ECON 252: Financial Markets (2008)

Lecture 19

 - Brokerage, ECNs, etc.


The exchanges in which stocks and other securities are traded serve an important function in finance. They bring together people interested in buying and selling securities in order to create a universal price. Brokers and dealers are also an important part of the system, their methods and standards are ultimately behind the success of the exchanges. Many information innovations have advanced the functioning of exchanges, going all the way back to the ticker machine, which was created to communicate the price of securities at a point in time to all interested parties. Electronic Communication Networks and automatic exchanges, more generally, have significantly impacted the exchange of securities and few exchanges still have physical trading floors.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 19 - Brokerage, ECNs, etc.

Chapter 1. Introduction: The Broker and the Dealer [00:00:00]

Professor Robert Shiller: What I want to talk about today is about places where stocks are exchanged — or bonds or other securities. It’s another huge industry. I would say it’s part of our information technology — our information network. What we have to do is find a national or international price for a security. The problem is that when securities are traded without a central market, different people will be getting different prices for the same thing. We have what’s called — or maybe the term — what markets do for us is — the important term is “price discovery.” That means that there is a market price that an asset would have if everybody in the whole world were free to buy and sell the asset on the same market and at the same time. But if you don’t have an organized exchange, which is open and available to everybody without a lot of cost, then you don’t have effective price discovery and that means that nobody knows what the asset is worth in the whole market. We take price discovery for granted but we have to realize that there’s a technology that brought us that and it’s the technology that we want to emphasize that has been improving over the years; it’s not static.

I wanted to start by just defining some important terms regarding exchange of securities. One important term is “broker” — and I’ll put it over here — another one is “dealer.” Those are the two kinds of people who trade securities. It’s important to keep the concept, so one thing that’s used to describe is to start with the letters BOAC — that sounds likes it’s British Overseas Airways Corporation, but that’s not what I mean. This is a mnemonic to remember broker. It says brokers act on Behalf or for Others as an Agent for which they earn a Commission. A broker goes between two people and the two people trade with each other. The broker makes it happen and the broker receives a fee called a commission for bringing these people together so that they could find each and make the deal — make the trade. For dealer, we have a different — it’s DHPM. A Dealer acts for Herself or Himself as a Principal for a Markup; that’s the fundamental difference. In contrast to a broker, the dealer actually buys and sells himself or herself and that means the dealer has an inventory of whatever it is that — so that the dealer has something to sell. If you go to a dealer and buy a security, you’re buying it from the dealer out of the dealer’s inventory. If you sell through a dealer, you sell to the dealer. There’s a fundamental diff — the markup is the difference between the price that the dealer buys and sells at; so, you see that there’s a fundamental difference.

Now, securities law says that you can never function as both a broker and a dealer in the same transaction. You’ve got to be one or the other. The same person can do both. You can be both a broker and a dealer, but not in the same transaction. We also have the term in finance “broker-dealer” and that’s called BD. A BD is a firm that hires — that employs brokers and dealers. The fact that they hyphenate them doesn’t mean that any one transaction involves both brokering and dealing. You can see the difference in ordinary life. When you buy and sell a house, your real estate agent is a broker. The real estate agent usually does not buy the house from you if you’re selling your house. Or if you call up a real estate agent and say, “I want to sell my house,” the agent doesn’t say, “okay I’ll buy it;” so, that person is operating as a broker. However, if you go to an antique shop and say you want to buy a chest of drawers or a dining room table, you’ll be dealing with a dealer.

I guess there are fundamental reasons in why it works out well in one and why it tends to break down differently for the different — why is it that we have dealers for antiques and brokers for homes? Well, I think it has something to do with — can you tell me, why do we do it that way? I was thinking it has something to do with the information cost of — since buying a house is such a big decision and you’ve got to go looking at the houses anyway. Somehow, antiques — you wouldn’t have an antique broker would you? I guess you could. People could have antiques for sale in their homes and the antique broker would take you around on a tour.

I wonder if that was my Blackberry. I am so wired here. Yes, I think it was my Blackberry.

The concept of a BD is that it is something regulated, once again by the Securities and Exchange Commission; that means any BD must register with the SEC. In that sense, we have a sort of licensing for BDs. BDs in turn are responsible for their employees, who are acting as brokers and dealers, and the employees will have to be appropriately licensed. What BDs do is, according to our securities law, they would manage their employees exams through FINRA — now, I mentioned that before. That’s the successor to National Association of Securities Dealers; that has exams for brokers and dealers. What it is — a BD is a company that hires people and they become licensed as brokers or dealers through their own BD using FINRA, so that’s the organization method that we have.

