Proprietary Trading History

Abstract

The only universal constant in the world of finance today is change. At the turn of the 19th century, stock trading in New York City was originally conducted on the street. What we knew as the AMEX & NYSE Euronext today was originally named the New York Curb Market. Curb Stone brokers used to conduct transactions out on the street. The modern day commodities Exchanges opened in Chicago and New York in the late 19th century and the open outcry (which you may have heard referred to as a pit) was born. This practice continued unabated for over almost one hundred years until the advent of the microprocessor and the birth of the information technology age. In 1971, the NASDAQ was born, which was the first all electronic stock market. As information technology expanded, it was integrated into the markets making them more efficient. Cities became connected through strings of fiber optic cable and the world of trading became a much smaller place. Nowadays, global markets are electronic and the open outcry is no longer an efficient method of conducting commerce. Today, highly sophisticated algorithms conduct the majority of trading activity in US Equity Markets.

Most people are very unfamiliar with the risk of Equity securities and their prominence in the investment world over traditional assets like a land or a house. Equity securities trading can be linked back as far as two hundred years back in the United States. Governments in colonial times needed to finance their debts for war. To do so, they sold bonds which were simply government promissory notes to pay back with interest. Around the same time, private banks began issuing equities (stock) of companies they owned to raise money (Buck, 1992). This was a very new form of investing and gave birth to a new era of entrepreneurship unlike any the world had seen prior. In order to facilitate the growth of these new markets, a meeting of about two dozen large merchants resulted into the creation of the New York Stock Exchange (NYSE), where merchants would meet daily to bid (buy) or offer (sell) their stocks or government bonds (Buck, 1992). The market served as a means of liquidity which was needed to establish the credibility of these investments.

The United States during the 19th century held massive growth for US businesses both domestically and internationally. In order to raise the capital necessary to finance expansions and new businesses, companies sold stock (partial company ownership) to interested investors (Geisst, 2004). The new demand for US products coupled with the recently founded potential of these efficiently tradable assets lead to millions of dollars worth of stocks traded on the streets of New York City by 1900. It took over 20 years; however, in 1921, the stock market moved indoors (Kent, 1990).

The industrial revolution fueled the market’s fire; however,  new forms of investing began to emerge as speculators began to buy stocks hoping to resell them at a higher price to interested investors (Cutler, 1991). The market became more volatile than before. The market addressed this concern rather well. The NYSE quickly began to be seen as the more stable investment alternative. (Kent, 1990) Because the NYSE dealt with mostly very large and well-established organizations, it served as a more stable investment for investors interested in making long-term investments. The smaller organizations evolved into the American Stock Exchange (AMEX) (Geisst, 2004).

The massive spread of investment in these new securities lead the government regulation, however, the overvaluation of the markets due to the devaluation of the currency based on lower gold reserve ratios behind the dollar lead to a bubble similar to the housing bubble of the early and mid 2000’s. Demand was high, which lead to overvaluation of most of the market. A correction did occur  in the form of the great crash of 1929 and in 1933 and 1934 congress enacted two sets of legislation and established the Securities and Exchange Commission overseeing IPOs (initial public offerings) as well as secondary markets (where speculative trades occur). The SEC sets out rules through the original acts of 1933 and 1934 and subsequent amendments in order to regulate US markets with the help of exchanges (Mandelbrot, 2008). The SEC oversees the daily actions of market exchanges and how securities trading is carried out. They also oversee IPOs (Initial Public Offerings), overseeing the requirements for companies to issue shares of ownership of their company to the public along with ensuring relevant information is made available for investors through requiring relevant information to be made public (Mandelbrot, 2008).

