Jump to ContentJump to Main Navigation
What is an Exchange?Automation, Management, and Regulation of Financial Markets$

Ruben Lee

Print publication date: 2000

Print ISBN-13: 9780198297048

Published to Oxford Scholarship Online: October 2011

DOI: 10.1093/acprof:oso/9780198297048.001.0001

Show Summary Details
Page of

PRINTED FROM OXFORD SCHOLARSHIP ONLINE (www.oxfordscholarship.com). (c) Copyright Oxford University Press, 2017. All Rights Reserved. Under the terms of the licence agreement, an individual user may print out a PDF of a single chapter of a monograph in OSO for personal use (for details see http://www.oxfordscholarship.com/page/privacy-policy). Subscriber: null; date: 26 February 2017

(p.317) Appendix 1 Trading Systems

(p.317) Appendix 1 Trading Systems

What is an Exchange?
Oxford University Press

There is a wide variety in the types of trading systems currently operating, and an even greater potential diversity in the types of systems that could be built.1 No attempt is made here to summarize, let alone describe, the full range of existing systems. The market structures of many traditional exchanges have been described at length elsewhere, and information about most of the new non-traditional trading systems remains confidential.2 Instead, some ways of categorizing trading systems are briefly outlined, and then the market architectures of three specific trading systems are described. They are the Arizona Stock Exchange (AZX), Delta Government Options Corporation (Delta), and Instinet.

These systems are chosen for two reasons. First, each one has played an important role in various regulatory developments. Second, they illustrate three common types of trading systems, namely those of a single price call auction, an OTC bulletin board, and a continuous limit order book. For the most part, the market structure of both the AZX and Instinet are similar today to the way in which they operated in the period around 1990, during which some key decisions concerning their regulatory status were taken. In contrast, while the analysis of Delta's regulatory status was also undertaken at the same time, the structure of the Delta system has changed significantly since then. The description of the Delta system presented here is of the way in which it operated when the seminal regulatory decisions about it were taken.


Following the taxonomy devised by Domowitz (1993a), a range of different types of trading algorithms may be identified.3 The order execution algorithm of a trading system is the set of rules that determines both how orders submitted to the system are to be ranked for execution, and the manner and price of any executions that may occur. The primary priority of an algorithm is the first criterion by which competing orders are ranked so as to determine which of them are to be executed first. The most common primary priority employed, that of ‘price’ priority, stipulates that higher bids and lower offers are executed respectively before lower bids and higher offers. Once the primary priority of an algorithm has been applied, other secondary priorities may be used to provide a further ranking of competing orders. For example, if price is used as the primary priority, any secondary priorities employed wilt specify which of the orders with the same price associated with them should be executed first.

Many possible secondary priorities may be employed. These include: ‘price with market maker exposure’, which stipulates that specified market makers are allowed to match or improve on the prices quoted elsewhere in a market; ‘time’, which requires that orders submitted earlier to a system are executed before those submitted later; ‘order type’, which stipulates that certain types of orders are executed before other types of orders, for example when market orders take priority over limit orders; ‘quantity’, which requires that larger orders are executed before smaller orders; ‘quantity allocation’, which specifies how orders with the same price are to be executed if a countervailing order comes on to the other side of the market, for example by allotting an equal number of shares to all orders at the same price; ‘modified time’ is a form of quantity allocation, which allots shares to (p.318) the largest order which was input first into a trading system; ‘display’, which specifies that those orders about which more information is publicly displayed take precedence over those orders for which some information remains hidden; ‘trader class’, which specifies that the orders of specified types of traders should be executed before those from other types of traders, for example by giving retail investors precedence over financial intermediaries; ‘preferencing’, which specifies that a particular customer's orders should be routed to a particular financial intermediary; and ‘hit and take’, which allows any trader to deal with any quote in the market, and thus implies that there are no rules determining which orders should be executed first in a trading system.

