City braces for a new order with advent of Big Bang 2

The introduction of electronic order-driven trading of Britain's biggest stocks next month has been described as Big Bang 2, the most radical shake-up at the Stock Exchange for 11 years. Tom Stevenson, Financial Editor, examines the reasons for abandoning the current system of buy and sell quotes, the likely winners and losers and the impact of the changes on investors large and small.

The threat to Liffe posed by the announcement this week of an alliance between the derivatives bourses in France, Germany and Switzerland was a timely reminder that London's position as the financial centre of Europe is far from assured.

The danger is not just in futures and options trading. No one is more aware of the need to fight off the competition than the Stock Exchange, whose system for trading shares is so popular, as one commentator put it recently, that no other exchange has bothered to borrow it.

Indeed, many American funds are deliberately underweight in British stocks because they resent the relatively high cost of trading here and what they perceive to be a clubby, old-school attitude that deliberately sets out to exclude outsiders.

As part of a bid to ensure that attitude does not drive more business elsewhere, the Exchange will next month push through the most radical change in share trading for 11 years, when the introduction of order-driven computerised dealing will alter the way Britain's largest and most liquid stocks are bought and sold.

The shake-up has been called Big Bang 2, and rightly so - the revolution is likely to be as far-reaching as its predecessor in 1986 when floor trading was abolished in favour of a screen-based version of the old jobbing system.

From 20 October, trading in Britain's largest 100 shares will switch from the Exchange's Seaq quote-driven system to the completely automated order-driven model used by many European bourses. The new system, Sets, will replace the current regime where market-makers quote investors firm prices at which they will buy and sell shares. Instead, brokers will input orders directly on to a computer that will automatically match buy and sell orders.

So, for example, an order to buy 100,000 ICI shares will be posted on the screen until it has been matched by sell orders at the same price. If there is an offer to sell 50,000, the buy order will stay posted until other sell orders for, say, 40,000 and 10,000 shares are placed. The broker will have no idea who he is dealing with until the transaction is completed.

That may sound like nothing more than a technical difference in the way deals are done, but market players have no doubt that it will radically change the way the City operates and make it much more competitive. One recent report estimated that transactions costs could fall from 0.6 per cent of the value of a deal to just 0.2 per cent.

The chief executive of one large bank's equity dealing division, described the introduction of order-driven trading as "the biggest change since Big Bang - it will lead to a sea change in working practices among firms and their clients."

It is also likely to boost volumes substantially as the scope for automated programme trading is explored.

To begin with the new system will apply only to the largest shares, but there are plans to roll it out to include the next 250 biggest stocks and beyond.

Even restricted to the FTSE100 index, the new system could apply to the lion's share of dealing in London.

The fact that the Exchange has reached final testing for the new system at all is an achievement that many would have bet against only recently. After a series of recent fiascos, the success of Sets is crucial to the credibility of a City institution that has been the object of more than its share of ridicule over the years.

The collapse of the Taurus paperless trading project showed how fraught with problems large computer systems of this kind can be. That debacle cost the job of the Exchange's then chief executive, Peter Rawlins.

His successor, Michael Lawrence, fared no better, brought down by the abrasive manner in which he tried to push through the early stages of the order-driven project against the wishes of the City's powerful market- makers who stand to lose more than anyone from its introduction.

Bringing the likes of Merrill Lynch, BZW and NatWest Markets on board is actually the biggest achievement of Gavin Casey, the current chief executive. There may be rumblings about the desirability of order-driven trading, but all the big players accepted long ago its inevitability.

It is easy to see why the market-makers should be ambivalent about the new regime. Fund managers are unlikely to be willing to pay large commissions to brokers, whose sole function now is to input a mechanical order on a computer keyboard. They will demand bargain basement dealing commissions for simple deals and if institutions turn to the new system in large numbers because it turns out to be much cheaper, it could leave many dealers without a role.

That doomsday scenario is by no means certain, however, because order- driven trading has its limitations and it is still not certain how many investors will choose to use it. About 50 per cent of bargains would put London on a par with overseas electronic exchanges.

Its main drawback is that it does not allow fund managers to offload risk entirely as they do when they sell large blocks of shares to market- makers. Because their whole order is posted on the screen, buyers can in effect see them coming and there is a danger the price could move against them. Many investors will choose to have their larger deals worked for them off-market by their broker.

Others unlikely to welcome the changes with open arms include small private investors, who could find themselves paying extra for small deals, which the new system won't accommodate.

Sets will only deal in lots of 1,000 or more (500 for stocks costing more than 500p each). That will also hit smaller brokers: much of the low margin retail business will simply be clumped together and dealt with by the bigger players who increasingly are expected to dominate the market.

Stock Exchange members are taking the new system extremely seriously, spending millions of pounds installing new systems. Datastream/ICV has been successful selling off-the-peg systems to smaller players, while RoyalBlue, which floated recently, has been the preferred choice of some larger players who have required tailor-made software for their more complex needs.

What is now certain is that the system will go ahead and London's position will be more secure as a result.

Once people have got used to working with the technology rather than against it the changes brought by electronic trading could be more explosive than Big Bang itself.