The first technological development to the stock markets came in 1867. Following the invention of the telegraph, the ticker tape was created. Ticker Tapes used telegraph technology to report information regarding transactions being made on the exchange (Kent, 1990). The exchange of information sought the growth of the industry from one location to the buildings nearby. Many brokers were hesitant to relocate further into Manhattan out of fear of delayed ticket tape data. The practice continued up throughout the first half of the 1900’s. Access to secondary markets at the time were very limited and could only be done through a broker whom used information from the ticker tape to buy and/or sell at the best possible price (Kent, 1990). Large brokerages soon emerged, including one large NASD (National Association of Securities Dealers) whom by 1971 formed their own ECN, the NASDAQ (National Association of Securities Dealers Automated Quotation System. An ECN is a computer system which facilitates trades by matching bids and offers electronically (Geisst, 2004). This provided a new era of efficiency for placing trades from long distances. So much so, in fact, that by 1975, the Securities and Exchange Commission established regulations abolishing fixed commissions and allowing competitive firm to firm pricing for executing trades. Many firms such as Schwab seized the opportunity and allowed customers to trade at discounted rates. Orders were mostly conducted by phone in which representatives would place orders using NASDAQ or another similar ECN (Geisst, 2004).  Today, we refer to these type of firms as discount brokerages. They provide access to markets relatively affordably for smaller investors and regardless of what scale your investment is, there is a broker out there catering to your type of investment strategy.

The phone order entry system was not perfect. Trades conducted over the phone have one major downside. The firm accepting the calls has the discretion to decide in what order to answer calls or place orders. These became apparent in the market crash of 1987. Some large brokerages simply avoided calls from smaller investors to deal with other issues (Mandelbrot, 2008). In response, the Securities and Exchange Commission responded by introducing the Small Order Entry System, which made smaller orders under 1,000 share lots have priority over larger institutional orders (Perminov, 2008).

Moore’s law states that the number of transitions on a chip roughly doubles every twenty four months (Sloane, 1980). In this framework, we see the speeds of computerized trading systems evolve to a point where latency is so much of a requirement for the profitability of such systems that not even every millisecond, but now even microseconds count towards achieving a profitable trading systems. Nowadays, most of the volume in the markets are done by supercomputers taking many factors into account and using microsecond decision-making abilities.

The internet made way for ground-breaking new investment technologies (Sobel, 1980). Direct Access trading is facilitated through the use of Electronic Communications Networks. A trader accesses ECNs such as NASDAQ using a PC and a high-speed connection such as Cable or DSL. A typical trader runs a run-of-the-mill personal computer, some with GPU upgrades for multiple output to multiple monitors allowing the ability to monitor multiple charts and see markets in real-time (Taleb, 2008).

Fast forward to 1997 and the widespread adoption of internet access around the globe leads to a huge electronic commerce market. We saw technology stocks showing enormous growth. Several companies such as Charles Schwab, E-Trade and others launched competitive electronic brokerage services featuring Direct Market Access – a venue for sending orders directly to an exchange eliminating the broker’s role other than collecting commission and maintaining basic information technology infrastructure. Suddenly, small investors had direct access which leveled the playing field between institutions and smaller investors (Mandelbrot, 2008). SOES, the Small Order Entry System provided an advantage to small investors; however, some quickly learned to use this to their advantage by simply placing blocks of smaller orders in using high frequency strategies. Institutions, boasting powerful algorithmic trading systems once again regained the edge (Perminov, 2008).

By 2000, so much secondary market volume had become electronic that congress investigated the matter. It was estimated that only 1.4% of investors (7000 out of 5 million) in the market participated in high frequency strategies (Taleb, 2008). By 2000, SOES was eliminated for high-frequency traders, however, while the government was focusing on regulating small traders, the dot-com bubble grew hugely over-valued the burst wiped out much more investment in American markets than any amount of high frequency could have done (Perminov, 2008). Despite this, computerized trading became a easy target for blame for the crash. Fast forward to 2011 and these computer systems have grown exponentially more powerful and the algorithmic logic behind decision-making for these systems has become sophisticated and increasingly complex both in variables taken into account as well as actual lines of code. Couple that with the consistent high rate of change in the industry from both the market perspective as well as regulatory authorities and it’s not difficult to see why traders often remain in the shadows.

It is estimated that rough 60% of volume handled daily by the exchanges are executed on behalf of computer decision making and not based on any individual action (Mandelbrot, 2008). Much of this volume is not conducted by larger institutions but rather by individuals and smaller firms which employ up to a few dozen people (Mandelbrot, 2008). Because of Direct Market Access and discount brokerages, it is now possible for a small group of investors to compete with larger banking institution systems from anywhere in the world, providing them an edge if they can remain efficient and stay a step ahead of larger market makers. Most high frequency trading firms were founded after the year 2000 (Taleb, 2008). The industry profits in 2009 & 2010 for high frequency traders were estimated to be between 12 and 13 billion dollars. The Securities and Exchange Commission quickly reacted voicing concerns that tighter controls need to put in place to avoid technological advantages unduly punishing smaller investors. On may 6, 2010 a flash crash occurred where stocks plunged about 700 points before moving right back up within minutes (One Year After Flash Crash Regulators Vexed by Fragmentation, 2011). Although it is still very unclear what exactly caused this crash (my personal opinion being someone entered a few too many 0’s into an order), the SEC maintains its position that high frequency trading exacerbated the issue and many algorithms sold immediately causing a huge unwarranted decrease in price before the systems readjusted and began trading at normal levels once again  (One Year After Flash Crash Regulators Vexed by Fragmentation, 2011).

