High-Frequency Trading: A Primer
The term “stock exchange” tends to conjure up images of a room crowded with men in suits – one hand pressing phone firmly to ear, the other waving furiously in the air. Once upon a time those iconic images were an accurate representation of the controlled chaos that was the floor of the venerable New York Stock Exchange, or NYSE as it is known.
When NASDAQ launched in 1971 as the world’s first electronic stock market, it set in motion the changes that would lead to the complex and fragmented status of markets today. A status better represented by the image of the "1s" and "0s" in a line of binary code. As alternative market centers proliferated – some exchanges, some not – so too did the choices of where to execute a trade. Today there are over 50 different venues at which a broker can seek to match his buy order with a seller.
Today there remains a common misconception that when you place an order with your broker to buy or sell a security, that order is sent to an exchange and immediately executed. The reality is the broker has a number of choices as to how best to fill your order and only a minority end up being executed at one of the major stock exchanges. While brokers are required by law to provide “best execution” for their client’s orders, best execution is not simply determined by price.
Speed and likelihood of execution are also taken into consideration. The subjective concept of best execution gives rise to the choices a broker has when executing your order. Those choices include alternative trading systems, different pools of liquidity, assorted market makers or matching the order themselves.
After receiving your order, your broker may route it to an electronic communications network (ECN) or to a dark pool. He may send your order upstairs to be internalized or matched against the broker’s own inventory or he might send it to a wholesale market maker, some of whom pay the broker for that order. Each has advantages and drawbacks and the best option for any given order depends on factors such as size of the order, liquidity of the security and time required to execute.
ECNs are alternative trading systems to the traditional stock exchanges. Many operate on what is known as a maker/taker pricing model, meaning they either pay a rebate or charge a fee depending on whether the order hitting their book is adding (making) or removing (taking) liquidity.
Dark pools are private market centers originally designed to allow institutions to trade large sized orders with a minimal impact on price.
Internalization means your order is being filled by the broker itself, either matched against another client’s order or against the broker’s proprietary trading desk.
A market maker is someone who provides liquidity to the market by placing two-sided quotes on the order book, meaning they are willing to buy or sell certain price points and look to make money by capturing the spread between those two prices (buying at the bid and selling at the ask).
Wholesale market makers who pay for the right to trade against retail order flow do so because they believe they have better information as to the intrinsic price of the security, that the buyer or seller is unaware of a mispricing or simply because retail order flow tends to be smaller in size than institutional flow and less likely to move the market. From the market maker's perspective a 2,000 share order from a retail broker is likely just that – an order for 2,000 shares. Whereas a 2,000 share order from an institution may be part of a 200,000 share order that may result in the market moving rapidly and significantly against the liquidity provider.
Despite the fact that it has been common practice since the 1980s, the concept of payment for order flow is a controversial one. The idea is that the retail broker cannot effectively handle the multitude of orders that come from their clients, and these orders, when bundled with others may be more effectively filled by a firm that specializes in trade execution. The retail broker is, in essence, outsourcing the trading function and getting paid to do so. This helps them keep costs down and in theory, those savings can be passed through to the end client.
Market makers compete for retail order flow by their payments to the retail broker but also by the quality of the service they are providing. If the bid/ask spread on a particular stock is $12.01 bid and $12.03 ask, the market maker may be willing to sell the stock at $12.02 offering a price improvement of one cent per share. The market maker is able to make this trade because of the sophisticated, high-speed trading systems they have in place. Having bids and offers at multiple price levels in the order book exposes the market maker to risk and being able to react very rapidly to moving market conditions is essential for them to be able to mitigate that exposure.