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THE SPEED TRADERS
AN INSIDER'S LOOK AT THE NEW HIGH-FREQUENCY PHENOMENON THAT IS TRANSFORMING THE INVESTING WORLD
By Edgar Perez
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
The Emergence of High-Frequency Trading
While high-frequency trading has gained relevance with the general public only recently, the practice of using computerized trading has been active for decades, going as far back as 1971, when Nasdaq started as the world's first electronic market.
In the Beginning, 1969–1976
Traditionally, financial markets were physical locations where brokers with buying and selling orders met and matched them appropriately. The technological evolution and, consequentially, the exponential growth of computing power brought a revolution to the financial markets, making it unnecessary for brokers to meet physically and enabling traders from remote locations to participate. The now Nomura-owned Instinet led the charge more than three decades ago.
February 24, 1969
On this day, Institutional Networks Corp. filed a patent application for its "Instinet Communication System for Effectuating the Sale or Exchange of Fungible Properties Between Subscribers." The company, founded two years before, aimed to compete with the New York Stock Exchange by means of computer links between banks, mutual funds, and insurance companies, with no delays or intervening specialists. Through this Instinet system, which would start operating by 1970, the company would provide computer services and a communications network for the automated buying and selling of equity securities on an anonymous, confidential basis. It also acted as a securities information processor, supplying professional-level market data systems containing last sale, quote, and size information. Institutional Networks received income from commissions on the trades and from the rental of the Instinet terminals located in the offices of its clients. Institutional Networks was renamed Instinet in 1985.
February 8, 1971
This was the first trading day at the Nasdaq, an electronic alternative to over- the-counter stock exchanges. Nasdaq opened electronically with 2,500 over-the-counter stocks. It was not until the 1990s that the Nasdaq became a competitor of the New York Stock Exchange (NYSE); Nasdaq merged with the American Stock Exchange (AMEX) in 1998.
May 1, 1975
On this date, the Securities and Exchange Commission (SEC) banned fixed minimum commission rates, a cornerstone of the U.S. securities markets and all other organized exchanges throughout the world. "Until then, the NYSE fixed the minimum commission of stock trading; these extraordinary high costs had hindered quantitative traders from entering the equity markets," according to author Lars Kestner.
March 1, 1976
The fully automated Designated Order Turnaround (DOT) system was introduced on this day by the NYSE to route smaller orders electronically. The orders attended by a stock exchange agency would be sent electronically to the computers inside the market, allowing the stock exchange agencies to confirm the execution of some operations while still having the client on the telephone line, significant progress for the time.
The DOT system involved the use of computer technology to relay orders. With a network interface, it was possible for investors to submit orders that were immediately logged in the servers for the exchange. The orders could be executed and confirmation of the execution relayed to the investor in what was then considered real time. This type of real-time investment capability made it possible for investors to benefit by having an order executed immediately rather than 10 minutes or an hour later. The DOT system was able to handle such transactions as limit orders, basket trades, and several other types of market orders.
The Lead-up to Black Monday, 1982–1987
There were many voices eventually blaming the market collapse on electronic trading. The "flash crash" of 2010? No, Black Monday in 1987. That's right—even back then, startups and banks, which were just getting started in the electronic trading race, were pointed as the culprits of the dramatic decline in the financial markets. The story would repeat itself 23 years later.
July 5, 1984
On this date, the NYSE approved the use of a version of the Super-DOT system for options trading. Super-DOT was an improvement over the DOT system and guaranteed that any market order of less than 2,100 shares of a stock would be executed within three minutes at the prevailing bid price (for a market sell order) or asked price (for a market buy order) at the time the order was entered or at better prices, if possible. The DOT-for-Options system provided the NYSE options floor with an electronic order-routing system not available on any other options exchange. The Super-DOT system, which included the NYSE's DOT, Opening Automated Report Service (OARS), and Limit Order (LMT), had been used to provide automated trading support to the NYSE equities trading floor since 1976.
October 19, 1987
After five days of intensifying stock market declines, selling pressure hit a peak on this day, Black Monday. The Dow Jones Industrial Average (DJIA) fell a record 22 percent, with many stocks halted during the day because order imbalances prevented true price discovery. The lead-up to October 1987 had seen the DJIA more than triple in five years, and price/earnings (P/E) multiples on stocks had reached above 20, implying very bullish sentiment. And while the crash began as a U.S. phenomenon, it quickly affected stock markets around the globe; 19 of the 20 largest markets in the world saw stock market declines of 20 percent or more.
Floor traders, working by telephone, dominated the action, and computer-generated trading still was in its infancy; certainly, dark pools and high-frequency trading were the stuff of science fiction, said the Wall Street Journal. Nevertheless, that didn't stop people from speculating on the exact causes of the crash (which was rare in that the market made up most of its losses rather quickly rather than falling into a protracted economic recession) and pointing to automatic trading programs in place at the time as possible culprit. An important parallel, though, was how a number of traders abandoned the market; in 1987, some human market makers on the floor of the exchange stopped providing bids for certain stocks; more than two decades later, in a market dominated by technology, high-speed traders, who often provide liquidity for the market, just switched off their computers for very important reasons that will be detailed in Chapter 9.
Technology Improves, 1994–2001
Upstarts and established players jockeyed for positions at the end of the 1990s to advance their standing as the SEC readied itself to approve Regulation ATS, the regulation of alternative trading systems, an area now dominated by BATS (Better Alternative Trading System) and Direct Edge.
August 1, 1994
On this date, Banque Nationale de Paris (BNP) announced that it would purchase most of the operations of Cooper Neff, a Philadelphia-based options trading firm with a reported $400 million in capital, to provide a broader array of financial products to its corporate and institutional clients worldwide. The acquisition would include all of Cooper Neff's technology and research capabilities, as well as most of its trading operations.
Richard Cooper, founding partner of Cooper Neff, expected the buyout would push his firm "into the direct OTC [over-the-counter] customer market" using BNP's clients in Europe and Asia. Before, Cooper Neff's 100-plus traders made markets in exchange-traded options
Excerpted from THE SPEED TRADERS by Edgar Perez. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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