From Minutes to Microseconds a Modern History of Securities Markets

F e a t ure

From Minutes to Microseconds A Modern History of Securities Markets

By Christopher R. Petruzzi, PhD

ike much of our culture, securi- advances of the day were being used for keep inventories of stock in a few com- ties markets appear to have military applications and transmitting panies and quote prices at which they Loriginated in Babylon around stock prices and trades. Arbitrage profits were willing to buy (the bid) and higher 2000 BC with the trading of tokens were the incentive. If stock was trading at prices at which they were willing to sell representing various commodities.1 different prices in New York and (the ask). Dealers generally had rela- The purpose of this article, however, is Philadelphia, an arbitrager would buy in tionships with brokers, who sent them to explain how U.S. securities markets the lower-priced market and sell in the customer orders and let them profit went within a few short years from higher-priced market. Only traders with from the bid-ask spread. Dealers then trading floors to high-speed computers the fastest data sources and the fastest made payments to the brokers (typically where one-millionth of a second makes order execution could succeed. Because two cents per share), who were prohib- a difference in execution. Consequently, success meant a great deal of money, ited from also charging a commission to I will skip about 4,000 years of very securities arbitragers were willing to pay customers. Large brokerage firms had interesting history and flash forward to higher prices than anyone else for the their own dealers in order to capture the 18th century. fastest communication. Telegraph and profit due to the spread. telephone lines were installed and new The 1933 and 1934 Acts of Congress, Background devices were invented to satisfy this which created the Securities and The Philadelphia Stock Exchange demand. The results changed the nature Exchange Commission (SEC), required (PHLX), founded in 1790, was Ameri- of securities markets—in the 19th century that participants in the trading of secu- ca’s first stock exchange. The New York and the 21st century. rities be registered. Most brokers and Stock Exchange (NYSE) was founded dealers chose to be regulated indirectly Modern Electronic two years later, and it quickly overtook through the quasi-public National Securities Markets the PHLX in volume and importance. Association of Securities Dealers During the 19th century, other major Modern electronic securities markets (NASD). Registration directly with the U.S. cities created their own stock ex- began with the creation of Instinet, SEC was possible but legally cumber- changes, largely because local investors which became operational (for insti- some. Brokers also could register needed to make transactions, and doing tutional investors only) in 1970, and through stock exchanges. OTC dealers business with New York was too dif- NASDAQ (the National Association of were trading off of the exchanges, so ficult and expensive. Hence, the Boston Securities Dealers Automated Quota- they registered with the NASD and Stock Exchange appeared in 1834, and tion system), which became operational were classified as “market makers.” Chicago and San Francisco exchanges in 1971. Market Makers formed in 1882. Brokers and Dealers The inventions of the telegraph in Market makers kept an inventory of 1838 and the ticker tape machine in When NASDAQ was created, most stock and offered to buy at one price 1856 made communications easier and large U.S. companies were listed on and sell at another. Market makers diminished the need for these regional the NYSE or the American Exchange. needed to be sure that they were quot- exchanges. The regional exchanges that A large number of publicly traded ing near market prices and they needed survived did so by providing unique companies were traded informally “over to know which other market makers services to the national market. the counter” (OTC), however, either would make trades to replenish their Transmitting current securities prices was because they did not meet the listing inventory of stock or buy up excess one of the first uses of the telegraph, and requirements of these major exchanges inventory. They needed a central system the ticker tape was the most sophisticated or because they chose to not be listed. to contact other market makers. This communications device in existence Because it was unlikely for a buyer (or system became NASDAQ. when it was invented. Indeed, as in the seller) to find a seller (or buyer), some NASDAQ displayed quotes and present day, the greatest communications people became dealers. Dealers would showed bid and ask prices along with

