How Modern Trading Systems Work

Published in Investing on 4 November 2009

SETS and SEAQ enable share trading to be carried out cheaply.

In my recent look at the classical at the way in which traditional market makers work, I mentioned that there are new-fangled electronic trading systems around these days that carry out the functions of a market, and the largest companies in the FTSE are traded using them. Today I'll examine how those systems work.

SEAQ

The first technology I want to take a quick look at is known as 'SEAQ', the Stock Exchange Automated Quotation System.

A company needs at least two market makers to be operating in order to be eligible for trading using SEAQ, and as such, SEAQ is really just a computer-based system by which the prices set by individual market makers are published and compared, and by which the best bid or ask price can be obtained by your broker.

So when you place an order with your broker to buy or sell shares, your broker doesn't actually have to phone around all the individual market makers to get the best price -- they just need to get the price from SEAQ. Of course, if a stock only has one market maker, there's no need to SEAQ -- brokers only need to check with the market maker directly.

SEAQ also largely removes the need for face-to-face bargaining on the stock exchange floor, with market makers using it themselves to buy and sell shares and so determine their bid and offer prices.

It used to cover larger companies but these days SEAQ is confined to around 1,000 or so of the least traded shares on the Alternative Investment Market (AIM) and fixed income securities.

SETS

For the larger companies quoted on the LSE, there are many trades taking place every day (often with millions of pounds worth of shares changing hands), and that's where the LSE's flagship trading system, SETS, the Stock Exchange Electronic Trading Services, comes into play (and yes, there probably should be two Es in there).

SETS was launched in 1997, and was originally used to trade shares in the 100 largest companies listed on the FTSE-100 and some of the next largest group of companies on the FTSE-250. Today, it has also been extended to include around 900 companies, including many in the FTSE Small Cap index and the most heavily traded AIM shares.

The idea behind SETS is largely to minimise the the number of shares needed to be held by market makers using traditional systems in order to create a liquid market and guarantee that buyers and sellers can always find someone to buy from or sell to, and so reduce the risk faced by market makers, in turn reducing the costs needed to compensate for that risk.

I suggested last time that when you place an order to buy or sell shares, you might think that your broker will go off to the market, armed with your order, and ask around the other brokers, "Do any of you have any customers trying to sell shares in this company?"

For smaller companies traded using traditional systems, that would really not be effective (which is where SEAQ comes in), but it is exactly how SETS works for companies that are widely traded. What your broker does is enter your order on the SETS system, and the system will match it to other individual investors wishing to buy or sell shares at the same time. With such largely traded stocks as those found on the FTSE 100, it can be pretty much guaranteed that there is enough trading going on to find someone to sell shares to you, or buy them from you, in a very short space of time.

If you, say, want to buy 10,000 shares in a particular company, you don't have to find someone wanting to sell exactly that number. SETS might match your order up with several sellers who want to sell fewer shares, or take a portion of the shares that a larger seller wishes to dispose of.

In doing so, SETS bypasses traditional market makers, and so reduces the spread between the bid and offer prices. Some input from market makers will be needed to fill the occasional gaps when there isn't a matched bargain available, but as that is rarer with larger companies, in general the larger the company the lower the spread.

Since 2007, SETS has been extended by the SETSqx system (Stock Exchange Electronic Trading Service - quotes and crosses), which covers all main market stocks not covered by SETS, and a number of stocks quoted on the Alternative Investment Market (AIM). SETSqx currently covers around 1,000 securities, effectively sitting between SETS and SEAQ.

Good news for investors

With the largest and most widely traded companies, the spread can be very small indeed. As an example, shares in BT Group (LSE: BT-A) are, at the time of writing, trading on a spread of 133.6p to 133.8p, so the price you need to pay to buy some is a mere 0.15% more than you'll get if you sell them.

SETS, therefore, largely eliminates the need for market makers, and makes the whole job easier for brokers, enabling today's online execution-only brokers to bring down their prices accordingly. And that all adds up to a very good deal for individual small investors.

More Investing Basics from Alan Oscroft:

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Comments

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hakerite 05 Nov 2009 , 4:54pm

An interesting report I recently heard regarding share trading in the States and gaining momentum over here - High Frequency Trading using computers and algorithms. Around 400000 trades per second.

What chance do I stand in a hostile environment when surrounded by 'Dark Pools'. This makes a nonsense of share ownership and previous values held by ordinary investors.

It's hard to imagine buying and selling a share, say 30 times in one second.

You mention SETS largely eliminates the need for market makers. With future technology we may eliminate the need for Stock Exchanges altogether.

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