A trade touches many hands as it makes its way through the system. The simple act of buying or selling a financial instrument goes through a number of components to ensure that trades are executed, cleared, settled, and reported properly. The functions remain the same; however, a trade requires far less manual processing by humans than it did in floor-trading days. The trade cycle from execution to settlement takes much less time than it did before; in fact, for derivatives it is done in real time, without any manual processing. The electronic infrastructure can be divided into three major sections required to complete the trade cycle: front office, middle office, and back office.

The early adopters started developing their electronic exchange architecture to bring the electronic trading model as the replacement for floor-based trading. These early exchanges have gone through numerous iterations of their technology platforms to continually improve the stability and reliability of their architecture. They now rely on their hardware and software to gain access to exchanges worldwide.

As adoption of electronic trading by the financial community increased, the trading architecture continued to evolve. New players, whom we will discuss shortly, entered the financial markets to provide application and services for the trade cycle. These new players serve a vital role in this overall trading architecture. Today there are players for every component of the trade cycle. There are front-end trading screen providers, exchange connectivity providers, market data providers, and network connectivity providers. All these players, along with exchanges, must work harmoniously to build an infrastructure that can move trade from the front office to back office with much less human intervention than in the past.

Traders no longer rely on their loud voices and tall statures to buy and sell products on only a single exchange. For the floor-trading model, all one needed to trade was membership on an exchange, a knowledge of hand signals to communicate with others on the floor, and the ability to deal with stress on volatile trading days. For electronic trading, the trader might need membership on some exchanges to gain direct access, but virtually direct access is available to nonmembers at many exchanges. Of course, the trader still needs the ability to deal with stress. Additionally, today the traders need to understand how to use a computer that provides them with market access. Instead of feeling the market on the floor, traders today must understand the wealth of information blasted on their trading screens. They must learn to adapt to the speed of trading on the electronic trading floor. The trader must learn the complex order types and trading strategies available through the vendors to gain an edge in a market that is transparent.

The trading firms must also understand technology and the trading architecture to ensure that they build an electronic trading infrastructure that is fast, reliable, and stable. Today trading firms need to have technical staff who can analyze the pros and cons of the new players offering the trading screens, exchange connectivity through gateways, risk management applications, and tools to help meet regulatory requirements. In addition, they must understand the network details in depth to ensure that they have the hardware capacity to handle the message traffic and telecommunications setup to provide the fastest connection to the exchange.

Therefore, understanding the overall architecture of the electronic trading infrastructure is critical to the success of a trading firm as well as the exchange. An in-depth understanding of the electronic infrastructure will also allow the players to understand who provides software applications for the components as well as the connectivity details that take a trade from the front-end trading screen to the clearing and settlement process. The exchanges and trading firms today must understand this architecture (see Figure 4.1) and the players involved to build and improve their own electronic trading infrastructure.

As we explored in Chapter 1, trades must flow through numerous components of the trade cycle. These components consist of individual applications such as the trading screen, exchange gateway, risk management, and the clearing and settlement process. In the electronic trading model, buyers and sellers submit their orders through the front-end trading systems. These systems are software applications that are installed on traders’ computers. The front-end trading systems are also known as graphical user interfaces (GUIs) or trading screens, since they are windows through which traders can view the market(s) across the globe. The front-end trading systems display the market information from multiple exchanges and route the trader's submitted orders to the exchange gateways. The financial markets have the choice of building these trading screens in house or buying them from third-party vendors. Today there is significant competition among the front-end trading screen vendors. These companies specialize in tools for traders to employ more sophisticated strategies and provide better visualizations across markets as well as charting tools to help analyze market movements. As electronic trading matured, so did the technology of independent software vendors (ISVs). Today companies such as Trading Technologies, RTS, GLTrade, Actant, and many others all provide trading firms access to multiple exchanges through their trading screens.

