Man Vs. Machine: How Stock Trading Got So Complex
CNBC "On-Air Stocks" Editor
The combination of faster technology and going to pennies created big changes:
- 1. It destroyed the profitability of the old system. Once trading went to a penny, it became difficult for specialists and market makers to make money even when committing large amounts of capital. Now you couldn't make a sixteenth of a dollar off a trade, you could only make a penny, so it had to be a big scale business.
- 2. Faster hardware allowed the creation of more sophisticated algorithms that permitted computers to decide the timing, pricing, and quantity of orders based on rules developed by the programmer. Traders could now slice up big orders into hundreds of tiny orders.
- 3. It paved the way for high-frequency trading, a type of trading which employs algorithms but uses those algorithms to make millions of trades a day at very high speeds. Instead of big money on a few trades, they make pennies (or fractions of a penny) on millions of trades.
In the early to mid-2000's, these developments were given a further push by the SEC, which was actively seeking to foster competition. They encouraged electronic trading over traditional, floor-based trading and created a new regulatory structure to foster that goal.
2001: NYSE introduces Direct+, which provided immediate automatic execution of limit orders up to 1,099 shares. This is real electronic trading (automated matching of buy and sell orders) and was the beginning of the end of the old floor specialist system.
2005: Reg-NMS changes everything. The SEC consolidates all rules on the national market system into Reg-NMS, which forced the NYSE to go electronic and fostered the growth of competing ECNs and exchanges.
The key tenet was the trade-through rule, which required all participants to respect the best bid and offer wherever it was. This meant that no exchange could "trade-through" (execute an order at an inferior price). The effect: the NYSE floor system, which was a "slow" system, had difficulty competing against the "faster" electronic marketplaces, which sometimes offered better bids and offers.
In response, NYSE launches NYSE Hybrid in December, which attempts to combine the NYSE floor operations with electronic trading occurring off the floor. The 1,099 share limits on the Direct+ system were removed. Specialist participation in the marketplace begins dropping drastically.
2006: NYSE demutualizes, becomes a for-profit, publicly traded company. This gives the exchanges an incentive to start managing for profit and the brokers incentive to start more competition.
NYSE buys Archipelago, an all-electronic trading platform, and renames it NYSE Arca.
2007: NYSE merges with Euronext, which had been formed in 2000 through the merger of the Amsterdam, Brussels, and Paris exchanges.
2008: NYSE eliminates specialists, renaming them Designated Market Makers, though still in charge of maintaining a fair and orderly market in their stocks.
NASDAQ completes its acquisition of the Boston Stock Exchange and the Philadelphia Stock Exchange.
BATS, formerly an ECN, becomes an exchange.
2010: Direct Edge, formerly an ECN, becomes an exchange.
Bottom line: Technology + Competition = Big Changes.
The biggest change of all is who is doing the trading. It's been estimated that 60 percent of the volume is now done by high-frequency traders. What are they? Who are they?