Advanced Trading Technology: How Did We Get Here?

At the request of some of my Twitter friends at #irchat I have decided to write a post about advanced trading techniques and technology in order to help shed some light on the current practices and separate fact from fiction. One could write a book on such things, so I have decided to break this very complex topic into several smaller posts. This first post is going to point out several historical events and the regulatory reaction to those events that have helped encourage the use of technology and shaped the very complex trading environment that we now operate within.

It is my hope that over the course of my next several posts, I can help share my knowledge of this subject with my friends in the investor relations community. I am confident that by sharing this knowledge I am going to be repaid tenfold through reciprocal information exchange that will undoubtedly help me in my many areas of intellectual and professional deficiency.

The Beginning

In 1961 the United States Congress asked the Securities Exchange Commission (SEC) to conduct a “special study” which was completed in 1963. The study found that the over-the-counter market (OTC) was very fragmented and inefficient. The report suggested that technology could be utilized to automate the market and the National Association of Securities Dealers (NASD) was given the responsibility of implementing a solution.

In 1967 there was a widespread back office breakdown whereby brokerage firms could not keep up with the ever increasing volume that they were handling. The average daily traded volume increased from 4.89 million shares in 1964 to 12.97 million shares per day in 1968 peaking at 14.9 million in December of that year. Many brokerage firms were employing 3 shifts to keep up with the paperwork and the NASD actually had to shorten the trading day in August 1967 for a few days and again for an extended 6 week period beginning in January of 1968. As a result, the development of the National Association of Securities Dealers Automated Quotation (NASDAQ) began in 1968. During this time approximately 11.9% of all transactions resulted in a failure to deliver securities by the settlement day. This lack of back office infrastructure forced the NYSE to directly intervene in the operations of more than 200 member firms which represented more than half of the NYSE member ecosystem. A sharp market selloff coupled with poor operational capabilities lead to the demise of 160 NYSE member firms between 1969 and 1970.

The SEC wanted to encourage competition among the primary markets by Alternative Trading Systems (ATS) and in 1969 issued Rule 15e2-10 in response to Instinet which was launched that year. The SEC didn’t force ATSs to adhere to exchange-like regulation out of fear that it would stifle competition and thwart innovation. Instead the SEC required ATSs to submit quarterly reports so that the SEC could keep tabs on them and monitor the volumes that were being traded over those platforms.

In February of 1971 the NASDAQ market opened for trading yet many of markets remained fragmented and the SEC began pushing for a national market system. The successful launch of the NASDAQ caused spreads on OTC listed stocks to shrink by 17% between 1970 and 1972. Despite this success, it was not uncommon for the same stock to trade at different prices over different exchanges. The NYSE tickertape failed to report the execution of NYSE listed stocks that occurred on regional exchanges or in the OTC market. Price discovery was weak and bid ask spreads were still wide. In 1975 Congress authorized the SEC to implement a connected national market system and rules related to the National Market System (NMS) were laid out.

The market crash of 1987 caused overwhelming trade order imbalances which resulted in more than one third of the Dow Jones Industrial stocks being locked an hour after the market opened for trading on October 19^th. This event resulted in an extensive laundry list of regulation which resulted in better practices and the adoption of additional technologies.

A 1994 study by the SEC titled Market 2000: An Examination of Current Equity Developments laid the groundwork for decimalization by advocating for the ability for stocks to trade in sixteenths as opposed to the eights increment. The SEC also took note of an academic paper written by William Christie and Paul Schultz (a Notre Dame finance professor…Go Irish) in the December issue of the Journal of Finance titled "Why do Nasdaq Market Makers Avoid Odd-Eighth Quotes?" This study recognized that that there had been overwhelming price fixing on the NASDAQ and that market makers were conspiring to keep spreads wide. The negative backlash from this scandal prompted the NASDAQ to begin trading in sixteenths in 1997 which resulted in 40% bid ask spread reductions. The SEC began pushing for decimalization which was implemented in 2000 and resulted in a further 50% reduction in bid ask spreads on the NASDAQ and 15% reductions on the NYSE.

By 1997 Instinet had grown to a sizable force in the ATS market which accounted for 20% of the volume traded in NASDAQ stocks and 4% of NYSE listed volume. By this time a sufficient percentage of orders executed on ATSs were outside of NMS and the SEC passed Reg ATS in 1998. This new regulation stated that an ATS must make all best price orders available to the public quote stream for stocks that trade more than 5% of their volume over their platform.

The SEC strongly encouraged ATSs to innovate and develop technology to increase liquidity and speed of execution, reduce bid ask spreads and ensure that investors could get access to the best price regardless of which venue the trade occurred or from where the order was placed. This open call for innovation gave rise to ECNs, dark pools, flash orders and high frequency trading. After providing decades of encouragement to the ATS community, the SEC has recently shifted their stance and has suggested that they may adopt new regulation to deal with these practices.

There are several practices that I believe should be curtailed or banned (which I will cover in future posts), however I strongly believe that the overall structure and function of our markets is superb. The US markets functioned very well throughout the credit crisis and despite our problems, our markets are still the global gold standard.

I think that a modern day witch hunt is underway as politicians and bureaucrats feel the need to pin the blame on someone for the credit crisis and subsequent market crash. I fear that the ATSs are absorbing most of the blame mainly because people don’t understand what they do. The sad reality is that these ATSs have done everything that the SEC asked of them. The SEC is now on the hot seat for the Madoff scandal, among other things, and they are trying to deflect attention away from themselves. If the SEC concludes that the current advanced trading technologies and practices are somehow unsound or unfair, they have no one to blame but themselves.