Understanding: Order Matching Engine
- Aug 25, 2018
- 3 min read
Let us assume that the entire stock market is a black box. You quote a price into the black box for which you are willing to sell a stock, while from some other part of the nation some other guy chimes in the price for which he/she is willing to buy the same stock. Now as the stock market is a 'market' per se, it is expected that there will be millions of others who will have their bid and ask prices. So in this utter chaos, how does the black box sort out all these bids and asks, matches the supply with demand and makes the magic happen? Today, I'll help you understand the black box machine of the stock market!
The ‘machine’ that we are referring to is called the ‘order matching engine’ in investment management. Let’s start by analyzing the demand capturing mechanism when a stock is just about to be born - the IPO.
When an IPO is announced, the main underwriting bank (read Goldman Sachs) - called the book runner, takes up the duties to figure out the issue price of the stock for the IPO. They undertake a process called book building, where the book runner seeks out the interest levels of large institutional investor, and what prices are they willing to pay for the issue. They run an extensive survey among the various investors, to seek how much interest exists among the market participants to buy the issue. Once the book runner declares a price, he seeks the orders of interested investors. This is called subscribing to an IPO. You must have heard, that such-and-such stock was 5 times over-subscribed . That means, the demand is six times that of the supply. This pushes up the stock price when the IPO is just launched. This survey based mechanism helps investment banks place their underwritten IPOs in the secondary market.
Now, there are already existing stocks in the market that are trading day in and day out. To capture their demand and supply, a book of orders is maintained - in the present world it is electronic. Numerous buyers ‘bid’ their prices to buy an asset, and numerous sellers ‘ask’ for a certain value for the asset to be sold.
The ‘Order Matching Engine’ keeps a list of all these orders, chronologically, and if a bid and ask reach the same value, the first bidder and the first seller (based on the time when the orders were set) get their transactions through. And thus a matching is done.
This book of orders contains the number of bids and asks, and this information is available publicly to traders.
Whenever there are more bids than asks, it means that in general more people want to buy than sell, and with the invisible hand of Adam Smith, the prices start rising. The prices come down when there are more sellers than buyers. This is how the dynamic non equilibrium sets in.
It is this Order book that is the culmination of research, emotions, exuberance, irrationality, calculations, manipulations and a lot more. All of it simply boils down to the price of the bid, and the price of the ask - two simple numerical figures, reflecting all of man’s investment rationale.
But be aware of the fact that a lot of these bid and asks in the recent realm of quant trading are spurious. They are just there to test market sentiments, or sway it. Consider this as an example: In India only 0.3% of all orders are actually transacted in the end!
At the end of a trading day, the slate of orders is wiped clean.
I hope that this article took you one step closer to the nitty-grities of the stock market and its mechanism. We'll come up with more of these articles to help you take the steps to wards an advanced understanding of the market micro-structure.
Till next time, happy investing!
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