Today the trades can also be submitted by automated trading engines, also known as black boxes. These are software applications that run on computers and submit orders without any human intervention. The trading firms can simply create rules based on their trading strategies and allow the computer to automatically submit orders around the clock. The use of these applications has grown significantly in recent years. For example, an estimated half of the U.S. stock trades flow through black boxes. They allow trading firms to trade more products across multiple exchanges and to do so at a speed that could not be matched by the fastest human trader.

A number of vendors, such as SmartQuant and Strategy Runner, provide automated trading applications that can be modified to meet individual traders’ needs. The large trading firms also spend significant amounts of time and money to build black boxes. For example, the hedge fund giant Man Group's $16 billion assets are traded through its black-box application, called AHL. Built by three analysts with physics degrees from Oxford and Cambridge universities, the AHL black box is the backbone of the hedge fund's trading operations. AHL monitors markets across asset classes, analyzes market direction based on historical data, and every five minutes spits out trading decisions that are executed by a small number of traders. ¹

As the orders are entered by traders in the front-end application or through black boxes, they are also checked by risk management applications. These applications verify the limits set for traders. The risk management application provides controls to meet the risk parameters set by the risk managers of the trading firm. The risk management application also provides risk managers a full view of the trading activity for all the traders within the firm. These risk management applications’ monitoring capabilities allow a firm to monitor trading activity in real time. Vendors such as GlobalRisk specialize in risk management applications to provide trading firms with software applications that help the firms manage risk of their individual traders as well as the entire firm. For example, GlobalRisk's FirmRisk application calculates real-time profit and loss, volatility, and equity for traders and an entire firm. The application also provides trading firms with the ability to calculate “what-if” scenarios to determine hypothetical market movements’ impact on firms’ portfolios. ²

Once passed through the risk checks, the orders flow to the exchange gateway. A gateway is the bridge between the financial community and the exchanges and must keep pace with the rapidly evolving exchanges as well as the trading needs of the financial community. These are complex applications that perform many different functions to ensure that data flows among the front-end applications, exchanges, and the reporting applications utilized by clearing and back-office systems. Gateways are the software applications that connect to an exchange through the application programming interface (API; see sidebar). Although the design of gateways can vary by asset classes or vendors, their major processes are to route orders to the exchange, disseminate market data to the trading screen, manage order execution, and handle administrative functions such as authenticating the traders and providing audit trails of trading activity. The gateway generally is developed with the following processes:

The gateway sends the orders to the exchange trading system. Via networks, the exchange trading system receives orders from gateways from the trading firms located around the world. The exchange trading system processes these orders through its matching engine (see sidebar). Although the details of the various exchanges’ architectures might vary, they all perform the same primary functions: publish market data, match the buys and sells, and send confirmations back to the traders for their filled orders. The exchange trading system also sends the executed orders to the clearing and settlement system for the final processing of the trade. The process involves trade allocations and reconciliation, final margin calculation, fees and charges for the trades, and reports to meet compliance requirements. For example, an application such as GL RIMS³ processes trades to calculate the fees associated with the trades, create reports for the regulatory bodies, and process settlement instructions for the depository agencies. ⁴

Most floor-based exchanges made the transition to electronic trading in a gradual fashion. Some, like the CME, CBOT, NYMEX, and LIFFE, started with after-hours systems, as described in Chapter 3. But the majority started with what are called side-by-side arrangements, whereby the trading floor and the screens were made available during regular trading hours. In such systems, the two markets were two separate pools of liquidity, and customers could choose whichever they preferred. Prices were kept more or less equal via the activity of arbitrageurs. The securities exchanges in the United States would have liked to also follow a side-by-side approach, but the SEC would not allow futures-style side-by-side trading, because customers might sometimes not get the better price available on the other system. Equity and options exchanges could either go all electronic or stay floor based. The CBOE created a “hybrid” system that blended the two markets. And then some years later, the NYSE modeled its own hybrid system on that of the CBOE.

