ECON 252: Financial Markets (2011)

Lecture 21

 - Exchanges, Brokers, Dealers, Clearinghouses


As the starting point for this lecture, Professor Shiller contrasts the view of economics as the theory of the allocation of scarce resources with the view of economics as the study of exchange. After a discussion of the difference between brokers and dealers, he outlines the history of securities exchanges from ancient Rome, to the Amsterdam Stock Exchange and Jonathan’s Coffee House in London, until the formation of the New York Stock Exchange. He complements this historic account with an overview of securities exchanges all over the world, covering India, China, Brazil, and Mexico. An example of a limit order book allows him to elaborate on the mechanics of trading at the National Association of Securities Dealers Automatic Quotation System (NASDAQ). Subsequently, he turns his attention to the growing importance of program trading and high frequency trading, but also discusses their impact on the stock market crash from October 19, 1987, as well as on the Flash Crash from May 6, 2010. When talking about fairness in financial markets, particularly with regard to the relation between private investors and brokers, he discusses the National Market System (NMS), the Intermarket Trading System (ITS), and consolidated quotation systems. He concludes this lecture with some reflections on the operations of dealers, addressing the role of inside information and the Gambler’s Ruin problem.

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Financial Markets (2011)

ECON 252 (2011) - Lecture 21 - Exchanges, Brokers, Dealers, Clearinghouses

Chapter 1. Exchange as the Key Component of Economic Activity [00:00:00]

Professor Robert Shiller: Well, today I wanted to talk about exchanges and clearinghouses, primarily stock exchanges. So, these are places, where shares in corporations are traded. And I think, it’s good to devote a whole session to them, because exchange is central to economics.

In fact, I was struck recently. I was re-reading the presidential address of my old teacher. When I was an undergraduate at University of Michigan, I took a course by Professor Kenneth Boulding. I suppose, I’m influenced by him. When he was elected president of the American Economic Association, he gave a talk about economics.

And he had an interesting definition of economics. What is economics? There’s a lot of definitions given for the field, but one definition is the theory of the allocation of scarce resources. That’s, by some definition, what the essence of economics is. But Boulding said, that doesn’t sound right to him, because political science is about the allocation of scarce resources, and so is–even the family is an instrument of scarce resources. So, Boulding said in–it was his 1969 presidential address–that economics is the study of exchange. Obviously, it’s prices and quantities that economics emphasizes, and those are parameters of an exchange. So let’s say, that equals economics.

I’m reminded of another book. I’m talking in very general terms first, and then I’m going to focus in on stock exchanges. But I’m reminded of another really important book, which I read so many years ago, by Karl Polanyi called The Great Transformation. And that was written in 1944. What is the great transformation? Well, for Polanyi, it’s the invention of exchange. He said, what is the most important invention of man? Maybe, it’s exchange.

According to his history of humankind, this was a relatively recent invention, Neolithic or more recent than that. He argues that in primitive societies, there is really no arm’s length exchange. An arm’s length exchange is one, where you just quote a price and a quantity, and you don’t have any other business. The price and the quantity sum it up. It’s a business transaction. But Polanyi argued, that until just something on the order of 10,000 years ago, there were no business transactions. There was only gift exchange. There were relationships people had. And you would solidify a relationship by making a gift to someone else, and then that person would later reciprocate, but there’s no price, there’s no exchange.

So, he claims that the development of our civilization is really the result of the development of the idea of exchange, and then, an amplification of the idea as it became more and more pervasive.

By the way, I’ve since learned–I thought Polanyi was very impressive–but some anthropologists question, whether there wasn’t exchange more than 10,000 years ago. And they cite evidence. One kind of evidence that’s found of this is that certain commodities, even in the Paleolithic times, certain commodities are found far from where they were mined. Like flint to make stone tools, or ochre to make body paint. And they figured out where–you can do a chemical analysis and you can figure out where it was mined. And then, if you find that it arrived somewhere 1,000 miles away, there must have been exchange, right? The cave–no?

Student: Couldn’t they have just killed someone?

Professor Robert Shiller: OK. It could have been, that they just killed someone, right. So, I guess nobody knows.

But anyway, some anthropologists argue that there was exchange. Maybe, it was too pervasive. Of course, people did kill a lot of people in those days, too, anthropologists report.

So, maybe Polanyi had it exactly right. But I think, he had it at least approximately right, that exchange has become a bigger and bigger part of our lives, and that’s modern civilization.

Chapter 2. Brokers vs. Dealers [00:05:50]

I’m going to talk mostly about financial exchange. That’s the subject of this course. But I can be a little bit more general. I wanted to start by distinguishing a broker and a dealer. What’s the difference? It’s a fundamental thing. A broker–actually, I’ve got this almost as a slogan–a broker acts on behalf of others as an agent to earn a commission. So, it’s for others, trades for others as an agent for a commission. A commission is a fee. What is a dealer? A dealer trades for himself or herself, acting as a principal, not an agent, and profits from a markup.