The reason why we have it this way is that there are so many instances of bad behavior among brokers and dealers that have to be handled. This goes back to a basic theme of this course that human nature is imperfect and while economics theory tries to describe people as honest and following the rules, there are so many opportunities for bad behavior that have to be corrected. I’ve taken the licensing exams for FINRA because I wanted, myself, to do creating of securities. I think it’s actually a very good program they have and they have continuing education that brokers and dealers have to take. One thing that they do in the continuing education — I was impressed with what they’ve come up with — they have actors and actresses portraying situations that brokers and dealers will come up with — will encounter that are not quite ethical.

I remember there was a scene where a woman comes up to the broker and there’s a document that — she has a joint account with her husband and there’s a document that requires both their signatures. The broker hands it to her and she signs and then he says, okay can you get your husband to sign it? She says, oh he already did, look — right in front of the broker and then they show the BD backing down — this is in the skit that I saw — and accepting, okay. She said, I’m sure it’s all right with him; so he says, all right. The skit goes on and shows how much trouble he got into for accepting. Then, the husband shows up the next day and they’re getting a divorce and he’s furious and he [the broker] tries to cover it up by pretending he didn’t know. She then comes back and admits that he [the broker] just told me it was all right that my husband — I could sign for my husband.

There are all kinds of moral issues that arise and I think that the system works as well as it does because we have institutions. We recognize that there’s a tendency for all kinds of bad behavior. My own experience with FINRA was increased confidence in our BDs. I think that we have a good system — that there’s going to be a lot of temptation for bad behavior. We have a pretty good system in this country for educating people not to do that. We also actually go after BDs who do things that are seemingly innocent. For example, churning — I mentioned this before.

Churning is overtrading a customer’s account. It’s not obvious to uninformed investors that it isn’t a good idea to trade stocks every other day, but it’s obvious to anyone in the field. If you’re trading stocks that frequently, there’s just no way that you could make money. There’s nobody who can get a 50% return on stocks with reliability. We know that David Swensen — we mentioned him before — has got 18%, but he’s the star and you’re not going to do that well, realistically. If you’re churning — if you’re paying more then 18% in commissions every year, you just don’t have a chance. A broker could try to hide behind some kind of façade and say, well but I think I can earn that. But fortunately, we have good enough regulatory agencies to stop that, so right now, brokers who churn their portfolios will be caught by market surveillance and they will be thrown out of the profession. It’s actually — you can be disbarred — prevented from trading for life. That’s the kind of regulations we have.

I think it’s a very — the world is more ambiguous and faces more moral dilemmas than you would imagine. You have to get out into the business world and start seeing how often they come up. It’s kind of remarkable that we have a system that handles these dilemmas as well as we do. You see a lot of anger now, for example with the subprime crisis, and people who supposedly or allegedly behave very badly. Certainly some of them did behave badly, but we have a system that, I think, has developed over many years that works pretty well. Now these are — so, brokers and dealers are people who work with the exchanges, but I want to go on to talk about the exchanges themselves on which these people trade.

Chapter 2. Exchanges in the United States [00:15:11]

This is, unfortunately, a difficult topic to keep up with because the exchanges are changing every year. I think a big impetus for change is the advance of information technology. I might say also, financial technology. This is a world in rapid change; it’s not fixed at all. I wanted to just talk about different kinds of exchanges that we have. Traditionally, we say there are — in the U.S., there are four markets. One of them is called the first market and this is traditional and that is the New York Stock Exchange. I’m going to come back — it’s now called NYSE-Euronext, but let’s just be traditional for the moment. New York Stock Exchange is the old original stock market and the dominant one, so we call that the first market.

Then there’s the second market and that is NASDAQ and that stands for National Association of Securities Dealers Automatic Quotation System; that was the first electronic exchange. It was founded — the New York Stock Exchange was founded in 1792, NASDAQ was founded in 1971 — very different tradition between the two. I should say, the second market — I have to add that — is the NASDAQ National Market because NASDAQ is divided into two parts; there’s the national market.

The third market, so called third market, is NASDAQ small-cap; small-cap means companies whose capitalization is low. Capitalization, remember, is the price per share times the number of shares, so it’s the value of the whole company. The small caps are treated separately on NASDAQ. Then, there’s the fourth market and that’s beyond the exchanges itself. This is — it’s large institutions trading amongst themselves; it does happen. There’s no law saying you have to go through an exchange. You can just buy and sell whatever. Especially if it’s a very large transaction it can happen that, as part of some deal, institutions will trade shares and they don’t have to go through the market. We really think that these are the most important markets.

Let me — incidentally, these are not the first stock exchanges. The United States did not invent the stock exchange. I think maybe I mentioned this before, but Ulrike Malmondier, who is a professor at Stanford, has researched the Ancient Roman stock exchange and claims to have identified — I think I said this before — but has claimed to identify where in the Roman forum the Roman stockbrokers worked and it was out of a certain temple. You can find the location when you visit Rome now. I think it’s in ruins, but you can find where they traded stocks; it was never very big. Then, some people in Anthrop had the first modern stock exchange — I don’t know, like many centuries ago. Amsterdam was an early — London was an early stock exchange.

