What is a central limit order book?

A central limit order book (CLOB) is a trading system that matches orders. It’s transparent, low-cost, anonymous, and can check orders in real-time.

Outstanding offers to buy or sell are stored in a queue and filled in a priority sequence by price and time of entry.

The principle of price/time priority refers to how orders are prioritized for execution.

Orders are first ranked according to their price. Then orders of the same price are then classified depending on when they were entered.

The highest (“best”) bid order and the lowest (“cheapest”) offer order constitute the best available market price.

Customers can routinely cross the bid/ask spread and benefit from low-cost execution. (You’re able to enter limit orders “in-between” the bid and ask.)

They also can see market depth or the “stack” in which customers can view bid orders for various sizes and prices on one side vs. viewing offer orders at multiple sizes and fees on the other side.

The CLOB is by definition fully transparent, real-time, anonymous, and low cost in execution.

The use of a CLOB is typical for highly standardized securities and small trade sizes.

In the CLOB model, customers can trade directly with dealers; dealers can sell with other dealers.

And most importantly, customers can trade directly with other customers anonymously.

What you need to know about central limit order books.

Most exchanges around the world use a central limit order book. In a typical market, buyers and sellers must submit orders to a significant limit order book, collating all outstanding buy and sell orders.

When a new order can be matched against an existing order, it gets executed. Otherwise, the new order enters the database and waits for another order to offset it.

There are two central order books; hard, which executes orders immediately, and soft, which provides information but doesn’t include automation.

Central limit order books are expected to slowly replace over-the-counter (OTC) trading in the derivatives market, which is commonly used outside exchanges. Major limit order books are believed to carry less operational and default risk.

CLOB vs. RFQ

In contrast to the CLOB, the Request For Quote (“RFQ”) trading method.

RFQ is an asymmetric trade execution model.

In this method, a customer queries a finite set of participant market makers who quote a bid/offer (“a market”).

The customer may only “hit the bid” (sell to the highest bidder) or “lift the offer” (buy from the cheapest seller).

The customer is prohibited from stepping inside the bid/ask spread and reducing their execution fees.

Contrary to the CLOB model, customers can only trade with dealers. They can not deal with other customers.

And most importantly, they can not make markets themselves.

Trade execution costs are lower when more market participants can compete for order flow versus when orders are routed to a limited number of market makers with (potentially) non-competitive quotes.