So, I can give you an example of each. When you buy or sell a house, do you get a real estate broker or a real estate dealer? That’s almost obvious, right? Because you heard the term real estate broker so many times. When you buy or sell a house, you commission a broker, and you agree on a contract that pays the real estate broker a certain sum of money–maybe 6% of the value of the house–if a buyer is found. And then, the broker doesn’t buy your house, right? So, the broker is an agent. And the 6% is the commission that the broker gets, if he or she is successful in finding the other side of the deal.

What’s an example of a dealer? An antique dealer, right? Suppose, you’re buying a chest of drawers for your apartment. You go to an antique store, and there’s someone there–your antique dealer–who has furniture, that he now owns, having bought it, and makes a profit by selling it to you at a higher price, namely with a markup. He marks up the price that he paid for the item.

But let me just ask you, why is it that way? Why are antiques sold by dealers and real estate by brokers? I recently had a discussion with Guillermo Ordoñez, who is an assistant professor here, and we were wondering, maybe there are real estate dealers. Oliver helped us and found, actually, in Germany, a couple of real estate dealers. But only like a couple, and we couldn’t find any in the U.S. And we had searched around in many other countries, and there was just virtually none, no real estate dealers.

Anyone have any idea why? I’m asking you to think. It’s a little–or does anyone come from a country, where they have real estate dealers? And that would end it, if you–I bet not, right?

Well, what about antique brokers? Why not that? Have you ever heard of an antique broker? Maybe, there are.

But it’s an interesting question. It seems like some markets are naturally dealer markets, and some are broker markets. We thought of one explanation, why there aren’t real estate dealers, at least in the United States. We learned that a dealer has to pay income tax on the profits from a deal, and that is at a higher rate than a capital gains tax, and so that closes people out. You wouldn’t want to be a real estate dealer, because you end up paying a higher tax.

The other thing is, I wonder if there’s something about information, that someone who deals in real estate–it’s just too hard to know what to pay for a house. It’s so subjective. You could make big mistakes, if you’re going to buy houses, and then resell them at a markup, because the market is just so variable, and it ultimately changes quickly. Maybe it’s too risky. I don’t know. I’m trying to think. But of course, there are real estate dealers, just very rare.

So, we’re going to talk about stock markets. Which do you think stock markets are? Are they dealer markets or broker markets? Well, the answer is both. And now it’s not as clear, and I’ll come back to this. The New York Stock Exchange, New York Stock Exchange in New York is a broker market. Or they would say, an auction market. It’s a continuous double auction market, where a broker facilitates the trades. The NASDAQ market is a dealer market. So, you pay commissions to your broker at the New York Stock Exchange, you pay a markup to your dealer at the NASDAQ.


Chapter 3. History of Stock Exchanges around the World [00:12:25]

Professor Robert Shiller: I thought I will start by talking about stock exchanges, and historically–and I have a lot to say. I can’t cover it all, I was going to start with ancient Rome, I think I mentioned that before. But the–I’m getting there in my notes–the ancient Roman stock exchange is the first stock exchange, that, I think, anyone knows about. But traders–I’m relying on the research of Ulrike Malmendier, who has studied the ancient Roman stock exchanges much as can be studied. There’s not that much evidence about it.

But the traders met outdoors on the Roman Forum at the Temple of Castor. That’s where you went to buy and sell shares. The shares in Latin were called partes–I don’t know if I covered this or not–and the companies were called publicani. The peculiar nature of the ancient Roman corporations is that they sold–their customers were the government. And so, they did services for the government, like provide horses for the army, or they would feed the geese on the Roman forum, on the Roman capital. They always fed the geese there, because the geese were hallowed in Ancient Rome, because they once warned of an invasion by cackling. So, there was a publicanus that was in charge of feeding the geese. And also, they would talk about share prices. It’s known, that they would go up and down, even then, but there’s no data on their share prices.

It seemed that there was a long gap for stock exchanges after the fall of the Roman Empire, and the publicani disappeared. And there was a wide variety of financial arrangements, some of them resembling corporations. But the advent of the rebirth of the stock exchange didn’t occur until 1602 in Amsterdam, when the–I mentioned this before–when the Dutch East India Company started trading.

And then, Jonathan’s Coffee House–I like that story–in London. Lots of people would get together and talk there, and coffee houses became a big thing in the late 1600s. And somebody started posting stock prices on the wall at Jonathan’s Coffee House by–what was the date–1698. And so, the London Stock Exchange grew out of Jonathan’s Coffee House.

And then, moving forward in time, now we’re going to get lots of countries, but I’ll mention the New York Stock Exchange. The traders of shares in the United States met outside, in 1792, under a buttonwood tree. I’ll put buttonwood, it’s a curious name. I think that’s just a common tree that we still have around. And they signed the agreement to form the New York Stock Exchange.

