The Trading Industry: Exchanges, ECNs, and Market Players (Chapter 3, Part 1)
Chapter 3 of Trading and Exchanges is the chapter where Larry Harris dumps the entire trading industry on your desk and says, “Here is how it all fits together.” It is dense with jargon and institutional detail. Harris even admits you can skip it if you already know the industry. But for everyone else, this chapter provides the context that makes everything after it make sense.
This is Part 1, covering the players, the trade facilitators, and the instruments. Part 2 will cover markets, regulation, and market types.
The Buy Side and the Sell Side
Harris starts with a distinction that confuses a lot of people: the buy side versus the sell side. These terms have nothing to do with whether someone is buying or selling stocks. They refer to who is buying and selling exchange services, specifically liquidity.
The buy side consists of traders who need liquidity. These are the people who come to the market with a problem to solve. Investors want to move money from the present to the future. Hedgers want to manage financial risks. Asset exchangers want to trade one thing for another they value more. Gamblers want entertainment. All of them need someone to trade with, and they are willing to pay for the convenience of trading when they want to trade.
The buy side includes individuals, pension funds, mutual funds, endowments, foundations, and governments. These institutions often hire investment advisers (also called portfolio managers) who make investment decisions, and buy-side traders who execute those decisions.
The sell side provides liquidity to the buy side. It consists of dealers and brokers. Dealers trade directly with their clients, buying when clients want to sell and selling when clients want to buy. They profit by buying low and selling high. Brokers find counterparties for their clients and charge commissions for the service.
Many firms do both, which is why they are called broker-dealers. And here is the key insight: the sell side exists only because the buy side will pay for its services. You have to understand why the buy side trades before you can understand when the sell side makes money.
Trade Facilitators
Beyond the buyers and sellers themselves, a whole ecosystem of institutions makes trading possible.
Exchanges provide forums where traders meet to arrange trades. Historically, this meant physical trading floors. Now it mostly means electronic networks. Only members can trade at most exchanges, so nonmembers use brokers.
Some exchanges just provide a meeting place. Others have order-driven trading systems that match buyers and sellers according to rules. These exchanges are essentially brokerages, which is why exchanges and brokerages often compete with each other.
Harris also introduces electronic communications networks (ECNs), which are order-driven trading systems that are not regulated as exchanges. Island ECN, Instinet, Archipelago, and others were the ECNs of that era. Many have since become exchanges or been absorbed into them. The rise of ECNs represented a fundamental challenge to the incumbent exchange model, and Harris saw this clearly.
One interesting structural point: exchanges used to be owned by their members. But membership organizations tend to be slow and political. To compete more effectively, many exchanges demutualized, converting to corporate ownership. Nasdaq, the Chicago Mercantile Exchange, the Stockholm Stock Exchange, and others all went through this transformation.
Clearing agents match buyer and seller records to confirm that both agreed to the same trade terms. If the records do not match, traders have to resolve the discrepancies. In futures markets, unmatched trades are called out-trades. In securities markets, they are called DKs (for “Don’t Know”).
Settlement agents receive cash from buyers and securities from sellers, then transfer them once both sides have performed. This prevents one party from cheating the other. The National Securities Clearing Corporation (NSCC) is the big one in the U.S. securities world.
Settlement uses a process called net settlement, where the agent nets all of a client’s buys and sells in each security down to a single position. This dramatically reduces the number of actual transfers needed.
Clearinghouses in futures and options markets go even further. They guarantee performance on every contract by acting as buyer to every seller and seller to every buyer. They are owned by clearing members who are jointly responsible for settling all trades. If one member defaults, the others bear the losses. This is why clearinghouses obsessively monitor credit quality and require margin deposits.
Harris includes a great sidebar about the “Brazilian straddle”: a technically bankrupt trader holds a massive market position along with a one-way airline ticket to Brazil. If the position works out, he comes back to trade tomorrow. If it does not, he disappears and leaves his clearing member to clean up the mess. This is exactly why clearinghouses require frequent position reporting and intraday margin calls.
Depositories and custodians hold cash and securities on behalf of their clients. The Depository Trust Company (DTC), the world’s largest depository, held nearly $20 trillion in assets at the time Harris was writing. These institutions exist for security and efficiency.
Trading Instruments
Harris provides a thorough taxonomy of everything that trades. The key categories:
Real assets include physical commodities, real estate, metals, agricultural products, fuels, and pollution credits. The ones that trade in liquid markets tend to be highly fungible, meaning one unit is basically identical to every other unit.
Financial assets represent ownership of real assets and their cash flows. Stocks, bonds, currencies, and trust units all fall here. Financial assets appear on both sides of a balance sheet: as a liability for the issuer and an asset for the holder.
Harris explains the difference between primary and secondary markets. Primary markets are where issuers first sell new securities (like IPOs). Secondary markets are where those securities trade afterward. Underwriters at investment banks help issuers sell their securities, either through best-efforts offerings, underwritten offerings, or fixed-price open offerings.
The chapter then defines a parade of specific instruments: common stock, preferred stock, ADRs, exchange-traded funds (ETFs), REITs, bonds (straight bonds, zero-coupon bonds, Treasury bills/notes/bonds, commercial paper, mortgage-backed securities, and collateralized mortgage obligations).
The sidebar about toxic waste in CMOs is worth noting. The riskiest tranche of a CMO, where you get whatever is left after everyone else gets paid, is called toxic waste because no one wants it. People who buy it at high prices are betting that very few mortgage borrowers will default. When too many default, it becomes worthless. Harris published this in 2003. Five years later, toxic waste in mortgage-backed securities would help trigger the global financial crisis. He saw the risks clearly.
Derivative contracts derive their values from underlying instruments. These include forwards, futures, options, and swaps. They are in zero net supply, meaning total long positions minus total short positions always equals zero. They all have an element of futurity and most have expiration dates.
Harris explains the differences between physically settled and cash-settled contracts, between forwards and standardized futures (which are guaranteed by clearinghouses), between calls and puts, between American and European options, and between interest rate swaps and currency swaps.
Insurance and gambling contracts depend on future events. The distinction between them is about motivation: hedgers buy insurance to protect against risks they already face, while gamblers have no other financial stake in the outcome. Derivative contracts can serve either purpose, which is why the line between hedging and gambling is blurry.
Hybrid contracts combine elements of multiple types. Warrants are financial assets with derivative properties. Convertible bonds combine straight bonds with options. Oil-linked bonds are financial assets that derive part of their value from commodity prices.
Why This All Matters
Chapter 3 is a reference chapter. You will come back to it when you need to remember the difference between a clearing agent and a settlement agent, or when you need to understand why ECNs and exchanges compete, or when you want to understand the chain of custody for your shares.
But the deeper lesson is about complexity and interconnection. Every trade involves a web of relationships: between buy-side and sell-side traders, between brokers and dealers, between exchanges and clearinghouses, between depositories and custodians. Understanding this web is not just academic. It explains why trading costs what it costs, why certain trades are harder than others, and why the structure of the market itself is a competitive battleground.
Book Details
- Title: Trading and Exchanges: Market Microstructure for Practitioners
- Author: Larry Harris
- Publisher: Oxford University Press, 2003
- ISBN: 0-19-514470-8