Some trading systems determine the prices at which trades are executed by explicit reference to the pricing and sales activity in other markets. Such trading systems, which have no independent price discovery mechanism, are referred to as ‘passive’ or ‘derivative’ pricing systems. Some of these systems allow for the possibility of price improvement, by assessing market conditions in the underlying market, and then pricing their trades at a price better than the best quote on the underlying market available at the time of order entry. Prices may vary through the trading session, if the system operates at the same time as its associated primary market, or may be fixed at a single level, such as the closing price for an after-hours trading session. Trade execution on passive trading systems may be based on different secondary priorities than those present on the primary market.

A wide spectrum of order types may be allowed on a trading system, including: ‘limit’ orders, which have a price and volume attached, but need not be executed immediately; ‘market’ orders, which have a volume but no price attached, and which must be executed immediately; ‘day’ orders, which are good till the end of the trading day; ‘good-till-cancelled’ orders; ‘all-or-none’ orders, for which partial executions are not allowed; ‘minimum fill’ orders, which require the execution of a pre-specified minimum volume; and ‘market on opening/closing’ orders, which are to be executed at the opening/closing of the trading day. Some characteristics of some of these different types of orders can be associated in the same order. A limit order, for example, can also be an all-or-none order. Others are mutually exclusive. A trader cannot, for example, specify the price at which he would like his business transacted, namely submit a limit order, and require simultaneously that the transaction be executed immediately, namely submit a market order.

Many order types are contingent on the satisfaction of pre-specified conditions before they may be executed. These include: ‘last-sale price’ orders, which must be executed at a price equal to, or better, than the last-sale price; ‘mid-market’ orders, which must be executed at the middle of the most recent bid–offer spread; basket orders, in which the purchase or sale of a particular security may only be executed in tandem with the sale or purchase of another security; and index-related orders, where the execution price of a particular order must be related to the value of a specified market index. There are many other types of both contingent and non-contingent orders.


The AZX allows institutional investor and broker-dealer participants to trade US stocks directly with each other at a single price determined through a call auction process. Customers of AZX may enter limit orders (specifying the name of the share, the volume, the price at which they wish to deal, and whether the desired trade is a buy or a sell) through terminals linked to a central computer over a period of time up until a previously (p.319) established cut-off time. It is also possible to enter orders into a so-called ‘reserve book’. These orders are not shown to other traders on the system, unless they match against an appropriate order on the other side of the market. The orders in each share on each side of the market are ranked first by price, second by time, and third by whether they are placed in the reserve book or not, in order to derive a demand and a supply schedule.

Immediately after each auction cut-off time, the system calculates the auction price by maximizing the total volume traded over the range of possible transaction prices, given the bids and offers resting in the system. This price is the price at which the demand and supply schedules intersect, and thus at which the volume of buying interest equals, or is most nearly equal to, the volume of selling interest. If the demand and supply schedules are such that a unique price but no unique volume is determined at their intersection, the limit orders equal to the auction price will be filled on the basis of time priority to the extent that counter-parties are available. If the demand and supply curves are such that a unique volume but no unique price is determined by their crossing, the price is normally set mid-way between the two prices between which the two curves are congruent.5 Customers who entered bids above, and offers below, the auction price receive executions at the auction price.

Prior to the auction cut-off time, customers may at any time cancel or replace orders already entered. Customers may replace orders with more aggressive orders (i.e. higher bids or lower offers) without penalty, but are penalized for replacing an order with a less aggressive one (i.e. a lower bid or higher offer). Replaced orders are ranked in the order book according to the time of replacement, not the original entry time. In order to discourage the cancellation of orders, the AZX charges customers two commissions, on both the buy and sell side, for each cancelled order—even though no order is executed. The commission rate also increases as the time to the auction cut-off time decreases, thus providing an incentive for early submission of orders, and for not cancelling orders just before the auction cut-off time.