So, we came kind of late in the United States to stock exchanges — 1792 is kind of late in the world history. However, I think that the U.S. actually features somewhat prominently in the history of stock exchanges because there was a New York Securities Law — 1811 — which became a model for securities law and which made the stock exchange in New York especially important. The 1811 Securities Law in New York established two important principles. The first one was that anybody can set up a corporation and have it traded on the stock exchange. Anybody who satisfies some criteria specified by the securities regulator, but the criteria did not involve the state legislature convening and giving you permission; it was automatic. Didn’t matter who you were; they would do anybody, but of course there were restrictions. The company may have had certain capital requirements and the like, but it was democratic. Until then, it used to be that in many countries companies would require an act of parliament to be found or the king would have to sign something. Now, it was very clear that it was democratic.

The other thing that the New York Securities Law of 1811 did was make it law that limited liability was always the standard. That is that — limited liability means that you, as a stock market investor, can never be sued for the misdoings of the company you invested in. This was a very fundamental step in securities law because before 1811, while there was some limited liability — the idea was already out there and some companies put limited liability clauses in their charters — it was never so clear as in New York. So, you didn’t want to trade and buy a few shares on some exchange because you had the possibility of getting hit for that; they could come after you. With the New York Securities Law of 1811, the New York Stock Exchange began to really prosper because then it became something that anybody in the world could come in and buy a share there and have no worries — except, you could only lose your money that you put in, nothing more. That turned out to be a very important innovation, which came in the U.S., and accounts, I think, for the importance of New York in finance. It was copied later in the nineteenth century all over Europe — this kind of securities law — but it took a long time.

The New York Stock Exchange was founded in 1792, outdoors under a buttonwood tree. I’ve always wondered, what was a buttonwood tree. I guess some stock exchanges occurred in coffee houses. People used to like coffee, just as they do now, and that’s a good place to trade stocks. You would be at Starbuck’s or something in London probably — the equivalent of Starbuck’s — and it would be a natural place to trade stocks. Actually, the New York Stock Exchange was founded under a buttonwood tree. I looked it up, a buttonwood tree is just a sycamore or American plain tree and we have them — I was wondering — we have them around here; they’re just outside somewhere. I don’t know why they call them buttonwoods; maybe they made buttons out of them — of the wood.

Chapter 3. From Ticker Tapes to ECNs: The Impact of Technology [00:24:02]

The system has gone on now for well over two hundred years but it’s changing because of our technology. It’s one of the themes of my book, New Financial Order, as to how much technology has advanced our financial markets and institutions. There was some — if you look at the number of stocks traded on the London Stock Exchange, say, around 1800, it was just a handful; it was just not very big or not very important. But, it was certain kinds of information technology that really made stock exchanges take off. I’d like to just mention a few of them. One was — we were living in a very primitive world in 1800. People were actually using feather pens — that’s what you would use at that time; also, paper was very expensive in 1800. If you bought a newspaper, if you look at newspapers from 1800, there would be a single sheet, typically, that folded in half — of paper. Why was that? Well, it’s because paper was so expensive, because in 1800 paper had to be made out of scraps of cloth; they didn’t have wood pulp paper and they didn’t have — it had to be made by hand. You’d have people washing the fabric and then laying it on a screen — all by hand — and then rolling it; so, it was too expensive.

We got — in the nineteenth century, we got cheap paper and then we got — I mention that I think it’s important for — we got carbon paper; this came in the nineteenth century, although there were some maybe primitive versions. It allowed you to make copies. The typewriter — that came in in the late nineteenth century, so you could make records much more accurately with — and make copies and it’s important to make copies so that they’re backed up. We had printed forms, although those actually go back to the — in Holland, I think, we traced them back to maybe the 1700s. The idea is having a document with spaces to fill in numbers and then you put it in the typewriter; you’ve got printed up multiple copies of this with carbon paper between them. You type — it’s very accurate; it makes it possible to do business.

We invented filing cabinets in the 1890s; that’s comparatively recently — it’s kind of amazing. Filing cabinets — we have the drawers that come out and you put file folders in; it wasn’t until the 1890s that that came in. Before that you would take documents and tie them up with ribbons and put them on bookshelves. Well, there may have been other systems as well, but we didn’t have the modern filing cabinet. The really important thing was electronic technology. We had the telegraph, which came in by Samuel Morse in — when was that? 1840s? I think I might have it. Samuel Morse graduated from Yale University in 1810 and he patented the telegraph in 1837; so it was 1837. I’ll mention — there’s also a college here. Are you, anyone from Morse College? Yes? Only one, nobody else from Morse? There’s a good number. He did something very important. Incidentally, he lived — his house is 58 Trumbull, which is three blocks from here and if you want to, you can walk over there and see Morse’s house. He used to have inventions parked out on his front lawn, but they’re not there anymore; they’ve taken them in. This was a very important invention because electronic communication instantly — or at the speed of light essentially — is what now underpins our exchange.