What else? Next, in my little history. India. By the 1850s, there were in Mumbai–or then called Bombay–there were traders under a famous banyan tree. They’re all outdoors. In Bombay. Banyan trees are more impressive than buttonwood trees. But it was by 1875, the Bombay Stock Exchange was founded. So, that’s the BFC. So, that’s been around for over 100 years.

But things have happened more recently. One thing that’s been shaking things up–these are very venerable old institutions–what’s been shaking things up is the advent of electronic trading. And these were kind of old-fashioned, venerable institution. Do you know what happens at the New York Stock Exchange, what happened then and still happens today? There’s a floor called the trading floor, and the various brokers meet there, just like in Jonathan’s Coffee House. They actually physically come to the floor and they stand around, and there are posts for each stock. And if today you think, you have a customer who wants to buy IBM stock, then you go over to the IBM crowd, and there’s a crowd of brokers there who are trading. And you just do it, verbally. You talk to them and you make a trade. That’s really old-fashioned. There is something more electronic and more modern about the New York Stock Exchange, but that specialist post behavior still persists.

Most of the world is switching over to electronic trading, and so things happen that–so, for example, in India they developed another stock exchange called the National Stock Exchange, and that was in 1992. And the National Stock Exchange was all-electronic, and so it was the modern version. It’s rapidly gaining on the Bombay Stock Exchange.

So, let me go a little bit more forward. China, because of the communist government, did not have a stock exchange until 1990. And there were two stock exchanges founded in China in 1990–Shanghai, Shenzhen. And at least the Shanghai Stock Exchange is owned by the Chinese government, and that’s why Laura Cha, when she talked to us about that–she was on the China Securities Regulatory Commission, which actually owned the Shanghai Stock Exchange.

Oh, Latin America. Sao Paolo Stock Exchange, 1890. Mexico has only one stock exchange, but it was founded in 1894. So, we seem to have like two different kinds of exchanges. We have the old exchanges, which are at least 100 years old, and we have the new electronic exchanges. Things have really sped up with the advent of electronic exchanges.

So, I mentioned the New York Stock Exchange, which started on the street outdoors and is an old-fashioned exchange that has been slow to update. But more recently, we have–I mentioned it already–NASDAQ. It stands for, originally, National Association of Securities Dealers Automatic Quotation System, which was created in the 1970s.

The interesting story about NASDAQ. In the ’70s, the New York Stock Exchange with highly prestigious. It was the big board, the place. And a critical element of as stock exchange is, that, in order to get your stocks traded on the exchange, you have to satisfy listing requirements. So, the New York Stock Exchange would examine any corporation that wanted to be listed on the exchange, and it was the prestigious, big exchange, so it had high standards. So, the company had to have a history of earnings, it had to have the right kind of management structure and board. A lot of things were checked out by the exchange, and as a result, the way it would work in the 1970s, a startup company could never get traded on the New York Stock Exchange. It would be traded, instead, by brokers off-exchange, or over-the-counter. So, OTC means over-the-counter, that means not on an exchange.

So, in the 1970s and earlier, the over-the-counter brokers would deal with each other, informally with telephone call, or actually out on the street. Meet each other out on the sidewalk originally, and then they got telephones. And they had some record, which they called pink sheets, because they were traditionally printed on pink paper. These were lists of dealers’ buy and sell quotes on prices of over-the-counter stocks.

The National Association of Securities Dealers, then, was an organization of these over-the-counter traders. And in the early ’70s, they set up the first computerized system. They decided that everyone’s telephoning everybody–let’s create a system that really works and that gets us the information. And so, that was the NASDAQ system, the first computer based system, which has now increasingly taken over much of the world.

I shouldn’t imply that the New York Stock Exchange was entirely a laggard on this. Electronics played a role in stocks going back very early. The New York Stock Exchange used telegraph in the 19th century to convey prices, and they invented ticker tape machines. A ticker tape machine is an electronic printer that would print out stock prices. And in fact, Thomas Edison, the inventor, his first invention was actually a ticker tape machine. That was in, I think, the 1870s. It printed stock prices. But all it was, was a record of what had traded recently. It wasn’t a system that helped you trade. You just reported what had happened, it was historical.

Chapter 4. Market Orders, Limit Orders, and Stop Orders [00:24:28]

So, I wanted to show you, what NASDAQ created in the ’70s, and it’s a order book, that would be visible to everyone who trades on it. Prior to discussing that, I want to tell you about different kinds of orders. If you buy and sell stock, and you call up a broker and you say, I want to buy and sell, the simplest kind of order is a market order. And you would specify the quantity. You would say, I want to buy–and the name of the company, of course–I want to buy 100 shares of General Motors, or I want to sell 100 shares. But you don’t name a price. You’ll find out, whatever the price was.

