Electronic trading

Electronic trading is the use of computer networks, electronic communication systems, and digital platforms to facilitate the buying and selling of financial instruments and other tradable assets. It allows market participants to submit, route, match, execute, and manage orders electronically without requiring direct participation through traditional physical trading venues.

Electronic trading is widely used in stock markets, bond markets, foreign exchange markets, commodity markets, and derivatives markets.

History

Electronic trading developed alongside advances in computing and telecommunications.

Early financial markets relied heavily on physical trading floors, telephone communication, and manual order processing. The introduction of electronic quotation systems, automated order-routing systems, and electronic exchanges gradually reduced the role of manual trading.

The development of high-speed networks, automated execution systems, and algorithmic trading subsequently expanded the use of electronic trading.

Electronic trading system

An electronic trading system generally consists of:

trading interfaces;
order-management systems;
order-routing systems;
matching engines;
market-data systems;
clearing and settlement systems;
risk-management systems.

These components work together to receive orders, transmit them to trading venues, match eligible orders, and record transactions.

Order submission

An electronic trading system allows a participant to submit an order specifying parameters such as:

financial instrument;
quantity;
order type;
price;
time-in-force instructions.

Orders may be submitted directly through a trading platform or through an intermediary or automated system.

Order types

Common electronic order types include:

market orders;
limit orders;
stop orders;
stop-limit orders.

The availability and characteristics of order types depend on the trading venue.

Order book

An order book is an electronic record of buy and sell orders for a financial instrument.

A simplified order book contains:

bids — orders to buy;
asks or offers — orders to sell.

The highest available bid and lowest available ask can be used to determine the prevailing quoted market spread.

The bid-ask spread can be expressed as:

$Bid-Ask Spread = Best Ask Price - Best Bid Price$

Matching engine

A matching engine is a computer system that matches compatible buy and sell orders according to the rules of a trading venue.

Many electronic markets use a price-time priority mechanism, under which orders are generally ranked according to price and then the time at which they were submitted.

The precise matching rules vary among trading venues.

Electronic communication networks

An electronic communication network (ECN) is an electronic system that can facilitate the matching or routing of buy and sell orders.

ECNs have been particularly associated with electronic trading in securities markets and have contributed to the development of automated and alternative trading venues.

Electronic exchanges

An electronic exchange provides a digital infrastructure through which market participants can submit and execute orders.

Electronic exchanges can support trading in:

equities;
futures;
options;
bonds;
currencies;
commodities;
other financial instruments.

Some exchanges operate entirely electronically, while others may combine electronic systems with other forms of trading.

Algorithmic trading

Algorithmic trading uses computer programs to execute trading strategies according to predefined rules.

Algorithms may determine:

order timing;
order size;
execution venue;
price;
execution strategy.

Algorithmic trading is therefore closely associated with electronic trading but is not synonymous with it. Electronic trading refers to the electronic execution infrastructure, while algorithmic trading refers to the automated decision or execution process.

High-frequency trading

High-frequency trading (HFT) is a form of algorithmic trading characterized by high-speed automated order submission and execution, large numbers of transactions, and the use of low-latency technological infrastructure.

HFT is a subset of electronic and algorithmic trading rather than a synonym for electronic trading as a whole.

Direct market access

Direct market access (DMA) allows a market participant to transmit orders directly to a trading venue using electronic systems, subject to the access arrangements and controls of the relevant intermediary or venue.

DMA can reduce the number of manual steps involved in order transmission.

Smart order routing

Smart order routing uses automated systems to determine where and how an order should be routed among available trading venues.

A routing system may consider factors such as:

quoted price;
available liquidity;
transaction costs;
execution probability;
latency;
venue characteristics.

Electronic trading and market liquidity

Electronic trading can increase the accessibility and speed of transactions and may contribute to market liquidity by allowing orders from multiple participants to interact electronically.

Liquidity can nevertheless vary substantially according to:

market conditions;
trading volume;
instrument characteristics;
number of market participants;
available market-making activity.

Electronic trading does not guarantee continuous liquidity.

Electronic trading and price discovery

Price discovery is the process through which market prices emerge from the interaction of supply and demand.

Electronic order books can provide continuous information about quoted bids, offers, transaction prices, and available quantities.

This information can contribute to price discovery in electronically traded markets.

Electronic trading and market access

Electronic trading can broaden access to financial markets by allowing participants to submit orders remotely through digital platforms.

Access may be provided to:

individual investors;
institutional investors;
banks;
broker-dealers;
market makers;
proprietary trading firms;
other eligible participants.

The level of access depends on the market, jurisdiction, intermediary, and participant.

Advantages

Potential advantages of electronic trading include:

rapid order execution;
automated order processing;
greater market accessibility;
reduced manual processing;
increased transparency of displayed orders in applicable markets;
automated risk controls;
lower operational costs in some circumstances;
integration with algorithmic trading systems.

Risks and limitations

Electronic trading also creates technological and operational risks.

These may include:

system failures;
network interruptions;
cybersecurity incidents;
erroneous orders;
software errors;
excessive order traffic;
market disruptions;
connectivity failures.

Trading venues and market participants therefore use controls such as order limits, circuit breakers, kill switches, and monitoring systems.

Latency

Latency is the time required for information or an order to travel through an electronic trading system.

Low latency can be important for trading strategies that depend on rapid access to market information and execution.

Latency can arise at multiple points, including:

market-data transmission;
network communication;
order processing;
risk checks;
order matching;
execution confirmation.

Electronic trading and market regulation

Electronic trading is subject to financial-market regulation designed to promote orderly markets, investor protection, transparency, and market integrity.

Regulatory requirements may address:

market access;
algorithmic trading;
market manipulation;
order handling;
transaction reporting;
record keeping;
cybersecurity;
risk controls.

Requirements vary by jurisdiction and financial market.

Electronic trading and market manipulation

Electronic markets can be exposed to forms of market manipulation that exploit automated order systems.

Potential abusive practices include:

spoofing;
layering;
quote manipulation;
wash trading;
other prohibited trading practices.

Trading venues and regulators may use automated surveillance systems to identify unusual trading patterns.

Settlement

Execution of an electronic trade does not necessarily mean that the transaction has been fully settled.

After execution, transactions may proceed through:

clearing;
confirmation;
settlement;
custody;
transfer of funds or securities.

Electronic trading systems can therefore form one part of a broader financial-market infrastructure.

Example

Suppose an investor submits an electronic limit order to buy 1,000 shares of a company at a maximum price of US$50 per share.

The order is transmitted electronically to a trading venue and entered into the relevant order book.

If a compatible sell order becomes available at US$50 or less, the matching engine may execute the transaction according to the venue's matching rules.

The resulting trade is then processed through the applicable clearing and settlement infrastructure.

Importance

Electronic trading is a fundamental component of modern financial markets. It enables orders to be transmitted and matched electronically, supports automated execution and market-data processing, and allows participants to access markets remotely. Its development has contributed to faster execution, greater automation, and changes in the structure and operation of financial markets.