Crash of 87 lead to the world of quant based high frequency trading aka HFT
Here is a little history lesson provided by CNBC. These are some of the interesting highlights:
On October 19, 1987, the Dow Jones Industrial Average cratered by 23 percent, its biggest one-day decline ever. Stocks were plunging so quickly that Nasdaq market makers—the middlemen who grease the markets’ wheels—stopped picking up the phone. Retail investors who wanted to salvage their portfolios were left out in the cold.
It made it mandatory for market makers to instantly execute trades of 1,000 shares or less by retail investors in its Small Order Execution System, or SOES. Market makers and institutional investors, who usually traded in much bigger chunks of stock, had to wait in line behind the SOES traders.
Since the SOES trades were automated, meaning they received almost instant execution, and were given priority ahead of the rest of the market, a fast-moving trader could move in and out of stocks using SOES at a far-more rapid clip than large investors, generating big profits.
In 1996, Putnam teamed up with several partners to launch a SOES trading room in downtown Chicago. Like Houtkin, he started opening up SOES trading rooms around the country. In order to save money on the expensive Nasdaq terminals required to process SOES trades, orders executed by these satellite branches were routed via the Internet to his central station in Chicago.
This gave Putnam an idea: If he could start matching orders of their traders internally they could create an electronic communications network, or ECN, a relatively new marketplace that had been springing up in the 1990s at trading became more computerized.
And there was one specific ECN whose technology Putnam admired: The Island. T
he Island was also the offshoot of SOES traders. A New York branch of Datek Securities, a fast-growing firm that catered to day traders, had taken SOES trading to a new level, executing trades at unheard-of speeds. Behind the advance were two young whizzes who would go on to revolutionize markets forever: Jeff Citron and Josh Levine.
Citron came to be known as an ace trader, while Levine was the computer-programming genius who would amp up Datek’s system. In 1990, Maschler moved his operation to a small office on Staten Island. It was there that Citron and Levine created a trading system they dubbed Watcher.
The Island quickly gained a reputation as having one of the fastest “matching engines”—the computer system that links together buy and sell orders—on Wall Street. As its popularity grew, it started taking market share away from Nasdaq itself.
Putnam had used The Island and saw its potential. But he still had nowhere near the volume of traders that Datek had. So he came up with an idea: Traders could enter trades on his own ECN, and if no matches were found it would scan through the rest of the market for a match.
hus was born the revolutionary idea of the “smart order router,” a computerized system that constantly monitors the rest of the market for trade matches.
Putnam’s idea, therefore, was to go beyond a single computerized “island” to execute trades to a series of islands linked together electronically. In other words, an “archipelago” of markets. In 1997, he launched the ArchipelagoECN.
At the time, Archipelago was just one of several ECNs struggling for market share. But it grew quickly and soon bagged big investments from firms such asGoldman Sachs [GS 154.04 2.14 (+1.41%) ]. The Island was also on the fast track, eating up Nasdaq market share at a rapid clip as more day traders jumped on the bandwagon during the Internet bubble.
Accelerating the growth of the ECNs were new regulations instituted in the aftermath of a scandal that showed that Nasdaq market makers had been manipulating trades. In 1997, the Nasdaq implemented the Order Handling Rules passed by the Securities and Exchange Commission.
Another spur to electronic trading came in 2000 with “decimalization,” the trading of stocks in penny-wide increments rather than fractions of a dollar.
That meant that stocks could trade at many more points than before, a level of complexity easier handled by computers than the human brain.
Decimalization also cut down on the profitability of making markets, since the bid-ask spread narrowed dramatically, causing many established market makers to close shop—opening up the field for the super-efficient, high-speed firms.
The big exchanges could see the writing on the wall. In 2005, Nasdaq [NDAQ 19.56 -0.14 (-0.71%) ] purchased Inet, which had been formed by the merger of Island with another large ECN, Instinet. At about the same time, the NYSE purchased Archipelago, which had by then become an exchange known as Arca.
Today, the matching engine at Nasdaq is essentially the same one created in the early 1990s by Josh Levine (which many more bells and whistles, of course). The electronic trading platform at NYSE, now part of NYSE Euronext[NYX 29.37 -0.20 (-0.68%) ], is Arca.
Indeed, the computer whizzes have become the dominant players on Wall Street. Earlier this year, Getco, among the largest high-frequency firms, became a designated market maker on the floor of the NYSE, a role formerly held by specialists. This summer, the NYSE opened up a massive computer data center in Mahwah, N.J., to cater to high-speed trading firms.
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