Electronic Trading

Electronic trading is the conduct of trading in securities, derivatives, currencies and other financial instruments through computer systems. Orders are entered on a screen or generated by a program, carried over a network, and matched by software. It replaced two older methods: open outcry, in which traders shouted and signaled bids and offers on an exchange floor, and telephone dealing, in which a customer called a dealer for a price.

The shift took place between the 1970s and the 2000s and is now nearly complete in shares, listed futures and options, and spot foreign exchange. Bond and swap markets have moved more slowly and still rely partly on voice. Electronic trading is the foundation for everything that followed in market structure, including algorithmic trading, online brokerage for individuals and the present network of competing venues.

The Nasdaq market opened in 1971 as an electronic system for displaying dealers' quotes, although trades were still agreed by telephone. In 1977 the Toronto Stock Exchange introduced a computer-assisted trading system that executed orders automatically. London's Big Bang reforms of October 1986 moved share dealing from the floor to screens. The Chicago Mercantile Exchange launched its Globex platform for futures in 1992.

New exchanges began to open with no floor at all. The National Stock Exchange of India started fully electronic trading in 1994. In Europe, the German electronic futures exchange won trading in the main German government bond future away from London's floor-based exchange in 1998, a turning point that persuaded most remaining floors to convert. In the United States, each electronic communication network that emerged in the late 1990s took business from traditional markets, and the New York Stock Exchange adopted a largely automated model in the mid-2000s. Trading floors that survive handle a small fraction of volume.

An electronic market has a small number of linked parts. A participant enters an order through a trading screen or an automated program. The order travels to the venue in a standard message format; the FIX protocol, created in 1992, is the most widely used. At the venue a matching engine compares the order with those already in the book and executes it or stores it. Confirmations go back to the participants, market data is published to all subscribers, and trade details pass to clearing and settlement systems.

Two market models are common:

• Order-driven markets. All participants' orders are gathered in a central limit order book and matched by price and time priority. Stock and futures exchanges work this way. The rules are described under order matching.
• Quote-driven and request-based markets. A customer asks several dealers for a price electronically and trades with the best, a process called request for quote, or trades against prices that dealers stream continuously. Bonds, swaps and much foreign exchange trade in this way, largely over the counter.

The clearest effect has been on cost. Automation removed layers of intermediaries, and commissions fell sharply. Competition among venues and among automated market makers narrowed the bid-ask spread in actively traded instruments. Prices became visible to anyone with a screen, where once the best information was held by those on the floor. Individuals gained direct, low-cost access, which produced the growth of retail trading through online and mobile brokers.

Speed rose by many orders of magnitude. A trade that took minutes on a floor is completed in well under a millisecond. This made it possible to automate the trading decision itself, giving rise to automated trading and high-frequency trading, and it turned low latency technology into a field of competition. Institutions gained the ability to place orders in the book themselves through direct market access.

Electronic markets fail in different ways from floor markets. A software fault or a mistaken order can spread through linked markets in seconds, as in the flash crash of 6 May 2010. Liquidity supplied by automated firms can vanish abruptly in stressed conditions, since those firms have no obligation to keep quoting. Exchanges respond with safeguards such as the circuit breaker, price bands and limits on message rates.

Trading has also fragmented. The same instrument may trade on many venues, some of which do not display their orders, and investors depend on brokers' routing systems to find the best price. Critics argue that the speed race absorbs resources without benefiting long-term investors and that complexity makes markets harder to supervise. Outages at a major exchange or data provider can halt trading across a whole market, which makes operational resilience a regulatory priority.

Rules have been rewritten around electronic markets. In the United States, Regulation NMS, adopted in 2005, links competing venues by requiring that orders not be executed at prices worse than the best displayed quote elsewhere. In the European Union, the MiFID framework opened national exchanges to competition from 2007 and, in its second version from 2018, added specific requirements for venues' systems, for algorithmic traders and for transparency. Regulators in most major markets require venues to test their systems, maintain capacity and have arrangements for halting trading in disorderly conditions.