How electronic trading systems work
When a participant wants to get on to an exchange, they work with the exchange to provide necessary details and go through background checks so that they can be setup to trade on the exchange.
For electronic trading, the participants will not physically come to the market - they will connect to the computer systems on the market. They connect using different means - s0me co-locate in the exchange alongside the computer systems of the exchange so that they get the quickest access to the market.
Others connect to the market using dedicated high speed lines. The end goal for everyone is to be able to get on to the market quickly and faster than everyone else. The participants trade on the market as per the terms of the market - they are required to follow the rules set for the market and any violation is not taken lightly.
In addition they are also governed by the laws of the regulators of the country. Trading happens on a price - when the buyers specify that they want to buy by paying up to a certain price, called the bid price , and the sellers specify that they are willing to sell for not less than a certain price, called the offer price, a market is created on the exchange.
This market has two kinds of aspects - the price and the order. The data about these two are called the market data. As more participants place orders on the market the price moves up or down and these movements of price are called price ticks.
These price ticks are available to all the participants and also to others using various means like dedicated feeds or using public websites. The information about the price movements is very important for the participants because based on this they can make an informed decision on whether they want to buy or sell the product and at what price. Just like the price is important, the participants also need to know about orders placed by others on the market. Unless you know how much of the product is being sold at a given price, how can you decide the size of your order?
You need both the price and the size available on the market, your decision is not correct. In electronic trading, the exchange provides a specified format in which orders can be placed on the market - all participants know this format and place orders using this format. Once the participants have placed orders on the market, there has to be a means of matching all these to create deals.
Before electronic trading, the orders would be manually matched using the rules of the market. With the advent of computer based trading, all these rules for matching orders have been automated and the matching is performed very quickly. There are systems that can perform order matching in matter of microseconds. The matching engine is the core of the exchange and determines the performance of the market. This is the most critical piece of the entire platform and must perform under the heavy volume without failing or missing any single order.
These are built with various fail safe mechanisms and resiliency in order to guarantee that it is always available and can facilitate trading. Once a deal is reached, accounts need to be kept and the deal information needs to be sent to both the parties involved in the deal.
There are dedicated systems on exchanges that facilitate sending these details to the participants. These could be real time feeds or end of day snapshots. These need to be capable of handling the volumes generated on the market. All these systems that I described might sound simple - but in reality there are various levels of complexity built in to these like security, validation, resiliency and many many rules and regulations that will govern the market.
In addition, to achieve the high speed and large transaction volumes that are needed, these will be built with architectures that can withstand and perform a peaks loads.
Once we have a trading platform comprising of all these, it starts working as as soon as the participants start placing orders. As more and more orders are placed and executed, the market grows and performs.
Since there is no way to artificially create a market, everything must come from the participants. If there are no participants then the market will fail. Even in a market where there are participants, they might be interested only in certain products. The best markets out there perform and survive by providing those products which everyone is interested in.
The huge electronic trading market is created when a large number of participants connect to these markets and place orders based on up to date prices and in large numbers. The participants use their own systems and calculations to determine which price is good. Crashes happen when a wrong price, a too low price or a price that can be taken advantage of is put on the market. Crashes also happen when there is no balance between the number of buyers and sellers and one side is larger than the other.
Panic reactions from participants can also cause a crash. And of course there is the ever persistent threat of a computer system breaking down.
A good market will have means to identify all these issues before they happen and take corrective steps. All these systems are not some poorly done job that fails one day. 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.
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. Set up in , NASDAQ was the world's first electronic stock market, though it originally operated as an electronic bulletin board [ citation needed ] , rather than offering straight-through processing STP.
By investment firms on both the buy side and sell side were increasing their spending on technology for electronic trading. Traders also increasingly started to rely on algorithms to analyze market conditions and then execute their orders automatically.
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. 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. 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.
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. Charles Schwab , E-Trade went online during the late s and most retail stock-broking probably takes place over the web now.
Larger institutional clients, however, will generally place electronic orders via proprietary electronic trading platforms such as Bloomberg Terminal , Reuters 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,  foreign exchange,  derivatives,  and fixed income  trading.
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.
Exchanges typically develop their own systems sometimes referred to as matching engines , although sometimes an exchange will use another exchange's technology e.