The next thing that happened, and that’s a little bit later in the technology, was the ticker machine. It’s not entirely clear who invented it but — because there are various versions — but apparently it was invented by Thomas Edison. This was — he was — this was his first invention. You’ve heard of many inventions from Thomas Edison. Quite remarkable that his first invention was in the area of finance and that was in 1867. How old do you think he was when he invented the ticker machine? He was twenty-three; so that’s just a — those of you who are thinking of your careers, some people get started at a good, young age.

You probably don’t even know what a ticker machine is. Do you know what I’m talking about, a ticker machine? Some of you do anyway. What it was was like a computer printer. I mean. he was just like way ahead of his time. We have these printers — you have one in your room or somewhere — that when electronic signals come to it, it prints out on the paper; well, he invented one in 1867. What it did — remember the telegraph machine that Morse invented was — it required humans on both ends. One person would be tapping on the Morse Code on one end and there would be another person listening on the other end who would transcribe it by hand. So, Edison thought, well there’s no reason why it shouldn’t be done mechanically at the receiving end, so he invented a sort of automatic typewriter that printed out. The initial application of it was to stocks because that was — that’s the kind of information people needed continually on a big basis.

He invented this printer and it’s a little different from modern — we have a standard paper size now, which is 8.5” x 11”, but he didn’t want to use all that. Remember, paper was more expensive then and he didn’t need to get a lot, so he changed the shape of it. So, the paper, instead of being that wide, was like that wide because all he had to put was symbols for stocks — abbreviations for their names — and then the price at which it traded. He wanted to get a lot of these in rapid succession out, so he didn’t need a wide width. It’s all very logical. It was basically a computer printer with a narrow width.

I forgot to bring it today; I should have. I was telling someone at the New York Stock Exchange that I was telling my students about the ticker machine and students didn’t — my students didn’t seem to know anything about it. Then he sent me as a gift a ticker tape; it was just a roll of paper tape. They were using ticker tapes at the New York Stock Exchange until 1964, I think it was, and he said, well we still have some in the attic and he gave me a roll. Maybe I’ll try to bring it.

This is just, maybe, a curious history about communications. Do you know what a ticker tape parade is? Some of you — these ticker machines used to be printing out stock prices constantly, so this tape was just constantly running and it would pile up in these huge wads of paper tape. They had to always dispose of it at the brokerages because all this paper tape had to be thrown away and it was a disposal problem. Whenever there was a parade down Wall Street, people would — they would use this ticker tape like confetti and they would tear it up into shorter lengths and they would toss it out the windows and so you’d see all this paper tape coming down. We still — this is all obsolete now, but in a sense it is electronic communication technology that — I guess we’re still wasting a lot of paper; we just changed the width, so we don’t call it tape anymore. We call it printer paper or something like that, so it’s not exactly the same.

The idea that we should have one market — when we have ticker tape machines — we still use the word ticker symbol for the short abbreviation of a stock, so every stock has an abbreviated name. We don’t need abbreviations anymore because our printers are much more effective, but we still have them. That’s the official — the ticker symbol is the official name for a stock or other security that’s traded on an exchange.

When you have electronic communication, it should create a national market that is — where everyone is getting the same price. However, it doesn’t necessarily work automatically. In 1975, people made a number of complaints to our lawmakers in Washington that, in fact, while we have ticker machines and we have a lot of — well actually, they were already gone by ‘75, but there were a lot of electronic communications. But, some people were not always getting the same price. Someone would say, I placed my order in the Philadelphia Stock Exchange and I got a bad price. I realized later I could have traded at some other exchange — nobody told me — at the same time.

So, Congress created — it was The Securities Act of 1975 — wanted to create a national market system. So, Congress mandated that securities brokers set up some kind of electronic system that would allow people to trade on whichever exchange has the best price. It was sort of a challenge to the monopoly of the New York Stock Exchange because your broker — if you place an order with your broker this — we would have a new electronic system. The broker would look over all the different exchanges and see which one had the best price; that’s what you want as a customer. It was implemented with something called the ITS — Intermarket Trading System — which allows a broker to look over all the exchanges to find the best price. That was set up with computers in 19 — or in the early ’70s — 1975 or shortly after 1975. It’s been in place ever since; however, because it was mandated by Congress, the computer system was up to date and modern in the early ’70s or late ’70s, but it hasn’t kept up and it’s considered slow, as a sort of dinosaur, and people want to avoid trading in it.