The CBOE had been exploring electronic trading since at least 1988 when senior exchange officials (Gary Lahey, Dick Dufour, and Kruno Huitzingh) went to visit the pioneer electronic exchanges of Europe—including OM and SOFFEX. Over the subsequent years, the exchange put together a plan, a design, and actually built an electronic trading system. But because the CBOE was member owned, like all other member-owned exchanges, there was a deep aversion to electronic trading and even though the exchange had completed the development of an electronic trading system as early as 1999, there was neither member interest nor SEC willingness to allow electronic trading to proceed side-by-side with floor-trading. Just as important, there was a belief that options trading just would not work well on a screen. So when ISE opened its virtual doors in 2000, the initially light trading volume confirmed the views of those who believed screen trading would not work and the threat level moved back toward green. However, after about a year and a half of trying, ISE gained real traction, volumes started rising, and the ISE became viewed as a real threat to the CBOE and it was clear to the membership that CBOE had to become part of this new world.

While a side-by-side arrangement, where traders could choose, would have been the best and quickest way to get in the game, the SEC had blocked this option by requiring all floor or all screen. The CBOE felt that neither of these extremes was viable. It had already created an electronic system, and it decided to create a hybrid system that would integrate both screen and floor-based trading and thus satisfy the SEC's concern that customers would always get the best available price. The CBOE spent just under a year melding its floor and electronic trading platform into a single, linked system called the Hybrid Trading System.

CBOE received SEC approval to launch its Hybrid Trading System on May 30, 2003. The Hybrid system was launched on June 12, 2003, with Harmony Gold options as the first product. ⁷ Today CBOE's Hybrid Trading System incorporates electronic and open-outcry trading, enabling customers to choose their trading method. The electronic side of Hybrid is CBOEdirect, an electronic platform that also supports the CBOE Futures Exchange (CFE), CBOE Stock Exchange (CBSX) and OneChicago. Over 15 ISVs provide connectivity to the trading community to one or more of the CBOE markets.

With its launch of CBOEdirect, the trade engine behind the hybrid system, the exchange is able to grow and compete with the ISE and subsequent screen-based option exchanges, both domestically and internationally. CBOEdirect allows firms to trade electronically and still provides the flexibility for them to trade on the floor, if they choose. CBOEdirect supports an open interface and provides multiple connectivity options. It allows ISVs to connect to CBOEdirect via its own proprietary interface, CMi, through industry-standard protocol FIX, or through the CMS-based COMPASS. CBOEdirect allows its customers to trade its options via ISV trading screens through its Hybrid Trading System Terminal (HyTS) and the option to continue to trade on the floor. HyTS provides market access and order routing to all U.S. equity options from a single screen. Similarly, ISVs also provide customers the ability to trade multiple markets through a single screen. ⁸

The Hybrid system has turned out to be a reasonable compromise, given the SEC's refusal to allow side-by-side. Options are different from equities and futures, both of which lend themselves to straight buy and sell positions or at least relatively simple spreads. Because there are so many options for any given stock, many transactions often involve the purchase and sale of a number of puts and calls at different strikes. Combining this with the fact that market makers don't always post the best price at which they would buy or sell, because they have to watch so many different options and thus build in a protective cushion in the bid-ask spread, a lot of customers still prefer to negotiate trades on the floor to get better prices. Therefore, worldwide, options have been the financial product most difficult to migrate to the screen. And even on screen-based systems, the options transaction is often negotiated prior the execution on the screen.

The growth of electronic trading broke the traditional floor-trading model. The early exchanges used technology to design the electronic infrastructure. And, as they opened their APIs, technology vendors entered the markets with fresh new ideas and new concepts in the financial markets. These new players helped shape the direction for the new model and are now an integral part of bringing the trading world onto a single screen. Today, there are client-side application vendors that provide trading screens, charting tools, risk management, and analytical tools. There are vendors that specialize as market data providers. There are vendors that provide applications for the post-trade processing for clearing and settlement processes. And there are players that provide maintenance and support services for the trading infrastructure. These vendors introduced the concept of single-screen trading. They have allowed the financial market players to pick and choose applications to build the electronic trading infrastructure that allows traders access to markets from around the world in real time and analyze market movements against historical data, and, with the help of black boxes, they can trade around the clock.