] trading.

Impact

The increase of electronic trading has had some important implications:

Reduced cost of transactions – By automating as much of the process as possible (often referred to as "straight-through processing" or STP), costs are brought down. The goal is to reduce the incremental cost of trades as close to zero as possible, so that increased trading volumes don't lead to significantly increased costs. This has translated to lower costs for investors.
Greater liquidity – electronic systems make it easier to allow different companies to trade with one another, no matter where they are located. This leads to greater liquidity (i.e. there are more buyers and sellers) which increases the efficiency of the markets.
Greater competition – While electronic trading hasn't necessarily lowered the cost of entry to the financial services industry, it has removed barriers within the industry and had a globalisation-style competition effect. For example, a trader can trade futures on Eurex, Globex or LIFFE at the click of a button – he or she doesn't need to go through a broker or pass orders to a trader on the exchange floor.
Increased transparency – Electronic trading has meant that the markets are less opaque. It's easier to find out the price of securities when that information is flowing around the world electronically.
Tighter spreads – The "spread" on an instrument is the difference between the best buying and selling prices being quoted; it represents the profit being made by the market makers. The increased liquidity, competition and transparency means that spreads have tightened, especially for commoditised, exchange-traded instruments.

For retail investors, financial services on the web offer great benefits. The primary benefit is the reduced cost of transactions for all concerned as well as the ease and the convenience. Web-driven financial transactions bypass traditional hurdles such as logistics.

Technology and systems

Electronic trading systems are typically proprietary software (etrading platforms or electronic trading platforms), running on COTS hardware and operating systems, often using common underlying protocols, such as TCP/IP.

Exchanges typically develop their own systems (sometimes referred to as matching engines), although sometimes an exchange will use another exchange's technology (e.g. e-cbot, the Chicago Board of Trade's electronic trading platform, uses LIFFE's Connect system), and some newer electronic exchanges use 3rd-party specialist software providers (e.g. the Budapest stock exchange and the Moscow Interbank Currency Exchange use automated trading system originally written and implemented by FMSC, an Australian technology company that was acquired by Computershare, and whose intellectual property rights are now owned by OMX).

Exchanges and ECNs generally offer two methods of accessing their systems –

an exchange-provided GUI, which the trader runs on his or her desktop and connects directly to the exchange/ECN, and
an API which allows dealers to plug their own in-house systems directly into the exchange/ECN's.

From an infrastructure point of view, most exchanges will provide "gateways" which sit on a company's network, acting in a manner similar to a proxy, connecting back to the exchange's central system.

ECNs will generally forego the gateway/proxy, and their GUI or the API will connect directly to a central system, across a leased line.

Many brokers develop their own systems, although there are some third-party solutions providers specializing in this area. Like ECNs, brokers will often offer both a GUI and an API (although it's likely that a slightly smaller proportion of brokers offer an API, as compared with ECNs), and connectivity is typically direct to the broker's systems, rather than through a gateway.

Investment banks and other dealers have far more complex technology requirements, as they have to interface with multiple exchanges, brokers and multi-dealer platforms, as well as their own pricing, P&L, trade processing and position-keeping systems. Some banks will develop their own electronic trading systems in-house, but this can be costly, especially when they need to connect to many exchanges, ECNs and brokers. There are a number of companies offering solutions in this area.

Algorithmic trading

Main article: Algorithmic trading

Some electronic trades are not planned or executed by human traders, but by complex algorithms.

Many types of algorithmic or automated trading activities can be described as high-frequency trading (HFT), which is a specialized form of algorithmic trading characterized by high turnover and high order-to-trade ratios

References

↑ Lemke & Lins, Soft Dollars and Other Trading Activities, Chapter 2 (Thomson West, 2015-2016 ed.).
↑ Ian Salisbury and Geoffrey Rogow (September 25, 2008). "Gliches Cancel Electronic Trades". The Wall Street Journal. p. D3.
1 2 Graham Bowley (January 1, 2011). "The New Speed of Money, Reshaping Markets". The New York Times. Retrieved July 8, 2012.
↑ "Growth of CME Globex Platform: A Retrospective". CME Group. Retrieved October 4, 2012.
↑ ISITC 2011 Member Survey, March 12, 2012.
↑ "Trading from the Front: A CEP Hedge Fund". Global Trading. December 2011.
↑ Jain, Pankaj K., 2005, “Financial market design and the equity premium: Electronic vs. floor trading,” Journal of Finance volume 60, issue 6, pp. 2955–2985.
↑ "Commodities Trading with FIX". Global Trading. December 2011.
↑ "FIX in FX". Global Trading. December 2010.
↑ "Global Derivatives - Analysing the key developments and accelerators for FIX". Global Trading. September 2009.
↑ Sassan Danesh "FIXing Fixed Income" Check |url= value (help). Global Trading. 19 August 2013.

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