Chapter 1 - Overview of Electronic and Algorithmic Trading

Abstract

This chapter focuses on electronic and algorithmic trading, which are significantly focused by financial institutions, securities regulators, and various exchanges. Algorithmic trading has become an important method for large brokerage firms to grasp an advantage over their competitors for lower cost executions. However, smaller players such as agency brokers also view algorithms as a way to level the playing field and infringe on the bigger bulge-bracket firms. Algorithmic trading originated on proprietary trading desks of investment banking firms. Simple algorithmic trading systems feed the market by slicing up large block orders into a hundred smaller orders. These trades slowly enter into the market over some predetermined period of time. Algorithmic trading technology is based on volume-weighted average price models where these models set buying or selling prices based on what is calculated to be the average price for a given day—in other words, they use a low-risk, follow-the-herd approach. Decimalization and the availability of Financial Information Exchange (FIX) are the two drivers that have promoted algorithmic trading along with the reduction of soft dollar commissions, which the buy-side firms are willing to pay. The FIX Protocol is a series of messaging specifications for electronic communication protocol developed for international real-time exchange of securities transactions in the finance markets. The FIX Protocol has allowed various proprietary systems to plug into a common standard and communicate with one another.