Stage two of the trade lifecycle: Execution
For centuries, trade execution markets were very distinct and relatively straightforward.
Most trading took place at specific geographic locations where traders would stand in “pits” shouting out prices and waving trade tickets in the air in a seemingly chaotic fashion.
Advances in technology mean that this type of exchange trading has died out and most trading previously conducted manually on exchange floors now takes place electronically.
Buyers and sellers may be thousands of miles apart, but electronic communication means that it is straightforward to execute orders in fractions of a second.
What’s more, trading is no longer confined to physical exchanges such as those in London, New York, and other major financial centers.
While over-the-counter markets have existed for many years, other types of off-exchange trading have emerged in more recent times.
These “alternative” trading venues or systems have created competition for traditional exchanges and fundamentally altered trade execution markets.
Trade execution systems
A trade execution system is a system through which market participants wishing to purchase a specified asset are matched with those wishing to sell that asset.
There are two key types of execution system widely used in financial markets:
- Quote-driven
- Order-driven
A quote-driven execution system is a system where one market participant (“price taker”) that wishes to transact will do so with another market participant (dealer/market maker).
An order-driven market differs in that there are two types of order that create the system through which trades occur:
- Market orders
- Limit orders
Quote-driven: price takers
A price taker is a bank, fund, individual, or other entity that has decided to trade (buy or sell) a specified asset. The motivation for trading may be for a variety of reasons, including the need to access cash, hedge a position, diversify a portfolio, or turn a view regarding the direction of an asset’s price into profits.
Regardless of the trade motivation, a price taker is a liquidity demander (or liquidity buyer). Liquidity refers to the ease with which a market participant can trade – in other words, the ease with which an asset can be turned into cash or cash turned into an asset.
There are multiple dimensions to “ease” when trading, including:
- The cost of trading
- The speed of trading
- The size of trades that can be transacted
“Cost” can be defined in a variety of ways, ranging from explicit costs (such as fees/commissions) implicit costs (such as market impact), and opportunity costs (such as missing a trade that would have been profitable). Different traders define cost, and therefore liquidity, differently.
There are often trade-offs between the cost, speed, and size dimensions. For instance, it may cost more to trade quickly, or it may take longer to trade a large position than it does to trade a small one.
Quote-driven: dealers/market makers
A dealer is an entity that indicates a willingness to transact with a price taker, either by selling the asset that the price taker wishes to buy or buying the asset the price taker wishes to sell.
The mechanism through which a dealer indicates the willingness to transact is by providing price takers with a price or quote at which the dealer is willing to:
- Buy the asset (bid price), and/or
- Sell the asset (ask or offer price)
A dealer that always quotes both a bid price and ask price is known as a market maker.
Note that dealers are not liquidity demanders. In other words, they have no urgency with which they must trade. Hence, dealers are not trading because they need to turn an asset into cash, to hedge or diversify, or profit off a view. Instead, dealers are liquidity providers (or liquidity suppliers) as their willingness to trade facilitates the need of price takers to trade.
Order-driven: market orders
A market order is one in which a trader requests to buy/sell a certain number of positions in a specified asset at the best possible price.
The specification in a market order of “best possible price” communicates the deep desire of the entity placing the market order to engage in the transaction. By agreeing to transact at the best possible price, it expects to find a counterparty relatively easily. Note, however, an actual price is not specified in either a buy market order or a sell market order. The price at which a trade takes place is determined through the other types of order entered into the market, namely limit orders.
Order-driven: limit orders
A limit order is one in which a trader requests to buy/sell a certain number of positions in a specified asset at a specified limit price or better.
Buy limit order
A buy limit order is an order to buy at a specified limit price or less.
For example, a trader might indicate that it wishes to purchase 1,000 shares of a stock at a limit price of USD 45.56 per share or less.
Sell limit order
A sell limit order is an order to sell at a specified limit price or more.
For example, a trader might indicate that it wishes to sell USD 400,000 face value of corporate bonds at a limit price of USD 108.25 or more.
Note that limit orders in fixed income markets can also be placed by specifying a limit price in terms of a bond’s yield.
Many trading entities place both buy and sell limit orders. Some limit orders are more competitive than others.
- A more competitive buy limit order sets a higher limit price than a less competitive buy limit order.
- A more competitive sell limit order sets a lower limit price than a less competitive sell limit order.
In order to match buyers and sellers, limit orders are organized in a limit order book.
Other types of order
Market orders and limit orders are the two key orders in an order-driven market. But other orders may be placed as well. Some of these other order types are just additional instructions on top of the original market or limit order. For instance, these additional instructions may indicate how and when the order expires, or may specify the quantity of the order that must be filled for it to be deemed acceptable to the order-placer.
Order creation and order routing
A client/customer that wishes to engage in a trade will place an order with an entity – such as a bank, broker, or broker/dealer – that arranges transactions for clients for a fee.
The client communicates its order with the broker in a variety of ways, such as through the broker’s website, an electronic order system, or through a phone call. The broker then works to execute the trade for the client. The broker receives a brokerage fee for providing this service.
Trade execution usually takes place in two ways. The broker:
- Routes the order to one of a number of trade execution markets
- Internalizes the order, which means that the broker fills the order using the firm’s own inventory rather than routing the order elsewhere
If the broker chooses to route the order, it may receive a fee for routing orders in certain directions – this is referred to as “payment for order flow.”