In 2006, all the major exchanges proposed that we replace the ITS with something called NMS linkage, which is just a more modern version of the computer technology, but I haven’t heard anything about it being implemented. Again, since I don’t trade — maybe some of you know what’s happened with NMS linkage system. Let me put this — NMS linkage was proposed, but you see what’s happening. [The NMS Linkage plan was activated and replaced the ITS in June 2007] When the government tries to mandate a linking of exchanges, that’s not the same thing as having a market impetus for linking of exchanges, so what’s actually happened is really ignoring the national market system.

Computer technology has advanced so rapidly it starts to create opportunities for people to set up their own competing systems and who cares about the ITS, which is a dinosaur, which nobody likes. That’s something we have to recognize — that there are different approaches and there are going to be clever people who come up with new ideas about how to trade stocks. This brings us to the so called ECNs. They were called electronic communications networks and what happened was with the advent of the Internet — in the mid-1990s, people started setting up websites that looked like stock exchanges, but maybe they weren’t. I guess the first one was Instinet — I’m not sure it’s the absolute first one, but Instinet was — now, understand that an exchange has to register with the SEC. The SEC has all kinds of requirements, and if you’re setting up some website, you probably can’t satisfy all those requirements.

So, Instinet set up an electronic bulletin board, I called it, which was not an exchange but it was a place where people interested in buying and selling shares could post their interest. It was like an electronic bulletin board, so it would be especially important for people who are placing really big orders because they might want to not just put it on the floor of the exchange. But to — they might want to say something on the thing about under what conditions I would buy this or something like that. It became more flexible and became very popular among institutional traders.

Then there was a number of other — now the SEC allowed them to function as ECNs, which is a separate category, and they started to look like exchanges. I guess the legal history of these is very complicated. They ended up merging with exchanges; this is in the 1990s and early 2000s. I remember one that impressed me because I had heard in the ’90s a talk from the founder; Island was an exchange that was created — can you see this? — that was created for small investors. It actually started to look a lot like an exchange. What I found interesting about Island — the person I heard speak about it in the ’90s spoke of this as democratizing institutions. It was the Web culture taking over what the stock exchanges had done. What Island did was it posted its limited, so called, “order book” on the Web to the whole world to see and it was kind of challenging stock exchanges, which had kept the order books more or less in secrecy.

Chapter 4. Action on the “Floor” of the Stock Exchange [00:42:12]

Let me just step back and let’s go back to what happens on an exchange and how Instinet and Island are different. There was another one — another big one was called Archipelago — that sounds like Island. It was another website that you used to be able to get on and you could read these order books for any stock and you’d see some — let’s step back and talk about what’s goes on traditionally at the New York Stock Exchange and still goes on today. The New York Stock Exchange is the biggest stock exchange in the U.S., but also in some ways the most-old fashioned. They still have a floor, a trading floor. Most stock exchanges have abolished their trading floor. I just gave a talk in Moscow at their stock exchange and I was mentioning something about trading floors and someone raised his had in the audience and says, you’re talking at the Russian Stock Exchange trading floor; that’s where my talk was. I didn’t even know I was in it. I was in the German Frankfurt Stock Exchange and I was — they said, I’ll show you our trading floor. So, I walk in and I just see a bunch of school children and they had — there was nobody there except school children. It had turned into a museum. That’s what’s happening all over the world because everything is going electronic. The New York Stock Exchange, and the Toronto Stock Exchange, and the American Stock Exchange are the few — or is it the Montreal, I forget now — anyway, there are very few that still do it this way. [The Toronto Stock Exchange replaced its trading floor with an electronic system in 1997 — the Montreal Exchange has also augmented its trading with its SOLA platform introduced in 2005.] We still have a floor [at the New York Stock Exchange].

So, you have, for each stock, you have a specialist who stands at a post on the floor of the exchange; so each stock has a specialist. Then you have traders who roam around the floor and go to — these are brokers or dealers who are trying to buy and sell stocks and they go to the various posts and make their rounds. They have so many stocks they want to buy and so many they want to sell and they go around on the floor of the exchange. If they want to buy a particular company, they go to — they know where that specialist is and they go there. On the floor of the exchange, they can either buy and sell from the specialist, who is a dealer, who maintains an inventory, or they can buy and sell from anybody else they meet at the post. Of course, everyone there is licensed; it’s not open to the public.

What happens is, there is a crowd that develops at each specialist’s post and the crowd consists of people who decided to go to that specialist’s post to look at what they want to possibly buy or sell. They can buy or sell from anyone. The specialist is sometimes just standing there watching and it’s all happening. The specialist — and the New York Stock Exchange maintains — that the specialist fulfills an important function, which is to create an orderly market; so, the specialist has a responsibility as well as an opportunity. The other people at the crowd are just doing their own business, but the specialist is supposed to be obligated to preserve a good market. If for some reason the price is dropping rapidly and the specialist thinks something’s wrong, the specialist is supposed to come in and buy on his or her own account; that’s an obligation. There have been problems. For example, in 1987, when the stock market dropped precipitously, there were criticisms of the specialists for not buying to support the market. But then, specialists said in their own defense, what could we do? The market is crashing. So, it’s not clear that specialists make a huge difference, but that’s the presumed advantage.

