Different stock exchanges have different systems to facilitate trading. To make matters more complicated, the same stock exchange can have a number of different systems for the trading of different securities – largely dependent on their levels of liquidity. This article reviews the different trading systems used by the London Stock Exchange.
SEAQ (Stock Exchange Automated Quotation System)
SEAQ is essentially a computer-based system where all of the prices set by individual market makers are published, and where stockbrokers are able to find their clients the best price for a particular security. Some securities may have a dozen or more market makers, others may only have two.
What is a market maker? A market maker is a middleman. Their job is, as the name suggests, to make or facilitate the market. Without them, if you wanted to buy shares, you would have to ring around other shareholders and find one willing to sell at a reasonable price. Conversely, if you wanted to sell some shares, you would have to find a willing buyer.
By guaranteeing the trading of particular securities, market makers accept considerable risk. To counteract that risk, they are able to profit from the spread between the bid and the ask price. The changes in these prices by market makers reflect the supply and demand for particular securities.
Prior to the introduction of the SETS trading system in 1997, all UK stocks were traded under SEAQ. Up until quite recently, a large number of AIM-listings would still have been bought and sold using this system. However, nowadays only fixed-income securities are traded via this system. This doesn’t mean the end to market markers (or Retail Service Providers), though – as discussed in the coming sections.
SETS (Stock Exchange Electronic Trading Service)
Introduced in 1997, SETS is the London Stock Exchange’s flagship electronic order book. It is a further evolution from SEAQ. For instance, whereas SEAQ can be visualised as having brought together market makers on one screen – rather than them being stood on the floor of the stock exchange, serving brokers who served clients – SETS can be imagined as a ledger where everyone is free to enter bids and offers, which are matched if possible.
So, for instance, rather than simply five market makers providing five bids and five offers for a particular security on SEAQ, for example, the SETS order book represents all registered offers and bids at a selection of different prices from whoever has access and a desire to transact, as orders can be placed by brokers, market makers, traders and private individuals directly.
The operation of SETS is automated and, as such, much more efficient. Moreover, it drives down the costs associated with the risks taken by market makers to facilitate the market, such as the size of the spread. It also provides investors a close-up view of the equilibrium of the market, depicting the balance of supply and demand for a particular stock. In turn, this offers an insight as to how the price might move in the short-term.
However, due to the fact that an automated market needs a large amount of liquidity passing through it to work effectively, only the biggest stocks are included as SETS stocks. Therefore, only the most heavily traded AIM shares feature on this trading system. As of 6th January, 2019, there are 157 AIM companies traded via SETS.
SETSqx (Stock Exchange Electronic Trading Service – quotes and crosses)
Finally, SETSqx is a hybrid trading system, combining features from SEAQ and SETS, and is designed for securities with reasonable levels of liquidity, but which may at times require market maker quotes to maintain levels of trading. As such, the electronic order book is split into a quote book and an order book – the quote book being the listing of quotes by appointed market makers, and the order book being electronic orders entered as they are on SETS.
Launched in 2007, market makers provide continuous liquidity throughout the trading day on this system, whilst order book execution takes place through auctions, with four uncrossings designed to concentrate liquidity. Both market makers and non-market makers can participate in these auctions. In essence, SETSqx provides investors the opportunity to trade against market maker quotes, as well as by submitting orders into the auctions.
An important point to make about SETSqx is that market makers do not have a maximum spread requirement as they do on SETS. Consequently, there may be times when you see a share price jump quite significantly, but when you to try and sell via a market maker quote and so profit from this jump in price, the price offered might be far below what you had hoped. This will be due to the sizeable spread resulting in the current bid price being far from the current ask price.
As of January 6th, 2019, there are a total of 778 AIM-listed companies traded on SETSqx.
How is the best trading system determined for each company?
Concerning a new issue, the trading service is dependent upon the free float and market capitalisation of the security. For instance, based on such factors, if the issuer is judged likely to qualify for index inclusion within its first 3 months, then it is automatically allocated to SETS. If things are less clear, the London Stock Exchange consults both the issuer and its nominated adviser who then select their desired trading system in discussion with market participants.
With regards to existing securities on AIM, there exists a quarterly review process that is carried out to ensure that a security is allocated to the trading service that is most appropriate.
How important are trading systems when it comes to investing?
If you’re an investor with a focus on smaller cap companies, considering that the majority of these are traded via SETSqx, it would make sense to learn the ins-and-outs of this system in more detail – for instance, the time of the auctions, order types, how the securities are cleared and settled, market maker obligations, and how closing prices are determined.
Alternatively, if you wanted to ensure you were investing in a company with decent levels of liquidity and whose spread wasn’t ever going to be too wide, then you would want to make sure that the company is traded on the SETS system, and then learn the ins-and-outs of that system instead.
Irrespective of the system, you will soon encounter a need to better understand the impact of opening, closing and intra-day auctions.