Evolution Of The Marketplace: From Open Outcry To Electronic Trading

Brief History Of Trading

By definition, the term "trade" is the act of buying, selling, or exchanging goods with other parties.^[1] Dating back to the beginnings of human civilisation, "trade" has been the apparatus by which people have exchanged valued assets in an attempt to prosper or survive. The instrument of trade is credited with linking different cultures and acting as a conduit for the transmission of culture and ideas.

The earliest forms of trade came through prehistoric peoples exchanging anything of value for food, shelter and clothing. As the idea of exchange for sustenance became ingrained in cultures worldwide, a physical space known as the "marketplace" came into existence. A "marketplace" is an area designated for the exchange of goods or services, with an established set of trading conditions.^[2] Early marketplaces were local in nature, providing a viable outlet for individuals interested in engaging in trading activities with people from surrounding communities or geographical areas.

As time moved forward and the sophistication of trading practices matured, the need for an avenue of trade dealing specifically with financial securities became prevalent. Pioneering venues, such as the Dojima Rice Market or the Amsterdam Stock Exchange, provided the conceptual basis for modern trade in many disciplines. In fact, one can trace the trade of futures contracts, equities, debt instruments and even Bitcoin to these humble beginnings.

What Is Open Outcry?

Perhaps the oldest incarnation of trade is known as the "open outcry" system. This is defined as being a mechanism that matches buyers and sellers through the use of verbal bids and offer prices.^[3] Open outcry trading grew out of the necessity for market participants to see and verbally communicate with one another.

Visual and verbal confirmation between market participants was a key aspect of the early open outcry system because technology enabling interactive communication had yet to be invented. Trading locales earned the nicknames "pits" or "floors"; monikers that stuck until the latter years of the open outcry era in the early 21st century.

A Simple Process

The process of placing a trade during the early days of open outcry was surprisingly simple. Depending on the rules of the specific marketplace or exchange, an individual could either assume a place in the pit and directly engage other traders, or commission a floor brokerage service who traded on the individual's behalf.

Within the pit, the process of price discovery commenced via the oral auction of a specific security. As supply and demand forces interacted, the debate over a security's value at a given time was settled. Pit traders conducted business among themselves, while buyers and sellers of the security in question relayed bid and offer prices to their representative floor brokers.

Trading Restrictions Lead To Change

Monopolistic associations and extensive capital requirements were common barriers to entry in early open outcry marketplaces. The ability to trade freely within a given market was often gained by birth or social standing, thus the trade conducted in early open outcry markets was restricted and not readily accessible by everyone. Accordingly, traders with smaller capital resources were directed to trust their funds to a broker or banker for the facilitation of trading activities. These obstacles proved significant deterrents for many aspiring futures, currency and stock market participants.

However, as the evolution of trading promoted more standardised transactions, the desire to engage in active speculation grew. To service the growing demand, small regional markets underwent periods of vast capital investment and expanded into large exchange-based trading operations.^[4]

Open Outcry In The Modern Era

As demand for market access grew, fledgling products and marketplaces gained popularity. Financial instruments such as standardised futures and forward contracts enabled extensive hedging and speculative practices for agricultural market traders. The advent of futures and forwards offered commodity market participants a way to address international trade via the flow of a country or region's imports and exports. Additionally, bonds guaranteeing corporate and government debt satisfied the desire of investors and speculators to grow their capital.

The Backbone Of The Financial Industry

From the mid-19th century to the early 21st century, open outcry markets commenced trading on a large scale and became the backbone of the financial industry. During the early portion of this period, some of the largest trading venues in the world came into existence. The following are a few of the most prominent that specialised in the trade of financial securities per open outcry:

• Paris Stock Exchange: Officially recognised in 1801, the "Bourse de Paris" offered the indirect trade of convertible equities and debt instruments exclusively through "les courretiers de change" also known as stock brokers.^[5]
• London Stock Exchange (LSE): Trading operations on the LSE centered on equities and debt instruments, quickly making the exchange a global leader during the early 1800s.^[6]
• Chicago Mercantile Exchange (CME): Formed in 1874, the CME originally served as a futures exchange for butter and eggs. Products offered expanded throughout the 1900s most notably in 1961 with futures contracts based on frozen pork bellies.^[7]
• Chicago Board of Trade (CBOT): Founded in 1848, the CBOT originally served as an organised grain exchange. Over the course of its history, the board specialised in the trade of agricultural products.^[7]
• New York Mercantile Exchange (NYMEX): Originally known as the New York Butter, Cheese and Egg Exchange, the name was changed to NYMEX in 1882. Futures contracts based on agricultural products gave way to industrial products in the mid-1900s, led by the energy trading sector.^[8]
• New York Stock Exchange (NYSE): The origins of the NYSE can be traced to 1792, with the signing of the Buttonwood Agreement by prominent financial figures in New York City. Although originating with only five listed securities, the exchange grew to having a daily traded volume of 8,500 shares by 1835.^[9]

The marketplaces and exchanges listed above are a few examples of entities that began as small undertakings and grew into global financial leaders. As communication technologies evolved, the ability for exchanges to provide market access to a larger number of potential market participants became a reality and an avenue of exponential profit.

Advance Of Communications Technology

Although trading operations remained largely contained to the traditional open outcry system, technological breakthroughs during the 19th and 20th centuries fostered growth in market participation. The telegraph, ticker tape, telephone and programmable digital computer laid the foundations for today's computerised trading systems.