Now it used to be — this is an interesting historical thing — that before the 1930s there were two crowds on the stock exchange. There was the buy/sell crowd and there was another part of the floor — I can’t find this in my notes — where stocks would be rented. I had the dates here and I don’t remember. I can’t find it in my notes. [Charles Jones and Owen Lamont report in their study of the loan crowd that data on their trades was published in the Wall Street Journal from 1919 to 1933.] Well anyway, shares are — it’s called the loan crowd. There used to be a special part of the floor of the New York Stock Exchange where stocks would be lent rather than sold. There are two things you can do; there are two kinds of trade. You go to a real estate broker — you can say, I want to buy a house or you can say, I want to rent a house. The broker can do both of those for you. Same thing with stocks — you can say, I want to buy a stock or you can say, I want to rent a stock. Or you can go the other way — I want to sell a stock and I’d like to rent out my stock.

Why would anyone want to rent a stock? Well, that’s called short sales. They would rent a stock and sell it. It used to be that — of course, if you’re lending out a stock, you might demand some compensation for that. They used to argue — there would be a specialist crowd called the — there would be a loan crowd that would argue about the rental cost, which is an interest cost for borrowing a security. The Wall Street Journal used to publish — there were two stock sections; there was the price section and there was the loan section. That, however, disappeared after the stock market crash of 1929. Apparently, it disappeared because of concern that shorting stocks was the cause of the 1929 crash.

The story was that J. Edgar Hoover, who was head of the F.B.I., thought that shorting stocks had caused the Crash and he didn’t like it. If J. Edgar Hoover didn’t like what you were doing back then, you were afraid and worried. So, the New York Stock Exchange, without ever publishing it, just shut the whole thing down and to this day, we don’t have a loan crowd anymore. We do still lend out shares, but it’s not done on the floor of the exchange.

Anyway, the specialist at the floor of the exchange has a book and it used to be a big thick paper book. What the specialist would do — the specialist would record in the book offers and bids — bid and asked prices. There would be people who would tell the specialist that I want to sell so many shares at such a price or buy so many shares at such a price and the book would show the list of orders that were outstanding. Now, this comes back to — I should clarify kinds of orders. When you call up a broker and say, I would like to buy or sell shares, there’s different — you can give — you’re giving your broker an order. You can give the broker a market order. If you give a market order to your broker, you’re saying you only have to give the broker one number, which is a number of shares. So, I can have a buy order or a sell order — market order. If it’s a buy order, all I do is say, I want you to buy for me, let’s say, 1,000 shares of this company at whatever price is out there; just get the best price you can, but execute it right now. It only gives a number of shares.

Another kind of order, however, is a limit order. With this order you have to tell the broker both the number of shares and the price. There’s either a buy or a sell, so if it’s a buy limit order, you want to say, I want you to buy the stock at any price up to the one I mentioned. So, I would give — I would say, 1,000 shares at $30 a share and that means that if it’s a buy order, you wait until — you don’t execute it immediately. You execute it when the price falls below $30. A person would do this who thinks, I think the stock is a good buy at $30, but not where it’s trading now at $35. So, I just put — and just tell my broker, I want you to take this limit order and I don’t expect you to fill this order. Maybe you’ll never fill it, but I just want it to be there until I correct it. You’re just supposed to be standing ready and you’re supposed to notice when the price falls below $30 and then you buy.

If it was a sell limit order you would say, I want you to sell it if the price gets up to $40. Again, if it’s above the current market price, it won’t be executed now; it might never be executed. Then there’s another kind of order called a stop-loss order. With a stop-loss order, like a limit order, you have to both give a quantity and a price to your broker when you place the order. It’s similar to a — it’s in a different — a stop — a sell — you could have the same numbers here; you could say 1,000 and $30 again, but it would have a different meaning. A stop-loss order says to sell when the price hits $30. In this case, if it were a stop loss order for 1,000 shares at $30 it would be to sell — if the price today is $35 — not buy.

It’s a different motivation — that you would do a stop-loss order. You see the difference? If it’s a limit order, I’m saying I think the stock is only worth $30; I want to buy it when it gets down to $30. With a stop-loss order, if the actual price today is $35 a share, I’m saying, I’m worried about the stock crashing on me, so I want you to get me out if it’s crashing. The broker has to know, well when do I get you out? Well, you have to say when, so this is when. So, you’d be telling, if it’s a sell order, you would be telling your broker, sell the stock if the price falls below $30. There’s a fundamental difference between a limit order and a stop-loss order.

