A Short and Vastly Simplified History of Modern Stock Trading

June 2007 Martingale Asset Management A Short and Vastly Simplified History of Modern Stock Trading Alan J. Strassman, Chairman William E. Jacques, Chief Investment Officer Introduction From the late 18th century until the last quarter of the 20th, the NYSE and the Curb Exchange (later known as the American Stock Exchange) dominated stock trading in the United States, which essentially meant the world. For almost 200 years, stock trading was highly concentrated in a limited number of visible markets where buyers and sellers physically met to make transactions. In 1971, the over-the-counter market was organized into The NASDAQ (National Association of Securities Dealers Automated Quotation) Stock Market, the world’s first electronic stock market, and technology emerged as an irresistible force

for change. In the thirty plus years since, stock trading has evolved from a highly centralized to a highly fragmented activity characterized by exchanges in major cities around the world, multiple electronic crossing networks and a growing number of “dark” pools of “hidden orders.” 222 Berkeley Street • Boston, MA 02116 • Tel: 617-424-4700 • Fax: 617-424-4747 • www.mar tingale.com Information and the Cost of Trading return. The opportunity to generate trading profits based on legal “inside information” combined with Theoretically, a central market where all buyers and fixed NYSE commissions, made stock exchange sellers meet should be the best way to have price specialists some of the wealthiest brokers on Wall discovery. If someone wanted to buy five million shares Street. of IBM and someone wanted to sell five million shares of IBM, the two would find each other and the trade would Modern Era Changes take place with minimal market impact. Unfortunately, theory in this case ignores the practical reality that Investors tend to be skeptical; most of the time they supply/demand information is contained in the assume that large buyers or sellers have valuable intention to trade IBM stock. company-specific information when, in fact, they seldom do. But, if both sides are reluctant to reveal A large buy or sell order usually affects a stock’s price themselves, then the trade may never occur. To break since the supply/demand equilibrium is disturbed by this logjam, the specialist served as a private the new trade intention. In other words, if a buyer matchmaker; however, the matchmakers were taking a reveals that she intends to buy five million shares of distressingly high fee for their services. With the IBM, this information will put upward pressure on the growth of institutional trading in the ‘60s and ‘70s, stock and vice versa. Neither buyer nor seller knows that pressures began to build for lower trading costs. More the other exists until they reveal themselves. However, and more traders for large institutions chose to work neither has an incentive to reveal this information, since off the floor of the NYSE, taking, instead, their large it’s likely to hurt the party that reveals it. This is known orders “upstairs” to the “block desks”. Brokerage as the liquidity cost of trading. firms with capital and competitive instincts traded as Stock prices are also affected by company-specific principals, thus providing an alternative to the information that...

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