6 Investments&Wealth MONITOR

quantities to both market makers and traders who were aware of the delay in money and investments from a few brokers who had NASDAQ terminals. quote changes made arrangements with colleagues and former students. ATD The terminals allowed brokers to easily customers of retail accounts that they initially traded on the NYSE using the shop among the market makers for the could trade. The trader would watch NYSE’s fully electronic system, which best price. This likely resulted in smaller a couple of active stocks and look for nevertheless had a delay between the bid-ask spreads, to the consternation signs that quotes were about to change. times when orders were received and of the market makers. Because quotes The traders then would make a SOES filled. The NYSE specialist (i.e., the remained in eighths and quarters, how- transaction with a market maker who individual who made the market in ever, market making continued to make was slow to change quotes. After taking one stock) could see all the orders and high profits. a position on SOES, the trader would lay the names of the brokers who placed Madoff Brothers was one of the off the position in another transaction. orders. This “specialist book” was open largest market-making firms, and its The retail customer would be charged to all participants, but as a practical founder—the now infamous Bernard a commission that resulted in most of matter it was available only to the spe- Madoff—was behind the creation of the profits going to the trader. Generally, cialist. Thus, ATD traded NYSE stocks NASDAQ. Indeed, Bernard Madoff was these commissions were set so that the with a computer that made decisions NASDAQ’s first chairman of the board. retail customer earned a consistent rate that, compared to trading by humans, NASDAQ displayed automated of return from 12 percent to 20 percent were instantaneous and costless, but quotes, but until 1988 all NASDAQ per annum on his account. those decisions all went to the special- transactions took place over the phone. ist, who had additional information and Fully Electronic Stock Markets— Brokers would consult NASDAQ could change his quotes based on the Automated Trading quotes, then call a market maker. Trades identity of the parties who were sending were recorded on paper that was sent The market makers felt ripped off by orders. Regardless, ATD became the to the Depository Trust and Clearing these “SOES bandits.” Indeed, SOES first company to profitably trade stocks Company for clearing. bandits were so profitable that sev- with full automation. When the market melted down on eral firms formed just to trade their In the meantime, I had developed October 19, 1987, informed market par- accounts. Datek, founded by Sheldon portfolio analysis software and my ticipants knew the market was crashing, Maschler and Jeffrey Citron, became programmer, Glenn Rosen, became a but they didn’t know how low prices very successful, leading Citron to call SOES bandit. I quickly realized that would go. Market makers were afraid to for a fully electronic stock market that SOES banditry would be fairly easy to buy stock from selling retail customers. quoted in decimals rather than eighths automate. Rosen and I went to ATD Their solution was to not answer their and quarters. One of Datek’s young with a plan for fully automated software phones. When the SEC investigated, computer programmers, Josh Levine, to trade on SOES. We developed it with it determined that market makers’ not created a computer system called Island ATD in a joint venture. By the end of answering their phones deprived retail for a fully electronic stock market in 1994, ATD began trading on NASDAQ investors of their right to a continuous 1996. Island provided instantaneous with full automation using SOES. This market. So the SEC ordered NASDAQ executions with quotes in decimals (and was the first software to trade with full to create a system that would allow any increments as small as a tenth of a cent) automation on NASDAQ. ATD later retail investor to buy or sell up to 1,000 and was an immediate success. traded on Island and was reputed to be shares electronically. This became the Fully electronic stock markets its largest liquidity provider by the late Small Order Entry System (SOES). offered the possibility of fully auto- 1990s. Citigroup acquired ATD in 2007. When SOES was implemented in mated trading, i.e., all decisions In 1996 the U.S. Department of 1988, securities traders noticed that made by a computer with no human Justice brought an antitrust suit against some NASDAQ market makers were interference. the NASDAQ market makers. Phone slow to adjust their quotes. Traders David Whitcomb, a professor at taps had revealed that NASDAQ could look at their NASDAQ terminals New York University (where he and market makers colluded to keep bid- and see most market makers raising I were colleagues) who specialized in ask spreads large and had threatened (or lowering) prices simultaneously, securities-trading, saw this possibility in market makers who tried to reduce the with a few market makers taking sev- the late 1980s. Whitcomb sought ven- spreads. The settlement required paying eral seconds or even minutes to adjust ture capital to create a fully automated hundreds of millions of dollars to inves- their quotes. trading company, Automated Trading tors who had traded NASDAQ stocks Because SOES allowed automatic Desk (ATD), but no one would back (including, ironically, the customers executions only for retail accounts, the him, so he started ATD with his own of SOES bandits). Pressure increased

