December 19, 2001
SETS has nothing to do with tennis, at least not in the context of the stock market. It stands for Stock Exchange Electronic Trading Service. Like the Universe, SETS had its origins in a Big Bang. Unlike its bigger namesake though, this Big Bang was the one that heralded the introduction of electronic trading to the London Stock Exchange in 1986, with SETS itself opening for business quite some time later in October 1997. But what actually is it?
SETS is an electronic order book that allows buyers of shares to be matched with sellers more efficiently than by the old methods traditionally used by market makers. When an order to buy or sell some shares is received, the details of it are entered directly onto the SETS system which then tries to match it with a suitable sell or buy order, as relevant. If such a match can be made then the two are brought together automatically and the bargain is sealed. But what happens if such a match cannot be made? We'll come back to that shortly.
SETS currently applies to companies in the FTSE 100, and to FTSE 100 reserve companies. That will be extended to smaller companies in time, and it is already being slowly extended in one way -- companies that fall out of the FTSE 100 are kept on the SETS order book, and so may be traded on SETS even after they have left that index.
There are a couple of popular myths surrounding the operation of SETS, so let's lay those to rest. Firstly, SETS has not replaced traditional methods of dealing in FTSE 100 companies, and SETS transactions do not account for all such business. Currently, approximately 56% of all FTSE 100 dealing, by number of trades, is executed via SETS, which accounts for 49% of such business by value.
Secondly, it is often thought that SETS eliminates market makers, and that FTSE 100 companies no longer have any. Again, that isn't true. The largest company in the FTSE 100 by market capitalisation, Vodafone (LSE: VOD), for example, has over 400 market makers.
What SETS does, rather than eliminate market makers, is change the way they operate. Before SETS, market makers (who have an obligation to buy and sell shares in their selected companies in a timely fashion) needed to keep reasonably large floats of shares on their own books in order to satisfy orders as they received them. That exposed them to higher risk, for which they needed adequate compensation, and that compensation came in the form of high bid-offer spreads (the difference between the prices that market makers will buy and sell at, and the source of their profits).
But now, SETS "member firms" as they are known (and the distinction between conventional market makers, brokers and others will blur further as electronic trading is extended in the future), can execute a large number of their trades directly, by matched bargain, and so do not need to trade into and out of their own holdings. This lowers the risk that they are exposed to, and enables competition to bring the bid-offer spreads down a fair bit further than they would otherwise have been.
Market makers still need to put up some of their own money though, and still need to buy and sell shares themselves in order to maintain market liquidity. But why? Remember, earlier we asked what happens if a buy or sell order can't be matched to a suitable complement. That is an inherent problem with an order-driven system (and is one major risk with the very low liquidity OFEX market); it does not guarantee liquidity the way a traditionally mediated market maker system does.
So what happens is that the market makers soak up the unfilled orders and buy into or sell from their own floats of shares. With the liquidity of the FTSE 100, and the efficiency of SETS, almost all small trades can be executed rapidly on a matched bargain basis; but what about very large trades? If someone wants to buy or sell a number of shares that is unusually high by the standards of the company in question, then the likelihood of there being a matching investor who wants exactly the opposite at exactly the same time is considerably lowered. If that happens within the quoted Normal Market Size (NMS) , then the market makers are obliged to absorb the trade at the currently quoted price. Outside the NMS, a higher or lower price might need to be negotiated in the traditional manner before the market makers will execute the order.
So as SETS allows market makers to maintain lower floats of shares, it helps to bring the bid-offer spreads down, which is of great benefit to individual investors.
There is another advantage too. As all SETS member firms continuously register their current bid and offer prices on the system, the immediate visibility of those prices tends to bring market makers closely in line with each other. It also makes it much easier for our brokers to see the current price. Ever held on the phone line while your broker goes away to check the market, looking for the market maker with the lowest price? That's history with SETS; your broker just quotes the current SETS price.
It's not all sweetness and light though, and an unexpected problem that surfaced early in the life of SETS was the presence of unusually wide spreads very near the beginning and end of the trading day. With an automated matched bargain system, anyone attempting to execute a "rogue trade" by placing an order to sell at an unusually high price or buy at an unusually low price will have a chance of it being matched by a careless "at best" order in the opposite direction. The start and the end of the day are the times when orders are thinnest and when such trades are most likely to be successful. For this reason, many investors avoid the early morning and late afternoon periods when trading in shares on SETS. Others like to use "limit" orders to ensure they don't pay too much or sell too cheaply. SETS handles limit orders automatically, though whether your broker passes that flexibility on to you at no additional cost is another question.
That's it from Fool's School for a couple of weeks. This series of articles is going to take a Christmas break. See you in the New Year!
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