There’s also a buy-stop order. You could tell your broker, I want you to buy the stock if the price rises above $40. Now, why would someone do that? Why would you tell — have an order to buy the stock only if it gets expensive? Well, the people who would do that are people who have shorted the stock. If you’ve shorted the stock and the stock price starts going up, you’re potentially in big trouble. So, if you worry about that, then you can say a buy-stop order and place that with your broker.

What Island did — I’m going back to — the brokers used to have all these orders — well, the market orders wouldn’t end up on their book because it would just be executed immediately and it would be gone. These limit orders and stop-loss orders would be on the book of the broker and the broker would then know — the specialist at the exchange would have this book, which recorded customers’ orders. So, the specialist would understand the market because it would have a whole bunch of these orders on the books. The nice thing about Island, when it became part of our Web culture in the 1970s, is they created their own book on the Web, so you could get — you could actually — it was open to everyone. You’d have the — you would have buy orders and sell orders and this would be something you could see on the Web. Actually, you can see things like this on the Web now too, but not through Island anymore.

Let’s say this is some company, let’s say it’s IBM, and you would see something like this. It would be — the buy orders would — it would be — the first one would say for $90 a share, 100 shares. Someone’s willing to buy 100 shares at $90 and over here you would see something like, someone is willing to sell at $92, let’s say 200 shares. There’s no trade here, right? If somebody is willing to buy at 90 and someone else is willing to buy at $92 there’s no trade. Then you’ll see other orders; somebody else is willing to buy at 89 1/2, say 200 shares, and you see these descending. I’m just making up numbers — $88 for 1,000 shares and so on. On sell, we then see other people, someone who’s going at 92 1/4 for 300 shares. I’m showing all the purchases in round lots; a round lot is 100 shares. You could also have odd lots, but most of the time people put round lots on as a trade. This book would then sit there; there’s no trade here. This is the inside spread. That is the — on the limit order book, those are the trades that are closest to execution, but it’s not an executable trade yet.

What would happen then — and it was as you would watch the book — and since it’s now electronic, it corrects itself quickly. I don’t know what the specialist had to do with a feather pen. Originally, they would have to cross these things out with ink and the book was probably hard to maintain, but now it’s all automatic. Suppose someone comes in with a buy order for 100 at 90 and a sell order for 100 at 90, so someone’s willing to sell at a lower price. What happens immediately on this — this thing becomes executed and disappears, so you see that happening on the book. It’s fun to watch an electronic book. This is what brokers see who are members of NASDAQ and they see the electronic trading system. Of course, there are many such books now that are available. The dealer — the specialist on the exchange also has his own — his or her own — bid-asked spread, which is also an offer to buy or sell on the exchange.

Incidentally, Island would only allow one kind of order, at least originally. It was only limit orders because they didn’t — they had a system where you had to put it onto their book and everything had to appear on the book, so it was just a limit order book originally. The history of this — I guess one thing I wanted to — what I was leading up to is that the ECNs are history now. They’ve been generally merged and acquired. Notably, the New York Stock Exchange, which has been the holdout doing floor trading, bought Archipelago because Archipelago was growing so fast doing this kind of electronic trading; it was really catching on. New York Stock Exchange began to worry that it was starting to get behind the times.

The New York Stock — these things, which were started by kids — young college students in the late ’90s — just grew so fast and they got so big that Archipelago was starting to look like it was going to get bigger than New York Stock Exchange. So, finally New York Stock Exchange merged with them and they changed the name after 200 years in business. They changed the name to NYSE Archa — Archa is short for Archipelago Exchange. That didn’t last long; they changed their name again. They just merged — New York Stock Exchange merged with the European Stock Exchange, Euronext, and so now it’s called NYSE Euronext. Everything happened so fast and it seems fast to me. The New York Stock Exchange is in the process, we think, of merging with the American Stock Exchange and that’s happening right now. [NYSE Euronext announced on January 17, 2008 a “definitive agreement” to acquire the AMEX.]

Chapter 5. The Dealer’s Life and the Gambler’s Ruin Problem [01:01:46]

I wanted to just finish with just a little bit of a thought about what it means to be a dealer in this market. What is it that if you are a dealer operating on one of these exchanges, you are placing orders, effectively, in somebody’s book and standing ready to buy or sell. A dealer is someone who is trading everyday, who has an inventory of stocks for trading. I want to just maybe close with a little thought about what it’s like to be a dealer.

I’ve never been a dealer and I don’t know the emotional thing, but the problem with being a dealer of any kind — maybe it takes a certain moral stamina, mental stamina, to do this kind of thing — is that you’re trading everyday. You’re not someone who’s managing the Yale portfolio. What you’re trying to do is make money everyday by buying low and selling high and you have to be ready to stand — ready to take orders — because people come to you. Someone will come to you or there will be someone in a specialist’s crowd who wants to place an order or buy or sell and you have an inventory. You’re like an antiques dealer and one problem is that your life’s work, unfortunately, as a dealer is summarized by your portfolio and your inventory. That’s why I didn’t become a dealer, actually. I don’t — I guess you have to have the right stomach of steel or something. The thing that I wanted to impress on you is that no matter how well you do, your cumulative score is there in your portfolio and it’s a competitive business. So, you run the risk of being ruined at any time in your life.

