It’s hard to imagine anyone, other than Rip Van Winkle and a shipwrecked Maritimer, who hasn’t heard anything about program trading. Anyone with an interest in financial markets will have heard about the role of program trades in recent market history. Many of these discussions have produced more heat than light.
This article aims to stimulate an informed examination of past and future changes in the structure of trading in the various financial markets. Understanding the facts will allow reasonable people to evaluate policy issues in a rational way.
Before the 1960s, the public was the dominant participant in the stock exchange. The New York Stock Exchange traded as a floor broker, representing an individual investor meeting a specialist at the floor. The specialist asked for 100 shares from the floor broker, who purchased 100 shares of stock. This is mostly a good illustration of how things used to be.
In the 1960s, institutional investors grew rapidly and there was a need to trade large stock blocks. These trades could not be handled by the specialist because he or she did not have the distribution capabilities nor the capital. The specialist’s income from the execution of trades by other brokers declined in a world with unfixed commissions. This environment led to the formation of an ad-hoc joint venture between specialists and major block trading companies. The specialist system was augmented by the capital and distribution abilities of block trading firms.
A new trading method was developed after the 1974 passage of the Employee Retirement Income Safety Act (ERISA). This legislation emphasized diversification and indexation. An increasing number of equity market investors started to use systematic asset allocation strategies. They quickly realized the value of simultaneous executions at low costs for a variety of stock positions. Block trades are limited to a single stock or a few stocks with similar prospects. Institutional investors want to trade whole portfolios. Portfolio trades can involve as many as hundreds of issues, especially if the firm has changed managers or makes changes to its equity commitments.
It was unimaginable back in that time to get scammed at the brokerage floor. Everyone knew each other and respected each other. The trades were executed in front of hundreds of people and hence reduced any possibility of fraud and misconduct. However, as trading grew in volume, the scams appeared. We had numerous cases from ZZZZ best in 1986 to Enron in 2001 to CP Market scam very recently and many more. The growth in trading volume was not the sole cause responsible for the appearance of frauds, but online trading platforms’ emergence also played a decisive role.
SuperDOT was created to send small orders to specialist posts on the NYSE floor. SuperDOT could handle individual orders as well as portfolios and lists of orders. A portfolio trade’s stock positions were relatively small so the firm that handled it would have many specialists rather than one.
What 1987 market crash got us into?
The October 1987 market crash was discussed mainly in terms of program trading rather than portfolio trading. Portfolio trading was in its early days. Clients used to call a broker to read the names and numbers of stocks they wanted to purchase or sell. It was simple enough to verify that the broker didn’t sell Lowes Companies if the seller wanted to sell Loews Corp. There were many possibilities for miscommunication in a telephone conversation if several hundred stocks were included in a portfolio trade.
To save time and minimize errors, arrangements were made quickly to send stock lists from clients to the trading desk via modems and computer terminals. The client’s stock list was printed on a terminal and sent to the traders who processed the transaction. Modems worked a lot slower than they do now. It took a significant amount of time between the initial portfolio list transmission and when the broker received the last items on the list. The most common question in the trading room was “Is it done yet?” It meant “Has your computer program transferred the portfolio securities list from the customer?”
This high-tech, misleading terminology would not have caused any problems if it weren’t for the high-profile misinterpretation of program trades. Stock index arbitrage is a good example of this misunderstanding.
Computerized trading, program trading, and commoditization
Computer systems, which make investment decisions and transmit orders to the exchange floors without human intervention, are a recent addition to the market. We expect that humans will be able to exploit the weaknesses of this trading software in the future, much like human chess players. Computers can be very useful tools in the hands of skilled humans, but it’s easy to exaggerate their current role when it comes to decision-making.
However, computerized trading has been referred to as commoditization and program trading. Many investors find it difficult to accept and understand that you can trade both an index or a portfolio. These investors see a focus on indexes as a rejection of fundamental stock information.
We may be nostalgic for an era when every stock transaction was initiated and completed by an individual investor who had a deep understanding of the company behind it. An era where investment decisions were made only on the basis of Graham and Dodd’s principles. Unfortunately, this era is gone. Graham and Dodd had investment opportunities because of the chaos in the financial market from the Depression to the early postwar periods. These opportunities were available precisely because very few investors were willing to take advantage.
Free markets will be the best defense against instability in the long term. It would be a good step forward to allow member firms to trade portfolios off the floor during market hours. Portfolio trades wouldn’t overwhelm specialists or disrupt individual stock limit orders. There are many examples in the history of markets that have been freer and more productive for economic growth and activity. It is difficult to find examples of the benefits of strict market regulation.
Read More – How to Trade Crypto Coins and Receive Profit