November/December 2010 7

for markets to cease quoting in eighths 2005, more than 30 other trading firms NASDAQ’s technology investment of and quarters. A bipartisan House bill had computers co-located with Island. hundreds of millions of dollars. In 2006, to require decimal pricing and hearings Today, about 90 percent of all orders NASDAQ acquired INET largely to on the issue led the exchanges to agree and about 50 percent of all trades in get Josh Levine’s program, which had to price in decimals beginning in April securities in the United States are beaten everything else that Wall Street 2001. Around the same time, securities generated by co-located computers. had produced. markets were required to display all (The percentage of orders generated by Island’s success prompted entrepre- limit orders so that any investor could co-located computers is higher than the neurs to create other ECNs, including effectively act as a market maker. Before percentage of trades because automated ARCA. When ARCA founder Jerry then, limit orders on OTC stock existed traders quickly cancel and replace Putnam found financial backing for in name only. Buy (sell) limit orders orders as conditions change.) Another creating an ECN similar to Island, the were simply held by market makers trading firm acquired Smart Execution backers agreed to send some of their until the ask (bid) price equaled the in 2008. customer orders to ARCA. Those trades limit. That had meant that traders who Other electronic stock exchanges provided an incentive for professional weren’t market makers couldn’t profit were created, too, but for institutional traders to use ARCA, too. from the spread. investors or private transactions only. ECNs and other platforms were per- Decimalization and the fully Madoff took control of the Cincinnati mitted to trade NYSE stocks away from electronic NASDAQ opened the way Stock Exchange (re-named National the exchange, but SEC rules required for more automated traders. Dave Stock Exchange) and made it fully elec- that there be no “trade through.” This Cummings, a trader with a computer- tronic in 1976, apparently to facilitate meant that no transactions could take programming background, created Madoff Brothers’ off-board transac- place at prices below the NYSE bid or Tradebot with his own funds in 1999. tions. Madoff Brothers had a profitable above the NYSE ask. Fully electronic Tradebot quickly became a major business paying institutions for order- stock markets were faster and more liquidity provider to electronic stock flow on NASDAQ stocks. The firm efficient than the old-fashioned NYSE, markets. I had left the partnership wanted to expand to exchange-listed but the mandate to stay within NYSE with ATD in 1995. Backed by Paloma stocks, and the Cincinnati exchange prices eliminated much of the advan- Partners, a family of hedge funds, I provided the opportunity. Steven tage. When ECNs complained, the SEC created Smart Execution in 2001. I real- Wunsch founded the fully electronic proposed eliminating this rule effective ized that I would need to be faster than Arizona Stock Exchange, which had in mid-2006, and the writing was on the other automated traders, so I located single-price call auctions, but it closed wall for the NYSE. It was going to lose Smart Execution’s computers in the in 2001 due to lack of volume. most of its market because its executions same building as Island’s computers. took seconds instead of milliseconds. Electronic Communications That co-location let Smart Execution John Thain, the newly appointed NYSE Networks respond to price changes a fraction of chief executive officer, responded by a second faster than any other com- Instinet was the largest private electron- buying ARCA, a purchase that instantly pany, and we soon were trading as ic stock market (officially an electronic gave the NYSE technology competitive much as 8 percent of the total volume communications network or ECN) with that of other exchanges. of OTC stocks. Smart Execution was from its founding in 1970 until 2000, With the leading ECNs merged into also the first company to co-locate with but it was available only to financial NASDAQ or NYSE, Tradebot’s Dave Archipelago (ARCA) and the first to institutions. As Instinet watched Island Cummings saw a need for a new ECN. co-locate with NASDAQ. More than surpass its volume, Instinet opened to With the support of other trading orga- 99 percent of Smart Execution’s volume non-institutional traders. Still, Island nizations, Cummings founded the Better was from adding liquidity (buying at the grew faster than Instinet, apparently Alternative Trading System (BATS). bid and selling at the ask); electronic because Island had better software. BATS is currently the third-largest stock communications networks (ECNs) paid Island distributed data, entered orders, exchange in the United States. Smart Execution and other liquidity and filled them faster than Instinet or Within just two years of decimaliza- providers a rebate of $0.002–$0.003 per any other electronic trading platform. tion and the fully electronic market, share for this service. So Instinet bought Island in 2003 bid-ask spreads had fallen from fractions These automated liquidity provid- and changed the platform name to of dollars to fractions of cents. Market ers replaced the market makers and INET. INET quickly became the most makers and specialists were going out of specialists who provided liquidity to popular trading destination, and its business. Following the traditional path NASDAQ and stock exchanges. By volume surpassed NASDAQ’s, despite Continued on page 30