This just — I want to remind you of what’s called the gambler’s ruin problem because being a dealer is a little bit like being someone who goes to the gambling casino everyday. If you enjoy your visit to the gambling casino, maybe you want to be a dealer. Actually, I don’t really enjoy it, so I’m just not the right person to do this. What I really wouldn’t like about it is that you always stand the chance of being ruined — that is, losing everything. So, I just want to review. This is a little bit of mathematics that is in market microstructure theory.

Suppose you’re a dealer and you have a way of either winning or losing money on each transaction. Suppose the probability of winning on a transaction is equal to p — that’s the probability of winning on one of your trades. To simplify this thing, let’s say that you either win or lose. If you win, you get $1; if you lose, you lose $1. So, you win $1 with probability p and you lose $1 with probability 1 - p. I want to know, what is your life career going to look like if you’re just doing this everyday for the next thirty years? Well, the first question is, what is the probability of your being ruined? Let’s start with the case p = ½ and let’s not say — thirty years is close enough to infinity, but let’s just say you’re going to do this forever because I don’t want to have to figure out the effect of the last day.

What do you think is the probability of being — remember, being ruined means having your inventory fall to zero. You start with S dollars — that’s capital S dollars — which is an integer. When S falls to zero, you are “ruined;” you don’t have any money left; you’re out of the game; and you will be dismissed from the exchange. If you can’t trade anymore, you don’t have anything. You have to start with something, otherwise you can’t trade at all. So, S is something like $100. If p as a point — do any of you know the answer? What’s the probability that I will eventually be ruined? This isn’t something that you got in your probability theory? You got it right — that’s right, it’s 100%. You will with certainty be ruined. In fact, the probability of ruin is ((1 - p)/p)^S, if p is greater than .5 or greater than-equal to .5. That’s because, if you substitute in .5, this is 1, so, the probability of ruin is 1.

If it’s — if the probability is greater than .5, then the probability of ruin will be something less than 1. This is actually easy to derive because — think of it this way — we’ll call this the probability of ruin, if you have S dollars. The reason it has this is because if I start with s dollars, there are two possibilities: either gain $1 or lose $1. So, this probability of S has to equal p x Pr(S + 1) + (1 - p ) x Pr(S – 1). That is the probability — this is the probability of ruin if you have S + $1 and this is the probability of ruin if you have S - $1. So, the function determining probability of S has to satisfy this equation.

Also, we have the restraint — the probability of ruin if you have zero dollars is 1, so this is a difference equation. If you solve it, you get this. What it means is that you had better have a probability of winning substantially above $1 or else have an awful lot of dollars to start with. Unfortunately, it’s hard to get the probability of winning in any one trade much up above ½ because you’re living in a competitive marketplace. So, if p is close to ½, it’s just a little bit above ½, then you will be standing for your whole life, always with a probability that the rest of my life is going to end up in ruin. So, you may have been very successful and you now have S = 1000, but the probability keeps going down, but it never hits zero.

Student: A gambler can take money off the table.

Professor Robert Shiller: Well, that’s what you have — that’s what people do.

Student: I think you’re saying that the specialist — the first few [inaudible].

Professor Robert Shiller: Well, they are taking money off the — maybe because they are doing that. You live your life and you take money off. Yeah, you’re right; I don’t have to play it out to the bitter end like this. I wanted to show — this is actually — this mathematical model is something that you will find in the Page 1 or Chapter 1 of a market microstructure textbook because you’re right; there are strategies that can prevent ruin like that. This is the basic — this is just — I’m presenting this as a very simple model of what underlies the restriction on a broker. A broker has to maintain — create a strategy such that this p is sufficiently probable — that this ruin problem doesn’t become catastrophic. The way they do that, they set the bid-asked spread that a dealer has with consideration of this ruin problem, which has to be the focal point of their attention. They have to set the bid-asked spread wide enough so that they feel comfortable enough with this probability of ruin. If you don’t — of course, it’s a competitive market and so you can’t get this probability up too high.

So, if you don’t like this, don’t become a dealer; that’s the way it is. The people who are in this business are people who can tolerate this prospect of ruin. On the other hand, ruin isn’t death; that’s another thing you were saying. I can make a living doing this for a while and I am taking money out and that’s part of the strategy. Maybe I’m just being too much of an academic here. I live in great comfort in academia and these beautiful surroundings. This university has been around for 300 years; I have no worries. So, you might want to consider an academic career instead of a career in finance. I hope to see you again then on Friday. I think we’ll have a good time with Schwarzman.

[end of transcript]

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