TradingMaterial.com - Electronic Trading is the trading securities, foreign currency, and derivatives electronically
 

Electronic Trading: E-Trading

Electronic trading, sometimes called etrading, is a method of trading securities (such as stocks, and bonds), foreign currency, and exchange traded derivatives electronically. It uses information technology to bring together buyers and sellers through electronic media to create a virtual market place. NASDAQ, NYSE Arca and Globex are examples of electronic market places. Exchanges that facilitate electronic trading in the United States are regulated by either the Securities and Exchange Commission or the Commodity Futures Trading Commission, and are generally called electronic communications networks or ECNs.

Etrading is widely believed to be more reliable than older methods of trade processing, but glitches and cancelled trades do occur

Historically, stock markets were physical locations where buyers and sellers met and negotiated. With the improvement in communications technology in the late 20th century, the need for a physical location became less important, as traders could transact from remote locations.

One of the earliest examples of widespread electronic trading was on Globex, the CME Group’s electronic trading platform that allows access to a variety of financial, foreign exchange and commodity markets. The Chicago Board Of Trade produced a rival system that was based on Oak Trading Systems’ Oak platform which facilitated ‘E Open Outcry,’ an electronic trading platform that allowed for electronic trading to take place alongside the trading that took place in the CBOT pits. Oak Trading Systems continues to offer access to global markets via various software applications, including demo packages, and products are available through reputable brokerage firms such as EHedger LLC.

Electronic trading makes transactions easier to complete, monitor, clear, and settle. NASDAQ, set up in 1971, 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 early 2007, organizations like the Chicago Mercantile Exchange were creating electronic trading platforms to support the emerging interest in trading within the foreign exchange market.

Today many investment firms on both the buy side and sell side are increasing their spending on technology for electronic trading. Many floor traders and brokers are being r\from the trading process. Traders are relying on algorithms to analyze market conditions and then execute their orders.

Dates of introduction of electronic trading by leading exchange in 120 countries is provided in a Journal of Finance article published in 2005 "Financial market design and the equity premium: Electronic vs. floor trading,". Leading academic research in this field is conducted by Professor Ian Domowitz and Professor Pankaj Jain.

There are, broadly, two types of trading in the financial markets:

  • 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.
  • Business-to-client (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 probably now happens over the Internet, retail trading volumes are dwarfed by institutional, inter-dealer and exchange trading.

Before the advent of eTrading, 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).

For instruments which aren't exchange-traded (e.g. U.S. 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, BGC Partners and Garban, who act as middle-men between dealers such as investment banks). This type of trading traditionally took place over the phone but brokers are beginning to offer eTrading services.

Similarly, B2C trading traditionally happened over the phone and, while much of it 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.

Larger institutional clients, however, will generally place electronic orders via proprietary ECNs such as Bloomberg, TradeWeb or CanDeal (which connect institutional clients to several dealers), or using their brokers' proprietary software.

Impact of Electronic Trading

The increase of eTrading 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 etrading 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 - Etrading 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.

Electronic Trading Technology and systems

Etrading systems are typically proprietary software (etrading 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 software 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 companies' 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 etrading 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 who offer solutions in this area.