The pioneer of the automated quote system was the National Association of Securities Dealers (NASD). In the 1960s there were about 5,000 members of the NASD, two-thirds of them working solely in the OTC market. It was appropriate for this market to be a pioneer in automated trading, since it was, from the start, a “virtual” market: there was no floor, no board, just an invisible network of broker-dealers linked by the telephone and the pink sheets (retail investors could find “representative” prices in their newspaper listings). It was those sheets that were the problem—since they had to be compiled, published, and circulated, the prices on them were always stale. Because the market was inefficient, investors lost precious time while their broker dealers looked for trades meeting their requirements. The SEC pointed this out in its 1963 Special Study of the Securities Markets and recommended creation of a computerized, real-time substitute for the pink sheets. Robert Haack, then president of NASD, duly ordered construction of a centralized processing complex in Trumbull, Connecticut, begun late in the decade.
The new system might have been more ambitious, but pushback from smaller brokers worried about narrowing spreads and from NYSE members worried about loss of business on the floor, meant that the new system, dubbed the “NASD automated quote” system (NASDAQ) would have no retail interface and list no NYSE stocks. Instead the NASDAQ linked about 1,000 market makers in the most active stocks, reporting volume only after closing. The system went live in February 1971, listing some 3,000 securities (the rest remained on the pink sheets). NASDAQ commenced with three different levels of service. The least expensive, Level I, provided the same representative bids that could be found in newspapers. Level II contained the type of wholesale quotes found on pink sheets. Level III allowed users to place limit orders. As expected, this new level of transparency was a boon to investors, because spreads narrowed significantly.
The NASDAQ fared well during the 1970s, but still it remained in the shadow of Wall Street. Negotiations with the SEC enabled it to handle a few third market issues, but NYSE Rule 394 kept trading of NYSE listed securities - blue chip stocks - off the NASDAQ. Nevertheless, the NASDAQ was handling 63 percent of the volume of the NYSE by 1980, when it replaced its representative prices on Level I with actual bids and offers.
In 1984, 16 years after the Pacific Coast Exchange introduced SCOREX, the NASDAQ finally offered electronic execution. Its small order execution system (SOES) provided market makers the opportunity to trade 25 issues, in volumes of less than 1000 shares, electronically. It took a financial calamity – the 1987 Market Break - for the NASDAQ to become a fully automated market, however.
From October 13 to 19, 1987, the Dow fell by 31 percent. In all, almost $1 trillion in shareholder value disappeared in the 1987 Market Break. No event since the back office crisis did more to expose inherent weaknesses in U.S. financial markets. In the years before 1987, institutions and other large investors seeking to change their portfolios quickly had become increasingly involved in buying and selling indexed options and futures. Computerization of institutional transactions had also made “program trading” (the buying and selling of shares at trigger points), possible.
When the equities markets slumped in October 1987, derivatives and program trading exacerbated the trend. Afterwards there was a widespread perception that while computerization had protected institutions, retail investors were hurt as trading volume rose to the extent that market makers stopped answering the phone and specialists were swamped.
In its report, The October 1987 Market Break, the SEC Division of Market Regulation noted that to a great extent, price discovery was being done in the futures trading pit rather than by equity market makers or specialists. 16 The Report of the Presidential Task Force on Market Mechanisms underscored the fact that by vastly increasing investor leverage, derivatives were putting huge volume demands on the equities exchanges. SEC Chairman David Ruder was intent on seeing that the exchanges expanded their capacity, particularly when it came to retail investors. If computers had helped create the problems that led to the 1987 market break, it was determined, more computerization appeared to be the solution as well. 17
SOES had been purely voluntary. When, during the market break, prices began plunging, market makers began pulling out. There were also technological problems: as the system lagged behind the constantly changing orders, quotes became “locked and crossed,” with bids equal to, or higher than the asking price. But the biggest problem in 1987 was that the old telephone system simply could not keep up with the new automated quote system. In 1988, use of an improved version of SOES became mandatory for all market makers.
Before long, day traders known as “SOES Bandits” began exploiting the system, buying or selling ahead of market makers who were slow to update their prices. In 1990, NASDAQ rolled out an improved execution system appropriate for large as well as small trades, called SelectNet. By the 1990s, advertised as the “NASDAQ National Market” the NASDAQ had become an institution if not on par, then approaching in stature to the NYSE. Because it was the home to new tech and “dotcom” stocks, it benefited from late 1990s dotcom boom. Tech investors, said Joe Hardiman, president of NASDAQ at the time, “felt comfortable with a screen-based market, and they knew that was the future rather than a floor-based market.” 18 In replacing the old pink sheet and telephone dealer market with a new electronic one, the NASD had created a highly attractive alternative to the specialist markets.
(16) The October 1987 Market Break, February 1988.
(17) David S. Ruder, The October Market Break: A Stimulant to United States-Japanese Cooperative Securities Regulation, February 18, 1988.
(18) October 29, 2009, Interview with Joseph Hardiman, 41.
(Courtesy of Stuart Kaswell; made possible through a gift from the family of Milton H. Cohen)
(Courtesy of Alton Harvey)
Ben Indek, Carla Rosati, Margaret Foran, Robert Kueppers, John Ramsay, Theodore Levine, Jeff Caplan and Anne Flannery
(Andrea Corcoran, Richard Ketchum, David Ruder, Brandon Becker, William Johnston, Erik Sirri and Christopher Cox
From 1988 to 1993, Mary Schapiro served as SEC Commissioner. In 1993, President Bill Clinton appointed Schapiro Acting Chairman of the SEC, then appointed her Chairman of the Commodity Futures Trading Commission in 1994. In 1996 she joined the National Association of Securities Dealers (NASD) (now the Financial Industry Regulatory Authority) as the president of NASD Regulation. In 2006 she became NASD's Chairman and CEO. In January 2009 she became the SEC's 29th SEC Chairman. After leaving the SEC, Schapiro joined Promontory Financial Group in 2013 as Advisory Board Vice Chairman. She was one of the founding Trustees of the SEC Historical Society.
Moderator: Brandon Becker
Presenter(s): Andrea Corcoran, Christopher Cox, William Johnston, Richard Ketchum, David Ruder, Erik Sirri
Moderator: Alger Chapman
Presenter(s): William Brodsky, Gordon Macklin, William Morton, Donald Stone
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