Ask Mint | How do electronic trading systems work on bourses?

Ask Mint | How do electronic trading systems work on bourses?
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First Published: Sun, Dec 13 2009. 09 37 PM IST

Updated: Sun, Dec 13 2009. 09 37 PM IST
Trading in stocks earlier required as much sweat as tears. Things are simpler now. In our continuous march to the future, we have left the age of “open outcry” far behind. Now our stock exchanges use screen-based electronic trading systems. The National Stock Exchange (NSE) system is called the National Exchange for Automated Trading, or NEAT. The Bombay Stock Exchange (BSE) system carries the name of BSE On-line Trading system, or BOLT for short. Despite differences in nomenclature, both systems work like two clocks on the same wall.
Johnny: I know we have left the age of the hourglass far behind, but before finding out more about new-age things such as NEAT or BOLT, it would be interesting to know a bit more about open outcry.
Jinny: Well, open outcry used to be the system of doing trade on BSE before the advent of screen-based electronic trading systems. In an open outcry system, brokers used to shout to each other on the exchange trading floor to locate the best buy or sell orders. You might have seen the open outcry system at work in some of the old market clippings.
Our stock exchanges no longer use this system. NSE, from its very inception in 1994, has been using electronic trading system. BSE followed suit in 1995 by starting an electronic trading system of its own. Now the trading of stocks involves just a click of the mouse.
Illustration: Jayachandran / Mint
But you can still witness the open outcry system, alive and kicking, in many stock exchanges around the world. It would be a good idea to see open outcry at work before this system totally disappears.
Johnny: I don’t think this system is going to disappear anytime soon; after all, open outcry seems like a natural instinct for traders. But tell me what’s so unique about NEAT or BOLT?
Jinny: The screen-based electronic trading systems being used in our stock exchanges are order-driven, in which the order matching is done by a computer. An order-driven system is one in which all buy and sell orders are entered into a trading system, which finally chooses the best buy orders and the best sell orders. The best buy order is the highest bid price for buying a security. The best sell order is the lowest asking price at which someone is willing to sell. In this kind of a system, orders of buyers and sellers ultimately drive the market.
Johnny: I don’t understand how the system sorts out the best buy or sell orders. Can you tell me what happens once our orders reach the trading system?
Jinny: Two types of orders reach the trading system. One is called a “limit order” and the other a “market order”.
A limit order is one in which the buyer or seller specifies the quantity and the price at which he desires to buy or sell. A limit order is executed only at the indicated price or at a better price. Say, for instance, that someone is placing a limit order for buying a stock at Rs10, then the order would get executed only at a price of Rs10 or at a lower price. However, if someone is placing a limit order for selling a stock at Rs10, then the order would get executed only at a price of Rs10 or at a higher price. All limit orders to buy or sell that are not able to find opposite orders to sell or buy at the indicated or better price are kept pending in the trading system. It is quite possible for a limit order to remain totally unexecuted or to get only partially executed in terms of the indicated quantity. The trading system maintains all pending limit orders in the form of an order book on the basis of price and time priority. Better price gets the first priority. For instance, an order to buy a stock at a price of Rs10 gets priority over an order to buy the same stock at a price of Rs9. Likewise, an order to sell a stock at Rs11 gets priority over an order to sell the same stock at Rs12. In case two orders have been placed at the same price, then an order placed earlier in time gets priority over an order placed later.
Johnny: What happens in the case of market orders?
Jinny: Market orders and limit orders nicely complement each other. A market order is one in which someone is willing to buy or sell at the best available price. The buyer or seller only indicates the quantity without indicating the price. It is for the system to match it against the best available price. So a market order to buy a particular stock would get matched against a limit order offering to sell at the lowest price. A continuous flow of both market and limit orders is essential for the normal functioning of the market.
Johnny: That’s true. You always need two to tango.
What: Our stock exchanges—NSE and BSE—use screen-based electronic trading systems.
How: In electronic trading systems, the order matching is done by a computer.
Why: Electronic trading systems are popular because they bring efficiency and transparency in the trading process.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Dec 13 2009. 09 37 PM IST