We saw in Day
3 that the retail service provider will determine
a best price for you on equities with reference
to the electronic order book, SETS or SETSmm,
or to the market maker system. Let us look more
closely at how these trading
systems work. Bear with me on the technical detail
for the next few paragraphs because it is really
worth getting to grips with this.
The London Stock Exchange controls both the electronic
order book and the market maker system provided
by SEAQ, which is focused on small stocks. In
market making there is a small rival system, established
in December 2005 by PLUS Markets Group (see Day
11). Let us look in more detail at the order book
and market makers in turn.
Order Book
SETS, introduced in 1997, is used for trading
UK FTSE Euro top 300 securities, which include
all securities in the FTSE-100 index, consisting
of the largest UK quoted companies, and the most
liquid in the FTSE-250, which includes the next
largest. Orders entered on SETS compete directly
with each other and the system matches buy and
sell orders automatically.
In December 2003, the LSE introduced SETSmm, which
provides an order-book trading facility for FTSE-250
stocks not already traded on SETS, some dual-listed
Irish securities and now the constituents of two
smaller company indices, the FTSE Small Cap and
AIM 50. SETSmm combines order-book trading with
the liquidity backing of market makers, an approach
designed to suit those stocks that could not go
onto SETS because they were not always liquid
enough to get a good pricing mechanism on a pure
order-driven system.
SEATS Plus (Stock Exchange Alternative Trading
Service) combines an order book with market-maker
competing quotes but, unlike on SETSmm, there
is no interaction between the two. The system
is used for some stocks on the Alternative Investment
Market (AIM) (see Day 11), as well as for those
on the official list with only one market maker.
Market Makers
Market makers make prices and provide liquidity
in those shares in which they choose to make a
market. The market maker commits itself to providing
a price and to dealing in a minimum size, known
as normal market size (NMS), throughout the trading
day. The firm makes its money on the spread, which
is the difference between the bid and offer price.
A bid-offer spread of 8-10 means that you can
sell to the market maker at 8p or buy at 10p.
SEAQ is the quote-driven market for small- to
mid-cap stocks, including on the AIM. Before SETS
existed, all UK stocks used SEAQ. Competing market
makers display continuous buying and selling prices
on SEAQ terminals globally. They set their own
prices based on their anonymous proprietary position
and their knowledge of order flow as well as on
supply and demand.
On the SEAQ screen, a yellow strip shows the most
competitive bid and offer price for a given stock.
Above it are details such as the previous day’s
closing quote and trading volume, and the NMS.
On the lower part of the screen, Level 2 information
lists every market maker in the stock, with its
buying and selling price, which investors may
find useful to compare with the current spread.
If the broker is large or has a strong relationship
with the firm, it may be able to negotiate a price
better than the spread on SEAQ. But most brokers
must accept this spread as given. The broker must
reveal to the market maker the whole size of any
order for which he or she is seeking to transact
only a part.
The Trend
The LSE has been moving stocks from the 20-year-old
SEAQ market-making system to the two-year-old
SETSmm order book, partly to meet demand from
hedge funds that do electronic programmed trading
to exploit arbitrage opportunities. The spreads
on SETSmm are tighter and traders need not accept
the prices on offer.
An independent review of SETSmm in practice by
the ISMA centre at Reading University, completed
in February 2005, found that the headline touch,
the best bid–offer spread, was sharply reduced
from the level under the market-maker system,
and that transaction costs were significantly
reduced. But order-book trading posed problems
for many market participants, it found.
The PLUS Service is a quote-driven trading system
that was established in December 2005 and competes
directly with the other, longer-established systems.
Brokers have an incentive to use PLUS if it can
access better prices than the incumbent provider
and the dealing costs are lower. ‘UK investors
will want to ensure their broker is accessing
the best option available at the time they give
them an instruction,’ Nemone Wynn-Evans,
director of business development at PLUS Markets
Group, says.
PLUS has only a tiny percentage of the overall
market for share trading but, in its chosen market
segment, which is the FTSE Small Cap and Fledgling
indices, it has a 15 per cent market share by
number of bargains, according to Wynn-Evans. ‘This
proportion is rising as new brokers come on board,’
she says.
Settlement
Once you have dealt, you will need to settle within
a specified period, which in February 2001 was
shortened in nominee accounts from five to three
days. This is known as T+3 and means that both
counterparties to a trade agree to settle a trade
three business days after the trade date, although
market makers, as opposed to the electronic order
book, can offer some flexibility. If you have
share certificates, which are now used only for
a small percentage of UK transactions, the settlement
period is 10 days (T+10).
In all cases, settlement is electronic, through
the CREST computerized system, which matches trades
with payments and informs the underlying company’s
registrar of changes to the share register.
Once you have dealt, you may print your confirmation
note off the screen. Keep this as a hard copy.
It contains details of the trade and commission
charged, as well as stamp duty (charged at 0.5
per cent of purchase value when you buy UK shares,
but inapplicable when you sell them).