The broker will get you the best price–if he or she is a good broker, will try to get you the best price–but it’ll still be unknown to you, because you didn’t specify it. You might be unhappy with the price, OK? The price might be too high [addition: if you want to buy shares]. And then, the broker will say to you, well, if you’re unhappy, you should’ve told me. You could have told me not to pay more than a certain amount for a buy, or not to take less than a certain amount for a sell.

So, the alternative is a limit order. And so, with a limit order you give both quantity and price. So, if it’s a buy, I want to buy so many shares but I don’t want to pay more than such-and-such a price. Then, the broker will keep that on his or her books, until–well, whatever the agreement between you and broker is. It might expire after the day is over, or you could ask to have it kept on the book. And when the price becomes available, which is no higher than your specified price, then the order will be executed. Otherwise, it won’t be executed. And then, for a sell order, it would be the same thing. You specify both the quantity and a price, and the order will be filled or partly filled. Might not be able to get all of your quantity, but they’ll fill as much as they can of it at that price or lower.

And there’s another kind of order, called a stop order. With a stop order, you also specify quantity and price, but it’s different. With a limit order, say it’s a buy limit–well, let’s talk about sell. If it’s a sell limit order, you would sell the quantity at such-and-such a price or higher. With a stop order, you would sell that quantity at such-and-such a price or lower. Let’s make that clear. A stop order, also called a stop loss order, is an order that you can place with a broker to indicate that I’m worried that this stock might really collapse. I’m holding it, but I want you to sell it, if the price starts falling a lot. So, suppose the price is 100 today, I could put in a stop loss order at 80, and then, at least I know I can’t lose more than 20% of my investment, because the broker will immediately sell it when the price of that stock falls below 80.

There’s also a buy stop order, and that would be something that someone would rationally do, if that person had shorted a stock. So, if you had shorted a stock, and you were worried that the price would go up and ruin you, you can leave with your broker a buy stop order to sell it–I mean, to buy the stock, whenever the price exceeds a certain amount. And you would do that to prevent yourself from having unlimited losses on your short position. There’s other kinds of orders, but those are the main kinds of orders.

Now, I wanted talk quickly about limit orders–that’s the most important kind. A lot of advisors say, never place a market order. Why should you ever do a market order? There’s always some price that you’d be unhappy with. You might as well say that. And so, some exchanges don’t even allow market orders.

So, let’s talk about limit orders. And what I wanted to show you was, what a NASDAQ level II customer sees. NASDAQ is an organization–now it’s a firm traded on its own stock exchange, it’s called NASDAQ OMX–but if you want to subscribe to NASDAQ, it’s very expensive, I understand. So, you can subscribe at level I or level II, which is more expensive. I was going to show you an example of what you would see on your computer screen, if you subscribe to NASDAQ level II, for a particular stock.

So, this is a hypothetical limit order book for Microsoft. What it shows–this is not live, but it would be live on your screen, and these numbers would be changing before your eyes, flashing back and forth before your eyes. And so, I’ve just frozen it at a moment in time. So, what do we have? We have six columns here. This first column is the shares that people want to buy. So, the first three columns correspond to those. So, ”bid” is the price there, bidding to buy these shares, OK?

Remember, NASDAQ is a dealer market. So, these dealers are making these bids, or people are making them through a dealer, and MPID is the marketplace ID, where these bids and offers are being made.

So, the first one shown, someone is offering to buy 100 shares of Microsoft at a price of $25.23, and that is listed on ARCX. ARCX, there’s an interesting–I didn’t mention that exchange. It’s now part of the New York Stock Exchange. Maybe, I’ll come back to that in a minute, but let me just continue to explain this slide.

Now, you note that the bid prices are arranged in declining order, right? They go down as you move down. The computer has sorted all the orders. These are all the unfilled orders. Someone called their broker and said, I want to buy 100 shares, and the broker entered the bid through ARCX, and it’s now on the NASDAQ screen. Someone else had a much bigger buy order, wants to buy 9,430 shares, and this came in directly to NASDAQ, but it’s a penny less, $25.22. So, you can just see what’s going down.

Now, the other side–is that clear what we’re seeing here? The other side of the screen is the buy [correction: sell] orders, and it’s exactly the same, except that here the numbers go up as you move down the screen, because the computer has sorted them in the reverse order. So, that represents what various people are willing to buy [correction: sell]. So, somebody is willing to buy [correction: sell] 2,400 shares at $25.24. Actually, there’s two different customers. This one placed the order first, so I think that’s the priority, it’s by the one who placed it first. Somebody else at the Cincinnati Exchange–I guess that’s what that means–offered to buy 8,200 shares at the very same price, but it’s listed as a separate order, and so on.

