ELECTRONIC TRADING GLOSSARY

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1 ELECTRONIC TRADING GLOSSARY Algorithms: A series of specific steps used to complete a task. Many firms use them to execute trades with computers. Algorithmic Trading: The practice of using computer software programs to calculate the price, timing, quantity and other characteristics of orders, which manual traders can authorize in part or in groups of orders. Not all algorithmic trading is automated as the actual placement of orders can still be done manually using the information produced by algorithmic software. Often used interchangeably with the term automated trading. Arbitrage: The practice of levelling a price difference between two or more products or markets, transferring risk at the same time. Arbitrage is possible when the same asset does not trade at the same price on all markets, or when two assets with the same cash flows do not trade at the same price, or when an asset with a known price in the future does not trade today at its future price discounted by interest rates or other costs. Arbitrage exists as a result of market inefficiencies and contributes to healthy markets by ensuring prices do not deviate substantially from fair value for long periods of time. Automated Trading: A method of trading where computer software is used to fully automate order generation. Computers are linked to market data, which is fed into algorithms, and then automatically place orders in the market. Although the systems trade by themselves, they are controlled by both a risk manager and commands within the software. (Often referred to as Black Box trading.) Best execution: The duty of a firm executing orders on behalf of clients (see broker) to ensure the best possible execution for its customers orders. In Europe, this is codified into law under MiFID; in the U.S. under Regulation NMS (aka Reg NMS). Best Price: the lowest buy or highest sell price offered for a particular security on any venue in the market at the time of trading. Bid-ask spread: the difference in price between what a buyer has offered to pay for an asset and the price at which a seller is willing to sell. Broker: An individual or firm that initiates trades for a client for a commission. Serves an executing role; characteristics of trading behaviour depend on the client. Brokers do not always trade on lit markets and will often match client orders internally. 1

2 Central Counterparty (CCP): An organization that helps to facilitate trading in European derivatives and equities markets. There are two main processes that are carried out by CCPs: clearing and settlement of market transactions. Clearing relates to identifying the obligations of both parties on either side of a transaction. Settlement occurs when the final transfer of securities and funds occur. Circuit Breakers: A market safeguard implemented by trading venues to halt or pause trading if a severe price move reaches predetermined levels. Clearinghouse: A financial institution that provides clearing, trade matching, risk management and settlement services for transactions involving derivatives and securities. Co-location: The placement of computer equipment by market participants in close physical proximity to the order matching computers of exchanges or other trading venues. This development has allowed all market participants to minimize the delays caused by distance in receiving public market data and submitting orders. Colocation is a service open to any market participant whose latency-sensitive strategies justify the investment. Consolidated Tape (aka Consolidated Feed): An electronic system which combines sales volume and price data from different exchanges and certain brokerdealers. It consolidates these into a continuous live feed, providing summarised data by security across all markets. In the US, all registered exchanges and market centres that trade listed securities send their trades and quotes to a central consolidator. This system provides real-time trade and quote information. Under MiFID II a similar system should be established in Europe. Cross-market Behaviour: Trading strategies which involve placing orders or executing trades in several markets. Dark Pools: An alternative trading venue (i.e. not an exchange) where the details of trades are not made available to the public. Counterparties are anonymous before and during the execution of a trade, but not afterwards. Derivatives: A financial contract which derives its value from the performance of another asset, index, or interest rate (called the underlying ). Includes: futures, options, forwards, swaps, warrants, repurchase agreements (repos), etc. Direct Feed: A data feed from a single source, e.g. exchange, sent directly to traders. As no calculations are being performed on the data it is naturally faster than a consolidated data feed such as the US s SIP. Direct feeds usually supply data in a continuous format, rather than in batches or pulses, as was previously the case. 2

3 Electronic trading: A method of trading using information technology to bring together buyers and sellers on an electronic trading platform. Algorithmic trading is a subset of electronic trades where trades are planned by algorithms and executed electronically, not by human traders. EMIR (European Market Infrastructure Regulation): A European Union regulation designed to increase the stability of the over-the-counter (OTC) derivative markets throughout the EU states. Equities: The capital of a corporation partitioned into shares that can be transferred from shareholders to other parties, in the case of a publicly listed company, through trading on a stock exchange or other marketplace. Also known as shares, stocks, cash products. Exchange: A public trading platform where buyers and sellers of financial instruments, such as stocks, options, and futures contracts, trade with each other. Financial instruments: A tradeable asset of any kind, used to refer to equities, derivatives, commodities, fixed income, currency, etc. Fragmentation (Market Fragmentation): This refers to the dispersion of business across different trading venues in order to create competition. It is considered to reduce ready access to liquidity. Front-running: Where a broker intentionally trades because of and ahead of a client order for the broker s own account. For example a broker who buys 100 Company A shares, before executing a client's order for 100,000 Company A shares. Purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. The front running broker either buys for his own account (before filling customer buy orders that drive up the price), or sells for its own account (before filling customer sell orders that drive down the price). This is legally classified as Market Abuse and therefore not permitted. Futures: A standardized, exchange-traded derivative contract for a pre-agreed quantity and quality of a specified asset for a price agreed today with delivery and payment occurring at a specified date in the future (delivery date). 3

