Chapter 3: Understanding the Trading Exchange Dynamics

In the previous chapter, we learned how to create High-Frequency Trading (HFT) systems. We focused intensely on the critical components of a trading system. We also reviewed in detail how to create an order book, which is basically a replication of what an exchange collects from all the trading participants. In this chapter, we are going to study how an exchange works.

We will describe the functional components of an exchange and we will focus in depth on the matching engine. Understanding how the matching engine of an exchange works is one of the most important tasks you will have to do when creating HFT strategies.

This chapter will cover the following topics:

• Understanding trading exchanges
• Understanding matching engines
• Architecting a trading exchange

In Chapter 2, The Critical Components of a Trading System, we gained a decent idea of how to design a trading system. We went over how to design...

Architecting a trading exchange for handling orders at a large scale

Existing owners can deal with potential purchasers on stock exchanges. Exchanges are not primary markets: they can be secondary, tertiary markets. Companies that trade on stock exchanges don't buy and sell their own assets every day. They may buy back stock or issue new stocks when necessary. In a stock exchange, we purchase stocks from another shareholder. When we sell stocks, we sell them to another investor.

History of trading exchanges

In the 16th and 17th centuries, the first stock exchanges arose in Europe, mostly in port towns or commerce centers such as Antwerp, Amsterdam, and London. However, because a small number of corporations did not issue equity, these early stock markets were more analogous to bond exchanges. Most early corporations were deemed semi-public enterprises since governments had to allow them to conduct business.

The New York Stock Exchange (NYSE), enabling equity trading,...

General order book and matching engine

Millions of investors and traders make up the total market, all of whom may have various opinions on the worth of a particular stock and, as a result, the price at which they are willing to purchase or sell it. Over the course of a trading day, the thousands of transactions that occur when these investors and traders transform their intentions into actions by buying and/or selling a stock generate minute-by-minute gyrations in it.

A stock exchange provides a platform for this type of trading by connecting buyers and sellers of equities. A stockbroker is required for the typical person to have access to these markets. This stockbroker serves as a go-between for the buyer and the seller.

Initially, matching buyers and sellers of stocks on an exchange was done manually, but computerized trading systems are now being used more frequently. The open outcry system, in which dealers utilized verbal and hand-signal communication to purchase and sell...

Summary

As previously described, one nanosecond can create an edge in HFT. Knowing the microstructure of the market by learning how an exchange works (in terms of priority queues and the matching engine) will help you understand how to design your trading strategy. You now know that amending the price of an order will result in the loss of priority of the amended order in the queue. We also learned that depending on the exchange, changing the quantity of an order can get the same result. This chapter showed you how to design a trading exchange. We developed an in-depth understanding of how a matching engine works. In the next chapter, we will explain how hardware and operating systems operate in the context of HFT systems and trading exchanges.