So, now you’re sitting here looking at the screen now, and you notice that this ask price here, it’s higher than the bid price there. So, what does that mean to you? It means there’s no trade, right? Because someone is offering to sell at $25.24, and somebody’s offering to buy at $25.23. It’s no trade, until somebody changes their price. That’s no surprise, because these orders would be filled very quickly, if there’s a crossing. These two lines don’t cross, so it’s like, if you plotted these curves, they’re supply and demand curves, right? We could plot the amount at various prices.

Well, you can see, I’d have curves, a supply and demand curve, that don’t cross. Normally, they have to cross somewhere, and then, there’s a market-clearing price. These things normally don’t cross, because, if they did cross, would immediately disappear from the screen. Someone would finish the order and it’d sell. But you, sitting at the screen, now have a pretty good idea what the price is.

A NASDAQ level II is better than a NASDAQ level I, because level I just gives you the first row. It’s cheaper to subscribe to that. What NASDAQ level I gives you is the inside spread. It would tell you that there is a 100 shares bid at $25.23 and ask at $25.24, and if you want to hit that order, you could take either side of that. But it doesn’t tell you the whole picture. If you know NASDAQ level II, you know a lot more about the market, and if you’re going to play the game of trading, you want to know this. So for example, you know that it might be hard for a price to fall rapidly below $25.22, because there’s a big buyer down there, and so it’s going to be hard for the price to fall below that.

If you saw this screen in real life, these numbers would be just blinking, changing rapidly before you. And trades that were there 20 seconds ago would be gone in a flash. So, you’ve got to move fast to execute these trades.

Chapter 5. The Growing Importance of Electronic Trading [00:36:15]

On a fully automated system, the trades would be executed automatically, and this is becoming–electronic trading is taking over the world. And the orders can be executed by computers that make it instant, so that the number doesn’t even appear on the screen long enough for you to see it.

So, one development that’s coming in now is, what’s called high frequency trading, or HFT, which is trading that is done by computers. Once you have a system like this–when you have to trade through a floor broker on the New York Stock Exchange, it has to proceed at human pace, right? The way it works is you make a telephone call to your broker, your broker makes another telephone call to the representative on the floor of the New York Stock exchange, that person walks over to the crowd, and then discusses it, and indicates what–it’s like a poker game. You don’t want to reveal your hand, but you kind of feel people out, and then after a little discussion you reach a trade. But when you have something that you can hit on a computer, it just goes instantly. So, people start programming trading, and that’s been an important phenomenon, because you see these moving faster than you can–these prices disappear and reappear so fast that you can’t quite know, you can’t act fast enough.

So, we have algorithmic trading, or program trading. So, that goes back practically to the 1970s. Certainly by the ’80s, program trading was becoming a big and important phenomenon, and it’s becoming increasingly important now. High frequency trading now–brokers will invoke what are called ”millisecond strategies.” You can actually flash an order on some of the exchanges that lasts a thousandth of a second. You can put a buy order or a sell order, and retract it in a millisecond. This could be a trading strategy, which you might employ. You could do that to discourage people from trading. If you want to trade only with the computers, if you think people are too smart for me, I don’t want to trade with people, I want to rip off the computers, then you write a millisecond trading strategy, and then you can sort into who trades with you.

Now, the interesting thing about millisecond trading is that it’s favoring the electronic exchanges. As time goes on, people are getting more and more sophisticated about high frequency trading, and so they want to trade on exchanges that are fully electronic, so they can play all of these games. And that means that the floor exchanges are dying out over most of the world.

By the way, the New York Stock Exchange–I was going to give you a history of this–the New York Stock Exchange has been slow to adapt to these technologies. Let me just give you a little history of–electronic trading is an exciting thing for many people, but, I think, it started–or the really interesting electronic trading started with the ECNs, electronic communication networks, that were allowed by the Securities and Exchange Commission as alternatives to stock exchanges. Stock exchanges are highly regulated by governments around the world, but in the 1990s, the Securities and Exchange Commission allowed more sophisticated electronic trading, at least as an experiment. So, they didn’t call these things exchanges, they called them ECNs.

One of the most important ECNs was a company called Archipelago. Another one was called Island. And these were actually just websites, where you could trade, and they were open to the public. They had a different culture. They had more of a web culture. The web culture is, we’re not going to charge you to see the order book, we’ll just put it out to everybody. The web doesn’t charge you for a lot of things. And so, they became popular trading sites for the general public.

They grew up the way the personal computer grew, so the New York Stock Exchange, when they first saw Archipelago, they said, oh, this is a bunch of college kids fooling around, some computer game, sort of. And they didn’t take it seriously. But eventually, the New York Stock Exchange had to take it seriously, because Archipelago was growing so fast. So eventually, New York Stock Exchange merged with Archipelago. So, they’re now–I think most of their trades go through ARCX. I’m not sure if that’s right, but a large fraction of their trades go through ARCX. So, the New York Stock Exchange bought Archipelago in 2005. And at that time, ARCX was breathing close on New York Stock Exchange for trading volume.