4 High Frequency Trading (aka HFT): A general term referring to a subset of automated trading which occurs at a rate of action only computers can maintain. Best characterized by the use of sophisticated high frequency trading technology to facilitate algorithmic trading (in particular Market Making) with high message rates, characterized by powerful computers and direct network connections (including colocation) to minimize response times. This technology is used by a range of different types of firms involved in the markets. Most trading activity using HFT methods is sensitivity to latency: with trades taking place in time frames of less than 100 milliseconds. Hedging: Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Institutional Investors: Market participants who manage relatively large amounts of capital compared to most traders. Institutional investors typically have larger positions and hold them for longer periods of time. They often trade large numbers of shares at once: this creates price changes that can move the market and therefore many prefer to use dark pools instead of exchanges. Most institutions have their trades executed by a broker. Investment Banks: Market participants who undertake various trading activities (including sales, brokerage and market making) relating to the buying and selling of securities or other financial instruments. Typically an investment bank will perform these tasks on behalf of both itself (prop desk) and its clients (sales desk). The type of analysis used by and positions taken by investment banks depend on for whom it executes. Latency: A measure of the time delay experienced by a trading system in processing market data and orders. Latency Arbitrage: The practice of buying or selling an instrument based on the difference between the consolidated and direct feeds. A term used to refer to the idea that firms have different capacities to receive and process public market data; some firms typically those employing HFT technology make investment decisions to co-locate with exchanges in order to minimize data processing time (or latency) as much as possible because they regard it as necessary to facilitate their strategies. (See Co-location and Arbitrage) Liquidity: The ease with which a particular asset or security can be bought or sold without affecting the price: characterized by a high level of trading activity. Liquidity Provider: see Market maker. Lit Venues: A term coined to contrast with the term dark pool : where all information related to a trade is made available to a public. All exchanges are lit venues. 4

5 Manual Trading: A method of trading that involves human decision-making and action to enter orders to the market. Manual traders may employ computers in order to consolidate or analyse information, and may use computers to alert them to potential trading opportunities, but mental calculation and human action is used to send orders or cancellations. In some cases, they may also set automated indicators to alert them to potential trading opportunities. However, in all cases, human input is required to authorize trades. (See Automated Trading) Market Efficiency: The extent to which prices in a market fully reflect all the information available to investors. If a market is perfectly efficient, then no investors should have more information than any other investor, and they should not be able to predict the price better than another investor. (See Arbitrage) Market Intermediary: see Broker Market Maker / Market Making: A middleman that accepts the risk of quoting prices in a financial instrument to both buyers and/or sellers to facilitate trading in that security to keep the market liquid, or flowing. Can be a formal role contracted by a trading venue or an informal role as part of a firm s business plan. Once an order is received, the Market Maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in fractions of a second. Otherwise known as a Liquidity Provider. (See also HFT) MiFID (Markets in Financial Instruments Directive): a European Union law that provides harmonised regulation for investment services across all member states. The main objectives of the Directive are to increase competition and consumer protection in investment services. The original MiFID came into force November 1 st, 2007; it is currently being revised, with MiFID II due to come into force in OTC: Over-the-counter or off-exchange trading done directly between two parties, not via an exchange. Increasingly, OTC trades are legally required to be cleared by a Central Counterparty. Principal Traders: Market participants who trade solely with their own capital (rather than with depositors money), for their own risk and profit, and do not execute trades for customers. They may use a variety of strategies, including Market Making and Arbitrage, and a variety of techniques, including Algorithmic Trading, Automated Trading, HFT and Manual Trading. Principal traders generally trade based on technical trading data rather than fundamental analysis, often entering into and exiting trades in short time frames. Proprietary Traders: Used interchangeably with Principal Traders. Quote Stuffing: An abusive market practice whereby a large number of orders to buy or sell a financial instrument are placed and cancelled immediately afterwards. 5

6 Rebate Arbitrage: A reference to a model where exchanges or trading venues charge lower fees or offer rebates to any market participant that provides liquidity (see liquidity provider) as compensation for this important role. Liquidity providers can afford to break even or even take a loss on individual trades as long as rebates they receive cover their costs. Reg NMS (Regulation National Market System): a US financial regulation intended to assure that investors receive the best price executions for their orders by encouraging competition in the marketplace. Retail Investors: Individual investors who buy and sell small quantities of securities with their own capital. Access to the market is via a bank or broker; may use buy to hold or day trade strategies for investment purposes. Some investors pay the bank or broker a fee to control their funds. Risk: The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. Security / Securities: A tradeable asset of any kind, including equities and derivatives. Smart-Order Routing Systems: A program that allows investors to search for opportunities across a variety of venues to execute orders to minimize impact on the markets. Trading Volume: A measure of the number of shares or contracts traded in a financial instrument or in an entire market during a given period of time. Volatility: A measure of the changes in price of a financial instrument over time. A lower volatility means that an instrument s price does not fluctuate dramatically. Commonly, the higher the volatility, the riskier the security. 6