An understanding of the role and functions of financial markets is a necessary precursor to understanding the effects of advances in trading technology. Markets serve the function of enabling parties to engage in trade. However this is not the only function of markets. Markets serve a price discovery function: providing and aggregating information across both active and inactive market participants. Financial market stability will be enhanced by changes in trading technology which improve the price discovery function.
A trading technology or a market place enables parties to trade. I will explain below how this is intimately related to the price discovery function. However, it is useful to begin with a brief summary of the more elementary function of bringing trading partners together.
For illustrative purposes, divide the potential market participants into three groups: brokers, market makers and final customers. Brokers, by definition, never desire a position in the security. Market makers, by definition, take a position only for short term trading profits, i.e., the average return from a position held for the long run will not reward them for the risk of capital committed over the long run relative to other uses they have for their capital. Final customers, by definition, are willing to accept the average returns for the risk of their positions over the long run, and are trading perhaps with great current immediacy to achieve that position. This division of actors is obviously artificial, but it will help to explain some important concepts.