Things are happening fast in the stock exchange, because the technology is changing. Whereas we had the New York Stock Exchange in the old days, it was this single prestigious exchange that lasted for over 150 years without any substantive change, but now electronic trading is coming in and everything is being shaken up.

So, the New York Stock Exchange merged with Archipelago in 2005, and then they did another merger–let’s say this–New York Stock Exchange, with Euronext, which is another exchange in Europe, in 2006. And right now, they’re going through another merger process, apparently with the Deutsche Börse. And that’s 2011. It’s not finalized yet. And now NASDAQ is getting in, NASDAQ is making an offer for the New York Stock Exchange, and so is another exchange called the Intercontinental Exchange. [addition: The description of these events is as of April 13, 2011.]

But the little guys are buying up the old-time big guys, so it’s–Laura Cha was saying in her lecture, that she was struck, that we used to think of stock exchanges as like utilities, each country has its own stock exchange, it’s the pride of each country, but now it’s not happening anymore. And this reflects a bigger and broader trend that economies are becoming more and more integrated across the world. So, the idea that there would be a stock exchange for each country is becoming dated. So, the New York Stock Exchange may soon be a German company, but that’s what happens in modern times.

Chapter 6. Instabilities Related to High Frequency Trading [00:44:46]

I want to talk about some problems with high frequency trading, as things get so electronic. Let me give you one example. In 1987, this was the early days of electronic trading, but still had advanced pretty far. On October 19 of 1987, the stock markets in the United States fell, according to the S&P 500, over 20% in one day. The government did a study, President Reagan ordered a study, and put it in charge of Nicholas Brady. And so, the so-called Brady Commission did a report on why the stock market–that was the biggest single stock market drop in U.S. history. And the Brady Commission did a report on that stock market drop, and concluded that program trading, computer trading, had played a big role in the drop.

There had been a development of programs that were called portfolio insurance sell strategies. They called it portfolio insurance, but it wasn’t really insurance. It was an automatic sell strategy. It’s like a stop loss order, but a more sophisticated one that could be executed in continuous time by a program. And that led to an instability in the market that was not anticipated and shocked the world. So, the Brady Commission made a number of recommendations, notably the commission recommended that the exchanges impose trading halts that would prevent stocks, the whole market, from crashing.

So, the New York Stock Exchange and other exchanges, after the Brady Commission report, instituted what are called circuit breakers. And these are automatic market halts that stop the market, when prices are falling, to help prevent another 1987-type stock market crash.

But the system is getting complicated. Even before this, the United States government had created–had passed a set of rules in response to complaints about people not being given the best price. So, here’s the problem. We have multiple exchanges. The New York Stock Exchange is one of many, and if you call a stockbroker, the stockbroker has discretion over which exchange the broker will use to fill your order. And so, the broker might choose an exchange that doesn’t give you the best price. The broker can, in effect, rip you off as a broker.

In fact, there’s a practice called a payment for order flow. So, a stockbroker, who’s receiving orders from retail clients, may find that there is a dealer that’s willing to pay for order flow. When a customer asks to buy the stock, don’t put it through the New York Stock Exchange, give it to me. And I’ll give you, the broker, a fee for directing the order my way. And that may not serve the client well, because the client then might end up paying a higher price. So, there were a lot of complaints about this, and it’s a difficult problem, because it’s hard to monitor everything that people do. And there might be justification for payment for order flow.

But there’ve been efforts to try to make it a fairer system. And in 1975, the U.S. Congress set up something called the National Market System. So, NMS is the National Market System, and the ITS is the Intermarket Trading System. What the government in the United States did is it said that brokers have to get the best price, what’s called best bid, best offer for their clients. And they have a responsibility for their clients to take the market with the best price.

In conjunction with this, the exchanges built something called the consolidated quotation system, that allows brokers to see prices on various exchanges and direct the order of the client to the exchange that’s showing the best price. So, that is the system that was started in the United States in 1975, and brokers still have an obligation to get the best price for their customers regardless of exchange.

But the obligation is hard for the government to monitor, and it gets complicated. For example, if you’re confronting this system, and your broker wants 500 shares, well, I can’t fill them all at the same price, right? Well, actually I could here. If the broker wanted 10,000 shares, they’d be all different prices, because I’ve all these different customers asking different amounts. So what do you want us to do, SEC? And so the SEC recently clarified this. I think, it was in 2006. Well, we only mean that you have to get this, this one up here–2,400 for 25.24. How do you fill the others? Well, we can’t get into that. So, it’s not a complete protection for customers, but there still is this obligation for brokers to use the National Market System to get the best price. But the system is complicated and confusing, because there’s so many computers involved, there’s so many different exchanges, and there’s so many rules. It’s hard for people to keep up with it all.

