Overheated Economy: Factors That Contribute

What Are Matching Orders?

Matching orders is the process by which a securities exchange pairs one or more unsolicited buy orders to one or more sell orders to make trades. This can be contrasted with requests for a quote (RFQ) in a security to proceed with a trade.

If one investor wants to buy a quantity of stock and another wants to sell the same quantity at the same price, their orders match, and a transaction is effected. The work of pairing these orders is the process of order matching whereby exchanges identify buy orders, or bids, with corresponding sell orders, or asks, to execute them. Over the past decade, this process has become almost entirely automated.

How Matching Orders Works

Matching the orders of buyers and sellers is the primary work of specialists and market makers in the exchanges. The matches happen when compatible buy orders and sell orders for the same security are submitted in close proximity in price and time.

Generally, a buy order and a sell order are compatible if the maximum price of the buy order matches or exceeds the minimum price of the sell order. From there, the computerized, order-matching systems of different exchanges use a variety of methods to prioritize orders for matching.

Quick, accurate order matching is a critical component of an exchange. Investors, particularly active investors and day traders, will look for ways to minimize inefficiencies in trading from every possible source. A slow order-matching system may cause buyers or sellers to execute trades at less-than-ideal prices, eating into investors’ profits. If some order-matching protocols tend to favor buyers, and others favor sellers, these methods become exploitable.

This is one of the areas where high-frequency trading (HFT) was able to improve efficiency. Exchanges aim to prioritize trades in a way that benefits buyers and sellers equally so as to maximize order volume—the lifeblood of the exchange.

Popular Algorithms for Matching Orders

All major markets have transitioned to electronic matching. Each securities exchange uses its own specific algorithm to match orders. Broadly, they fall under two categories: first-in-first-out (FIFO) and pro-rata.

FIFO

Under a basic FIFO algorithm, or price-time-priority algorithm, the earliest active buy order at the highest price takes priority over any subsequent order at that price, which in turn takes priority over any active buy order at a lower price. For example, if a buy order for 200 shares of stock at $90 per share precedes an order for 50 shares of the same stock at the same price, the system must match the entire 200-share order to one or more sell orders before beginning to match any portion of the 50-share order.

Pro-Rata

Under a basic pro-rata algorithm, the system prioritizes active orders at a particular price, proportional to the relative size of each order. For example, if both a 200-share buy order and a 50-share buy order at the same price are active when a compatible 200-share sell order arrives, the system will match 160 shares to the 200-share buy order and 40 shares to the 50-share buy order.

Since the sell order is not large enough to fulfill both buy orders, the system will partially fill both. In this case, the pro-rata matching algorithm fills 80 percent of each order.