The information available to customers is dynamically updated with each new order entered into the system. Customers are able to see the full order book for any security, including bids and offers, their prices and volumes, both separately and in the aggregate. The expected auction price and trading volume based upon orders already entered in the system are also displayed. When established, only customers of the AZX could see information about the order book. All trading is anonymous.


In the period around 1990, the Delta system provided a trading mechanism, brokerage services and a central clearing facility for over-the-counter trading of options on US Treasury securities. Participation in Delta was limited to the major dealers in the US Treasury securities market and large institutional investors. Participants were linked via a continuously-updated automated communications network with video display terminals in each of their offices. The system was composed of three firms: RMJ Options Trading Corporation (RMJ), Delta Government Options Corporation (DGOC), and Security Pacific National Trust Company (SPNTCO). Each firm undertook a specific and different role in the operation of the system.

RMJ was a government securities broker, and owned and maintained the software, hardware, data transmission network, and communication interfaces of the system.7 It also (p.320) acted as an intermediary between participants trading on the system. DGOC performed a range of functions, including issuing the options traded on the system, settling all transactions, standardizing several aspects of the terms of all the option contracts, admitting participants into the system, enforcing the system's rules and procedures, and setting participants' margin requirements. SPNTCO cleared the trades executed on the system, and also undertook several administrative functions.

There were two ways in which trading could be conducted on Delta. A participant could firstly instruct RMJ by telephone to place a bid or an ask order on the system, information about which was then disseminated to other participants via the video display network. The premium, the exercise price, the expiration month, and the yield and maturity of the underlying securities, were chosen by the participant. Once a quote was on the screen, another participant could trade against it by telephoning RMJ with instructions either to hit the bid or lift the offer. In such trades, RMJ acted as a ‘blind broker’ between the two participants—traders could not disclose their identities when entering quotations, or trading against a bid or ask quote, through RMJ. When a participant hit a bid or lifted an offer, information about the trade was broadcast to all participants, again via the screen. The second manner of dealing was for participants to communicate and negotiate directly with each other via telephone, without using RMJ as an intermediary. Information about trades conducted directly between participants was not disseminated to other participants. It was possible to take a position using one of the trading methods, for example by direct negotiation with another participant, and then dispose of the position using the other method, for example by advertising the position on the screen via RMJ. All orders and information had to be delivered to RMJ by telephone.


Instinet is a screen-based computer network for trading the major equities of a range of leading international markets.9 It operates a continuous limit order book, in which bids and offers may be submitted and transactions may occur at any time (effectively twenty-four hours per day).

Two types of information are displayed on the Instinet screen: that coming from publicly available sources external to Instinet, and the prices or orders entered by Instinet customers. The raw quote data received from external sources are consolidated to form the ‘Quote Montage’. This is a display in which all the bids and offers from the different external sources are ranked according to price priority. The size of each such bid and offer is also shown when available, as is the exchange or market maker from where the quote originated. Each security has its own Quote Montage. The information is dynamically updated, so that changes in quotes on the markets are instantaneously and automatically reflected as changes on the screen. It is not possible for Instinet customers to deal through the Instinet system directly with the prices relayed on the Quote Montage.

Each security traded on Instinet also has its own internal order book, which consists of a listing of all live orders, some orders which have expired, and some which have already been executed.10 These different types of orders are ranked first by price and then by time. The price associated with each order is revealed on the screen, as is information about the order's size. Neither the identity of the user, nor the time the order was input, nor the period for which the order is good, however, is revealed on the screen. If a customer desires, dissemination of the order can be restricted.11 As discussed in Chapter 7, recent (p.321) regulatory developments in the USA now require Instinet, as an ECN, to publish the best-priced orders on its system. Information about the other contents of the internal order book for each stock, however, is not released to non-subscribers.

