Man Vs. Machine: How Stock Trading Got So Complex
The '90s brought erosion of NYSE specialists and rise of Internet trading
Then came algorithmic and high-frequency trading, which changed even bigger changes
Ah, the good old days of, say, 1960. It was pretty simple then: Greg Thompson, an investor from St. Louis, with the Scottrade account, did not have an online account in 1960 (there were none.)
Instead, he called his broker, who then entered the order in their own system, and if it was a stock that traded on the NYSE (and IBM did) it was called onto the floor of the NYSE, where Thompson's order to buy 100 shares was matched with an order to sell 100 shares.
If it was an over-the-counter (OTC) stock, that is, one not listed on the NYSE or AmEx but still traded, the broker called around by phone to market makers who quoted different prices to buy or sell the stock.
Then things began to change.
Timeline: Four Decades of Trading Transformation
1969: The first crack in the wall. Instinet is founded as the first Electronic Communication Network (ECN), which was created to allow brokers to post offers to buy and sell stocks after regular market hours.
The 1970s: Founding of NASDAQ.
1971: The National Association of Securities Dealers, an association of over-the counter (OTC) market makers formed in 1939, created the first electronic stock market: the National Association of Securities Dealers Automated Quotations (NASDAQ) market.
NASDAQ was different from the NYSE in two ways:
- There was no physical floor
- Instead of one market maker (the specialist at the NYSE), there were multiple market makers, often up to a dozen securities dealers who posted offers to buy ("bids") or sell ("ask") stocks over computers.
But this wasn't "electronic trading" in the way we understand it today. Initially, it was just a computerized bulletin board which merely posted bids and offers: prices were updated only once a day! Orders were not matched by computer, they were still taken over the phone well into the mid-1980s.
Still, it did serve to bring down the bid-ask spread and thus help lower the cost of trading.
1975: Fixed commissions are abolished by the SEC. This allowed for the rise of discounted commissions and facilitated the growth of Charles Schwab and others.
1976: NYSE introduces its Designated Order Turnaround \(DOT\) system, which allowed brokers to route 100-share order directly to specialists on the floor. These were not true electronic executions because the specialist still matched the orders, but it did bypass floor brokers.
The 1980s: The rise of electronic trading.
1984: NYSE adopts a more sophisticated SuperDOT system that allows orders up to 100,000 shares to be routed directly to the floor. More floor brokers cut out.
1987: Blame the computers. The 1987 crash is blamed partly on "portfolio insurance" (shorting stock index futures against a stock portfolio).
Electronic trading takes another leap forward as NASDAQ expands the Small Order Execution System (SOES), which allows dealers with small trades to enter their orders electronically rather than over the phone. This was done because during the 1987 crash many broker-dealers simply stopped answering their phones.
Market makers were now required to accept SOES orders, within certain volume and price limitations; this greatly improved the liquidity in many smaller stocks, but was flawed because some traders (SOES bandits) found ways to game the system. Still, it was the death knell for executing most orders by phone.
The 1990s: Erosion of the NYSE specialist business and the rise of online trading.
1996-1999: Online trading begins to explode as Internet traffic dramatically increases. Small traders suddenly had the same access to real-time pricing as professional brokers. The word "day trader" enters the vocabulary.
This became possible because of:
- 1. more powerful personal computers
- 2. higher volume and faster access to bids and offers, which was provided by electronic communication networks (ECNs) like Archipelago and Island
- 3. the growth of online brokerage firms like ETrade, AmeriTrade, and others
- 4. a dramatic drop in commissions which made online trading more profitable
- 5. the bull market in tech stocks which created enormous investor interest.
1997: Stock trading is allowed in increments of one-sixteenth of a dollar, down from one-eighth of a dollar.
New Era of Alogrithms and High-Frequency Trading
The 2000s: Decimilization, algorithmic trading, and high-frequency trading.
2000: The NASD spins off NASDAQ into a publicly traded company.
2001: Stock trading in pennies begins.