Basics Of The Mechanics Behind Electronic Trading

By Lisa Smith AAA

Electronic trading is easy. Log in to your account. Select the security you wish to buy or sell. Click the mouse or tap your phone, and the transaction takes place. From an investor’s perspective, it’s simple and easy. But behind the scenes, it is a complex process backed by an impressive array of technology. What was once associated with shouting traders and wild hand gestures has now become more closely associated with statisticians and computer programmers.

First Step: Open an Account

The first step is to open an account with a brokerage firm. This can be done electronically or by completing and mailing the appropriate forms. You will need to provide personal information, such as your name and address, that enables the firm to identify you, along with a bit of information about your investing experience level. Then the firm can evaluate whether the account you are seeking is appropriate. For example, if you have no experience trading stocks but wish to open an account that lets you trade using borrowed money (margin account), your application may be denied.

The account-opening process also enables you to designate electronic pathways between your bank account and brokerage account so that money can move in either direction. Should you wish to add more money to your investable pool, you can move it from your bank account to your brokerage account simply by logging in to your account. Similarly, if your investments have generated gains and you need that money to pay bills, you can move from your brokerage account to your bank without making any phone calls. If you don’t have a bank account, you can set up a money market account with the brokerage firm and use it in a manner similar to a bank account.

These electronic conveniences require computer equipment, such as servers, and human oversight to make sure everything is set up properly and works as planned. The technological requirements become even more complex when you are ready to trade.

How It Works

Before you place an order, you will likely want to learn about the security you are considering for purchase. Most brokerage websites offer access to research reports that will help you make your decision, and real-time quotes that tell how much the security is trading for at any given time. The research reports are updated periodically and loaded to the website when you access them. The quotes are a far more complex issue, as the technology must keep track of thousands of data points relating to stock prices and deliver that data to you instantly upon request.

When you actually place an order, the infrastructure level required to support the process increases again. Programming and technology must facilitate order entry and the variety of choices that it entails. First, you have the option to select your choice of order types (market or limit). Market orders execute immediately. Limit orders can be set to execute only at a certain price, within a certain time limit ranging from immediately to anytime within a period of months. These choices are available simultaneously to all investors using the system and must work in real time.

The purchase price and share quantity requested must be conveyed to the marketplace, which requires the computer system at the brokerage firm where the order was placed to interact with computer systems on the securities exchange where the shares will be purchased. The systems at the exchange must instantly and simultaneously interact with the systems at all of the brokerage firms, either offering shares for sale or seeking to purchase shares.

To complicate matters further, the electronic interface must include all exchanges (Nasdaq, NYSE, etc.) from which an investor may choose to purchase a security. The interaction between systems must execute transactions and deliver the best price for the trade. To prove to regulators like the Securities and Exchange Commission (SEC) that the trade was executed in a timely and cost-effective fashion, the systems must maintain a record of the transaction.

The computerized matching engine must perform a high volume of transactions every minute the market is open for business, and do so instantly and flawlessly. Backup systems are necessary to make sure investors have access to their accounts and can trade every minute the markets are open. Security industry regulators, such as the SEC, also need access to the information contained in investors' accounts.

That data is held at the Depository Trust Company, which is a recordkeeper responsible for maintaining details for all shareholders in the United States. DTCC is a holding company consisting of five clearing corporations and one depository, making it the world's largest financial services corporation dealing in post-trade transactions. This central repository serves as a backstop, enabling investors to recover account information in the event the brokerage firm responsible for facilitating the investor’s trades goes out of business.

Once the trade has been made, the transaction must be confirmed with both buyer and seller. The data must be sent back out to the systems that collect and display pricing to other market participants to facilitate trading in the broader marketplace.

A record of the transaction must be stored, so that data is available for client statements and for clients to access online when they log into their brokerage accounts. On an ongoing basis the system must capture data for corporate actions like dividends and capital gains, not only to keep the investor’s account balance up to date and accurate, but also to facilitate tax reporting. Enormous volumes of data must continually be tracked, captured and transmitted.

The system must also be able to facilitate both periodic and regularly scheduled recurring transactions. Everything from transfers to and from the investor’s personal bank account to ongoing transfers between accounts for account funding, bill payment, estate settlement and a variety of other transactions must be supported.

Risks

Electronic trading is integral to the financial markets. Everything from technological glitches to outright fraud can impair the smooth and efficient functioning of those markets, costing brokerage firms money and calling into question the credibility of the financial system. Even minor glitches, such as the “flash crash” that took place on May 6, 2010, can wreak havoc. The flash crash was a brief trading glitch that caused the Dow Jones Industrial Average to plunge 998.5 points in just 20 minutes. More than $1 trillion in market value disappeared. To rectify the situation and make investors whole, 21,000 trades were canceled — all because of a single glitch, triggered by an order placed in the futures market on a brokerage firm's computer system, which caused panic trading to spill over to the equity markets.

The Bottom Line

Electronic trading is amazingly complex and extraordinarily fast. It offers instant access to an impressive array of securities and markets. The data support includes all the reporting functions an investor needs and all the data that regulators require. It includes a secure environment for personal account details and an industry-wide repository designed to ensure no data is lost. Despite the high trading volume, the system is incredibly reliable. It’s a modern technological marvel, and it's available to you to use for just a few dollars per trade.

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