CHAPTER 1

The Emergence of High-Frequency Trading

While high-frequency trading has gained relevance with the general public onlyrecently, the practice of using computerized trading has been active fordecades, going as far back as 1971, when Nasdaq started as the world's firstelectronic market.

In the Beginning, 1969–1976

Traditionally, financial markets were physical locations where brokers withbuying and selling orders met and matched them appropriately. The technologicalevolution and, consequentially, the exponential growth of computing powerbrought a revolution to the financial markets, making it unnecessary for brokersto meet physically and enabling traders from remote locations to participate.The now Nomura-owned Instinet led the charge more than three decades ago.

February 24, 1969

On this day, Institutional Networks Corp. filed a patent application for its"Instinet Communication System for Effectuating the Sale or Exchange of FungibleProperties Between Subscribers." The company, founded two years before, aimed tocompete with the New York Stock Exchange by means of computer links betweenbanks, mutual funds, and insurance companies, with no delays or interveningspecialists. Through this Instinet system, which would start operating by 1970,the company would provide computer services and a communications network for theautomated buying and selling of equity securities on an anonymous, confidentialbasis. It also acted as a securities information processor, supplyingprofessional-level market data systems containing last sale, quote, and sizeinformation. Institutional Networks received income from commissions on thetrades and from the rental of the Instinet terminals located in the offices ofits clients. Institutional Networks was renamed Instinet in 1985.

February 8, 1971

This was the first trading day at the Nasdaq, an electronic alternative to over-the-counterstock exchanges. Nasdaq opened electronically with 2,500 over-the-counterstocks. It was not until the 1990s that the Nasdaq became a competitorof the New York Stock Exchange (NYSE); Nasdaq merged with the American StockExchange (AMEX) in 1998.

May 1, 1975

On this date, the Securities and Exchange Commission (SEC) banned fixed minimumcommission rates, a cornerstone of the U.S. securities markets and all otherorganized exchanges throughout the world. "Until then, the NYSE fixed theminimum commission of stock trading; these extraordinary high costs had hinderedquantitative traders from entering the equity markets," according to author LarsKestner.

March 1, 1976

The fully automated Designated Order Turnaround (DOT) system was introduced onthis day by the NYSE to route smaller orders electronically. The orders attendedby a stock exchange agency would be sent electronically to the computers insidethe market, allowing the stock exchange agencies to confirm the execution ofsome operations while still having the client on the telephone line, significantprogress for the time.

The DOT system involved the use of computer technology to relay orders. With anetwork interface, it was possible for investors to submit orders that wereimmediately logged in the servers for the exchange. The orders could be executedand confirmation of the execution relayed to the investor in what was thenconsidered real time. This type of real-time investment capability made itpossible for investors to benefit by having an order executed immediately ratherthan 10 minutes or an hour later. The DOT system was able to handle suchtransactions as limit orders, basket trades, and several other types of marketorders.

The Lead-up to Black Monday, 1982–1987

There were many voices eventually blaming the market collapse on electronictrading. The "flash crash" of 2010? No, Black Monday in 1987. That'sright—even back then, startups and banks, which were just getting startedin the electronic trading race, were pointed as the culprits of the dramaticdecline in the financial markets. The story would repeat itself 23 years later.

July 5, 1984

On this date, the NYSE approved the use of a version of the Super-DOT system foroptions trading. Super-DOT was an improvement over the DOT system and guaranteedthat any market order of less than 2,100 shares of a stock would be executedwithin three minutes at the prevailing bid price (for a market sell order) orasked price (for a market buy order) at the time the order was entered or atbetter prices, if possible. The DOT-for-Options system provided the NYSE optionsfloor with an electronic order-routing system not available on any other optionsexchange. The Super-DOT system, which included the NYSE's DOT, Opening AutomatedReport Service (OARS), and Limit Order (LMT), had been used to provide automatedtrading support to the NYSE equities trading floor since 1976.

October 19, 1987

After five days of intensifying stock market declines, selling pressure hit apeak on this day, Black Monday. The Dow Jones Industrial Average (DJIA) fell arecord 22 percent, with many stocks halted during the day because orderimbalances prevented true price discovery. The lead-up to October 1987 had seenthe DJIA more than triple in five years, and price/earnings (P/E) multiples onstocks had reached above 20, implying very bullish sentiment. And while thecrash began as a U.S. phenomenon, it quickly affected stock markets around theglobe; 19 of the 20 largest markets in the world saw stock market declines of 20percent or more.

Floor traders, working by telephone, dominated the action, andcomputer-generated trading still was in its infancy; certainly, dark pools andhigh-frequency trading were the stuff of science fiction, said the WallStreet Journal. Nevertheless, that didn't stop people from speculating onthe exact causes of the crash (which was rare in that the market made up most ofits losses rather quickly rather than falling into a protracted economicrecession) and pointing to automatic trading programs in place at the time aspossible culprit. An important parallel, though, was how a number of tradersabandoned the market; in 1987, some human market makers on the floor of theexchange stopped...