I had on the reading list I had a report that I–I found the report. It was very much in the news a while back. This is a report on May 6, 2010. Do you remember what happened then? That was not that long ago. The stock market, as of around 2:30 in the afternoon in the United States, had fallen 4%, and then, within a matter of minutes, it dropped another 6%, and then, it rebounded quickly. Some individual stocks dropped practically to nothing, and you could buy a $30 stock for $0.30, or something like that. And then, they rebounded.

So what happened? Why did we have this very brief crash in the stock markets? It wasn’t like 1987, where the market went down and stayed down. If you look at closing prices, nothing much happened. It was this brief glitch, which probably cost some people huge amounts of money, because, if you were trading right at that moment, you’d have a problem. So, I have as an optional reading on the reading list a study, that was made of May 6, 2010 by the SEC and the Commodity Futures Trading Commission, trying to understand what happened then. And the study does focus on high frequency trading. There were a lot of computers trading automatically at that moment in time.

So, what apparently happened on May 6 is, the market was already in a stressed mode before 2:30 PM. The VIX index had shot up. There was some bad news–the market was down 4%–there was some bad news. So, that meant that some traders were wondering, what’s going on? And maybe, they decided to drop out for a while and just be cautious, but the computers were still trading.

And then, something happened. The computers started trading back and forth in milliseconds. And I don’t know what the programs were supposed to do or what they–maybe nobody knows the whole picture–but the volume of trade just went to an astronomical level, and it scared people off. And so, there were a lot of trading pauses that were put. Exchanges have rules about that, and individual dealers will say, I’m dropping out. I see all this volume, I’m not in here anymore. So, it remains that the trading that was left was substantially computer trading, and the market became very illiquid.

So, this study has recommended fixes for this, but it doesn’t recommend ending high frequency trading. A lot of people would recommend doing that. There’s a popular anger, especially since this May 6, 2010 crisis occurred during the period of financial crisis, and people kind of imagine that the two are linked. I think, they’re kind of independent. I think the May 6, 2010 phenomenon was due to some kind of anomalies, or unfamiliarity with high frequency trading. It’s a glitch and not a major fault, but it lead to a lot of anger about high frequency trading.

I’ve talked to some people at the Chicago Mercantile Exchange and others, who think that the public anxiety over high frequency trading is misplaced. It’s kind of inevitable. The future is computers. They’re replacing people all over. Not in a judgment thing. You know, someone was saying at the CME meeting, where I was, that the basic business that we’re doing is still the same as it was 100 years ago, but now we have laptops, right? It’s just like, when you write a term paper. It’s basically the same thing that somebody would have done with a feather pen and a piece of paper 200 years ago. Right? It’s basically the same. But we live in a computer age now, and we don’t want to go back. And so, high frequency trading means that we have to be a little careful, things can happen with lightning speed, but we’ll learn. There hasn’t been another May 6, 2010 since. It was just an anomaly, because people were unfamiliar with that kind of event. So, I think it will be all right.

One thing that it does, however, is it’s changing the geography. It used to be, that in the 18th century, a stockbroker had to live in London or Paris or New York in order to be close to the trading, because they didn’t have any way to make phone calls. When they invented the telephone, people said, fine, I don’t have to live in New York anymore. I can live in anywhere, and I can just send my call by telephone. But now, high frequency trading is bringing it back, that people have to live close to the exchange because the trading goes so fast, that your electronic signal–if you try to set up a high frequency trading operation in St. Louis, and your operating by wire to New York, the time it takes for electricity to get from St. Louis to New York is too big, and you will be behind on the trade. So, you want to get as close as physically possible to the exchange, to the computer.

The regional exchanges, there used to be exchanges in every big U.S. city. And they were there, because of social reasons, that people in Chicago wanted to talk to a broker in Chicago. They wanted to be able to go to his office and see him, so there were social reasons for connection. But now we’re coming up with a new electronic reason. And because of basic theoretical physics, you can’t move anything faster than the speed of light. This is going to be with us now that we have microsecond trading.

Chapter 7. The Frustrations as Trading as a Dealer [00:59:14]

I wanted to talk a little bit now–and I think maybe this would be the last topic–about how you think about trading as a dealer, who is confronted with this kind of book. As a dealer, you can put orders on this book, and enter them, and leave them there. That’s basically what you do. So, you see various dealers, and their names are shown, and for example, well, I don’t know who these people are. But each dealer is going to be posting a bid and an ask, and a quantity for these. And if you do this, if you’re sitting at your NASDAQ screen, and you’re a dealer, you can enter your own number on either the bid or the ask or both of them. So, you have your own bid-ask spread, OK?