8 Investments&Wealth MONITOR

Summary Christopher A. Levell, ASA, CFA®, A 50-year-old insight is highly relevant CAIA®, is a Partner with NEPC Are You and useful in today’s investment environ- in Cambridge, MA. He earned a ment. Risk parity uses basic investment BS in actuarial science from tools: the efficient frontier, risk budget- the University of Illinois at Urbana- LinkedIn? ing, and scenario analysis. Leverage is a Champaign. Contact him at key component of successful risk-parity [email protected]. Network with your peers portfolios and products, and the under- through IMCA’s group. References standing and acceptance of leverage is a Join online at www.linkedin. critical factor in adopting and managing Markowitz, Harry. 1952. Portfolio Selection. com/e/gis/1620107 a risk-parity approach. Investors can use Journal of Finance 7, no. 1 (March): 77–91. risk-parity products to diversify away Minahan, John R. 2009. Looking into the • Business and Social from equities without sacrificing expect- Future Casts Shadows: A Perspective Networking ed return. Risk parity also can be used on Portfolio Theory, Fat Tails, and Risk • discussions at the total portfolio level, to seek an Management, NEPC (May), available at • Jobs optimal unconstrained market exposure. http://www.nepc.com/writable/research_ • news and Article Updates Risk parity is a viable investment option articles/file/09_05_looking_into_the_ • LinkedIN member directory for clients, helping them to deal with an future_casts_shadows.pdf.

uncertain future through the broadest Tobin, James. 1958. Liquidity Preference as ® possible diversification. Behavior Towards Risk. Review of Economic IMCA Studies 25, no. 2: 65–86.

Petruzzi Continued from page 8

Conclusion Acknowledgments of failing businesses, they complained to regulatory authorities. Technological changes continue to The author is grateful to David Whit- SEC Chairman William Donaldson, present new regulatory challenges. comb and Dave Cummings for their the former NYSE chief executive officer Those who stand to win or lose lobby valuable comments. and a Bush appointee, proposed that about proposed rules. The latest rules stock prices should only be quoted in require that automated traders send Christopher R. Petruzzi, PhD, is a full cents to stop traders from compet- orders through software that has been professor of accounting at the Mihaylo ing for orders by simply paying higher approved to control against spurious School of Business, California State fractions of cents. Two other Republican orders that might adversely affect the University, Fullerton. He also is SEC members opposed the suggestion, stock market. As ever, the wisdom of founder and chief executive officer noting that higher fractions of a cent favoring or opposing these new rules of Smart Execution, LLC. He earned would turn into better prices for inves- has been overshadowed by the partici- a BA in economics from Wabash tors. Nevertheless, Donaldson voted pating parties’ financial incentives. College, an MBA from The University with the two Democrats on the SEC Securities markets will continue to of Chicago, and a PhD in finance and to make full cents the minimum quote respond to technological change. The business taxation from the University increment on all stocks in the United big change, however—the change from of Southern California. Contact him States trading at more than $1.00. human beings making transactions face at [email protected]. As a result, liquidity providers now to face to computers that make deci- Endnote compete at the same price, only faster. sions and transact with other comput- Indeed, automated traders now mea- ers—already has taken place. It took 1 See The Origins of Value, edited by William sure their program speeds in microsec- place, for the most part, within just one N. Goetzmann and K. Geert Rouwenhorst, onds, not milliseconds. decade. published by Oxford University Press in 2005.

30 Investments&Wealth MONITOR