All this is substantial evidence that the financial markets server as early adopters for new technologies. The hunger for more freedom, more profits and more technology is very unlikely to diminish anytime in the near future. New technologies in the form of computer processing power & smarter algorithms; however, it remains to be seen what type of market conditions and activities will remain possible for the small investor. Without external intervention, the shift to these type of markets seems all but inevitable. The shift from relying on human capital to a more machine-intensive financial system will lead to similar conditions set by the effects of machinery on the garment industry (Cutler, 1991). Financial firms may look to be depopulated. There are larger repercussions for the US as a whole if this process continues at the rate it seems to be progressing in now. With the consistently increasing demand for few quantitative programmers and more automated systems, the long-established dominance of the US financial markets on our socioeconomic environment is seriously threatened by clusters of automated trading systems and supercomputers and extract capital from financial services centers such as New York in favor of remote distant locations (Perminov, 2008). For macro conditions, the stability of the US financial system. That is not to say that we are doomed for these type of scenarios. However inescapable they may seem, the US markets are remarkably robust and capable of picking up steam in a relatively short period of time.

Investment in mathematical and science education, cutting-edge technology research and public education about financial systems and their inner workings may help alleviate some of the symptoms, however, a more comprehensive understanding of our ability to quantify and explain systematic risk will be necessary if we want to keep our markets attractive to both investors in the US and abroad (Morris, 1999).

In my opinion, the following technologies serve to hinder the openness and accessibility of our financial markets if they were to come under the wrong hands or were to be regulated incorrectly: high performance processing using cloud technologies; proximity of server to exchange being replaced by processing power and latency; Adaptive algorithms which have no human operator overseeing operations & cyber-security.
Technology has contributed tremendously to the state of our markets, economy and world. Within milliseconds, billions of dollars are exchanged, however, with the red tape altering financial firm’s outlook is sure to proceed over more precise and detailed rules and regulations. The question we have to ask is whether this is the correct approach, or as history as demonstrated, will the free market itself provide the most useful and efficient mechanism for addressing its own fate?

References

Buck, J. E. (1992). The New York Stock Exchange: The first 200 years. Essex, CT: Greenwich Pub. Group.

Cutler, D., Poterba, J., & Summers, L. (1991). Speculative dynamics. Review of Economic Studies, 58, 520-546.

Geisst, C. R. (2004). Wall Street: A history : From its beginnings to the fall of Enron. Oxford: Oxford University Press.

Kent, Z. (1990). The story of the New York Stock Exchange. Chicago, IL: Childrens Press.

Mandelbrot, B., & Hudson, R. L. (2008). The (mis)behavior of markets: A fractal view of financial turbulence. New York, NY: Basic Books.

Morris, S., & Shin, H. (1999). Risk management with interdependent choice. Oxford Review of Economic Policy, 15(3), 52-62.

Mehta, N. (2011, May 06). One Year After Flash Crash Regulators Vexed by Fragmentation. Bloomberg. Retrieved April 12, 2012, from http://www.bloomberg.com/news/2011-05-06/fragmentation-that-fed-may-6-plunge-is-focus-of-regulators-one-year-later.html

Perminov, S. (2008). Trendocracy and stock market manipulations. United States: Stock Markets Institute.

Sloane, L. (1980). The anatomy of the floor: The trillion-dollar market at the New York Stock Exchange. Garden City, NY: Doubleday.

Sobel, R. (1975). N.Y.S.E.: A history of the New York Stock Exchange, 1935-1975. New York, NY: Weybright and Talley.

Taleb, N. N. (2008). Fooled by randomness: The hidden role of chance in life and in the markets. New York, NY, NY: Random House.

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