It’s the same thing as an antique dealer, OK? An antique dealer has an idea–maybe it’s not posted–of how much he or she will pay for a chest of drawers from a Yale student at the end of the semester, and how much he will charge to sell that. And the difference between the ask and the bid is called the spread, or the bid-ask spread.

So, I want to just think a little bit about the theory of this. How do you decide of the bid-ask spread of what to do? And why is it what it is? The spreads are obviously very tight here, because they’re off only by $0.01 on the inside spread, but it doesn’t correspond to one person. Maybe some of these are customer orders and aren’t dealers.

But think of placing an order as a dealer and leaving it on the screen, so that anybody can come and–the risk that you face is, that you will be picked off by people with superior information. And let me put it in the context of an antique dealer. One thing, antique dealers don’t like is, when professional antique dealers come shopping in their store. So, what do they do? You know, if you’re a good antique dealer, you go to all the antique shows, you try to disguise yourself, because they don’t want you, if you’re a dealer.

What do you do? You look through all their stuff and you find anything that’s mispriced. You know, there will be some chest of drawers that you recognize as an 18th century–by a famous furniture maker. So, you buy that at the guy’s price. You pick him off, right? So, he doesn’t want to be picked off, because somebody will come by, who knows more, will pick off all the good stuff, and buy it, and leave you with the junk.

So, how do you prevent that? Well, you might think that you could prevent it by just being smarter, you can try it, try to be as smart as you want, and read up about all the antiques, but it’s impossible. You cannot be the smartest guy out there. Impossible. There’s just too many antiques, and there’s too much inside information. So, that means you have to set your bid-ask spread wide enough, that you can be picked off and still make a profit, all right? You know you’re going to get picked off, and it’s the same for stocks.

If you’re going to put a bid-ask spread up on the screen for some stock, you’re just a sitting duck, because there’ll be some news story that’s either good or bad, and if it’s either way, somebody else is going to hear of it first, and when you get a hit on your order, it’s going to be deadly, because it’ll be at the wrong time for you. So, that’s the theory, that you have to make the bid-ask spread wide enough.

I wanted to then just give you a little bit of math–I shouldn’t end a lecture on mathematics, but that’s what I’m doing here this time. And I wanted to just talk about the frustrating life as a dealer. I was telling you about frustrations in life as an investment banker. There are different frustrations in life as a dealer, and I’ll tell you what is the difference is.

Life as a dealer is very different than life as an employee or something. You are a dealer and you have whatever money you make. And the problem is, you can get ruined, this is a classic–in other words, you can be working as a dealer for 20 years, and you see your portfolio growing, because you’re making a lot of money selling. But you know, all it takes is a few bad moves, and you can be wiped out. You know, 20 years of work, and you are ruined.

So, I wanted to just think about that, and this is my last bit of mathematics. This is the mathematics of Gambler’s Ruin, and it’s also a mathematics of Dealer’s Ruin. And so, here’s the theory. If I start up with S dollars, S is my initial amount of money as a dealer, OK? And let’s say I take a series of bets, which have a probability–p is the probability of a win. What is the probability of eventual ruin? Oh, and if I make $1 on each win and I lose $1 on each–minus 1 on each loss–I’m doing a sequence of bets–on each loss, all right?

What is the probability that I will eventually be ruined? That probability, and I’m not going to derive this, but it’s simple to derive, actually.

if p is greater than 1/2. So, if my probability of winning is 1/2, the probability of my being ruined eventually is 1. And if my probability of winning is less than 1/2, my probability of being ruined eventually is also 1.

I have to somehow raise the probability of winning on each particular sale above 1/2, but even if I do that, if I make it, say, 0.6, if I make the probability 60% on one bet, then 1 - 0.6 is 0.4 over 0.6, then my probability of eventual ruin, starting out with $1 is 4/6, if I did that right. Goes down with the number of dollars I start with, but it never goes to zero.

So, the theory of a dealer is that a dealer has to be thinking about being ripped off. I’ve got to set my bid-ask spread high enough, that the probability of winning on each of these little trades that I make is sufficiently above a 1/2, that my eventual ruin probability is satisfactorily low for me. But it’s never going to be zero. This is the irony of being a dealer. You don’t sleep well at night, because you never know that it won’t eventually unwind. And it’s a competitive business, because you can’t just set your bid-ask spread arbitrarily high, because then you lose all the business to other people. So, you’ve got to kind of fix the bid-ask spread enough, that you get business, but you don’t want to fix it too narrowly, so that this probability falls too close to 1/2, because then you’re courting the risk of disaster, and eventually having all of your life’s work being wiped out.

So, that was kind of a quick description of the–I’ve said, different personalities go into different parts of finance. You have to be kind of a game player, someone who is not bothered by the possibility of eventual ruin, in order to go into becoming a dealer. Very different from other aspects of financial life.

All right. I’ll see you soon with–we’re getting close to the end of the semester. Some wrap-up lectures coming.

[end of transcript]

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