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From Minutes to Microseconds a Modern History of Securities Markets

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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 sophis ticated 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 commun ications people became dealers. Dealers would showed bid and ask prices along with 6 Investments&Wealth MONITOR © 2010 Investment Management Consultants Association. Reprint with permission only. F e A t ure 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.
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