To trade on the system, a participant either responds to an order already placed on the internal order book, or initiates and places an order on to the book himself. The simplest. orders which may be entered into the system are limit orders, in which a participant specifies the name of the share, the amount of shares he wants to transact, his desired price of execution, whether he is a buyer or a seller, and the time at which he wants his order to expire. If no expiration time is entered, the system automatically enters a default expiration time of three minutes. There are several extra conditions which a participant may impose on the manner in which his order is executed. An order may be pegged to the last sale price (in which case the price at which the order will be executed is protected to be equal or better than the continuously updated last-sale price on a particular exchange); it may be pegged to the middle of the bid/offer spread (in which case the price at which the order will be executed is continuously updated to be middle of the bid/offer spread); it may require a minimum fill (in which case a partial execution of the order will only be allowed if a pre-specified minimum amount of the order is executed); or it may be non-negotiable as to price (so that it will only match against other orders which satisfy its price constraint).

If there is a bid or offer in the Instinet book, and a participant enters a contra-side order at the same price or better, and there are no impeding conditions attached to either order, the orders are automatically and immediately executed by the Instinet system. In-coming orders can be matched against more than one existing order, and can also be matched against those orders not shown on the screen, although placed on the order book.

As well as transacting directly against orders on the Instinet book, participants can also negotiate with each other directly, anonymously, and electronically. The Instinet book not only contains all orders currently alive, but also some which have expired, and some which have already been executed. Any one of these types of orders may be selected by a participant, who may transmit a message to the person who originally submitted the order, in the hope of resuscitating the previous interest and negotiating a further order. A series of commonly-used pre-formatted messages are available such as: ‘Are you still alive?’, ‘This is my best price’, ‘Could you do more?’, ‘Yes, I am interested’, etc. When negotiating, there is no requirement for customers to respond to any specific order, and in particular no need to observe price priority. This means, for example, that if a participant is a buyer and wants to negotiate a transaction, he is not required to approach the participant quoting the lowest offered price.


(1.) For a list of trading systems not regulated as exchanges in the USA, see Appendix IV, SEC, Division of Market Regulation (1/1994). In 1997, the SEC reported that there were about 140 such systems in the securities markets in the USA—SEC Release No. 34–38672 (23/5/1997: 15, footnote 14). For various other lists of automated trading systems, see Domowitz (1993b), Grody and Levecq (1993), and Grody, Levecq and Weber (1994).

(2.) See, for example, Schwartz (1991).

(3.) See also Domowitz (1990a; 1993b; d), and IOSCO (1990).

(4.) The sources for this description are: AZX (1992a; b; 1997); Brooks (1990); SEC Release No. 34–28577 (24/10/1990), Release No. 34–28899 (20/2/1991), and (28/2/1991); WASI (1990a; b; c; d; e); Wunsch (1988), and discussions with AZX management. The priorities have been changed from those presented in the description, so that time is now the primary priority. Orders with worse prices that are submitted earlier, may thus now preempt orders with better prices that are submitted later.

(5.) A rule similar to the NYSE's trade-through rule determines the exact auction price in these circumstances.

(6.) The sources for this description are: SEC Release No. 34–27611 (12/1/1990); Delta excerpts in CBT/CME Petitioners' Appendix (1990); RMJ Options Trading Corp. (undated—believed 1989a; b). The term Delta is used here to refer to the whole system. All quotes in this section come from these sources.

(7.) The operational link between DGOC and RMJ Options was subsequently disbanded, and now many brokers can provide similar functions to those previously solely provided by RMJ Options.

(8.) The sources for this description are: Brooks (1986); SEC (8/8/1986), Instinet (1990a: Appendix B; 1990b; 1991; 1992), Instinet Canada Limited, Appendix B, (1990), OSC (1990), Reuters Australia (1988), Schedule ‘A’, Toronto Stock Exchange (1990), and discussions with Instinet management. Quotes in this section come from these sources.

(9.) Although the system described here is the major activity of the Instinet corporation, the company also runs another trading mechanism called the Crossing Network, which allows shares to be crossed at the closing prices of the NYSE.

(10.) The extent to which expired orders remain on the screen depends on the level of trading activity.

(11.) Broker-dealers, market makers and specialists are defined not to be institutions.