The Telegraph

Upon its inception in 1832, Samuel Morse's "telegraph" was a breakthrough in communications. Shortly thereafter, it rapidly evolved the financial market business model. Information was disseminated and marketed freely, with financial newsletters being distributed in areas far away from the marketplace. By 1856, broker-assisted buying and selling of exchange-based securities was possible by way of telegraph.^[10]

Ticker Tape

In 1867, the first "stock ticker" was put into action in New York City at the NYSE. The stock ticker was the invention of Edward Calahan who adapted telegraph technology to transmit up-to-the-minute stock quotes originating at the NYSE nationwide. In effect, the service, known as the "ticker tape," was the first instance of traders not located at the exchange receiving streaming market data. The ticker tape was a major breakthrough in the capital markets and brought stock trading to the masses.

The Telephone

The invention of the telephone in 1876 improved on the telegraph through providing a means of bi-directional communication using actual dialogue. The telephone quickly became ingrained in the local financial industry surrounding the NYSE, and in 1920 nearly 88,000 telephones were in service in the Wall Street district. As long distance telephone connectivity grew, it became the industry standard for interacting remotely with the marketplace.

First Computer

The construction of the first digital computer "ENIAC" in 1946 marked the beginning of the computer age.^[13] In terms of the marketplace, the invention of the first programmable digital computer was a technological breakthrough that could be readily adapted to perform many market-related tasks. By the early 1960s, computer-based market data services began to take the place of traditional ticker-tape quotation services.

The inventions of the telegraph, ticker tape, and telephone all contributed to the growth of marketplaces and exchanges in the United States and Europe. When coupled with the computational power developed by the breakthroughs in information systems technology, the stage was set for the rapid evolution of computerised trading systems and interactive, electronic trading.

Origins Of Computer Trading

The development of the first digital stock quote delivery system during the early 1960s marked the beginning of the transition towards fully automated markets. Through the use of streaming real-time digital stock quotes, brokers could receive specific market data on demand without having to wait for it to be delivered on the ticker tape. The eventual result was an enhanced data flow and another step forward in the evolution of trading.

Scantlin Electronics' Quotron II Computer

One of the first providers of this technology was Scantlin Electronics, stationed in New York City. Scantlin provided streaming quotes to brokers and traders nationwide through its Quotron II system.^[14] In effect, Scantlin could use the capacity of the Quotron II to process market data at the exchange and distribute the information digitally, in real-time through a telephone-modem connection.

Stock retailers who subscribed to the Quotron II were able to request current bid and offer prices directly from the market before sending the information to their clients seamlessly. From beginning to end, the process was far more efficient than data transfer via ticker tape and telephone.

Instinet Introduces First Fully Automated Trading System

In 1969, building on digital exchange-based streaming quote technology, a company named Instinet introduced the first fully automated system for the trade of US securities. The introduction of the Instinet trading system afforded large institutional investors the ability to trade pink sheet securities directly with one another in a purely electronic over-the-counter capacity.

Competitors saw the potential of Instinet's system and followed suit providing similar products. By 1980, traditional brick-and-mortar exchanges around the globe sought to develop similar, fully automated processes of conducting trade.

Instinet's foray into automated trading systems marked the birth of the electronic trading movement and a divergence from the age-old practice of open outcry. Essentially, the business model of trading had changed from in-person interactions to computer-based transactions.

Creation Of The Digital Marketplace

In 1971, fully automated over-the-counter (OTC) trading became a reality with the formation of the National Association of Securities Dealers Automated Quotations (NASDAQ).^[16] Similar to Insinet's earlier efforts, the NASDAQ used cutting-edge information systems and connectivity technology to create a strictly digital trading arena.

NASDAQ Introduces The DOT

The implementation of the NASDAQ framework opened Pandora's Box for the computerised trading industry. The NYSE followed the example set forward by the NASDAQ and in 1976 created the Designated Order Turnaround (DOT) system. Ultimately, the DOT electronically connected member firms directly to the exchange.^[17]

NYSE Launches The SuperDOT

In 1984, the NYSE launched its SuperDOT trading system, which greatly sped up both order placement and order execution. Under SuperDOT, a market order was transmitted from a member firm directly to the NYSE trading floor for execution; upon the order's execution at the floor, a confirmation of the order's fill price was returned to the firm. The SuperDOT system marked a quantum leap in stock trading execution in terms of both speed and volume. As of 1993, the SuperDOT system was capable of processing stock market volumes of one billion shares per day, with a standard response time from floor to firm of 60 seconds or less.^[18]

In no uncertain terms, the system presented by the NASDAQ was based on removing impediments to trade, and it proved to question the inefficiencies and speed associated with the open outcry process. Although open outcry remained the preferred mode of trade in many futures and equities markets until the turn of the 21st century, the speed and efficiency on display by the electronic systems was undeniable.

Global Marketplaces Go Digital

The late 1980s and early '90s saw the desire to adopt automation gravitate from institutional investors to individual retail traders. As the personal computer became more and more powerful, and internet connectivity technology evolved, the overwhelming push towards automation soon overtook the holdovers from open outcry.

Pit Trading Shrinks

For an illustration of the shrinking demand for pit trading in the '90s, one has to look no further than the trading volumes taking place on US futures exchanges. In 1990, the US futures exchanges accounted for 65% of the aggregate global trade of futures contracts. By 1997, this figure fell dramatically to 41%. Several factors contributed to the decline of the industry over this period, but the movement towards electronic trading in the futures markets of Germany and the United Kingdom provided formidable competition to retailers in U.S. pits.

Exchanges Launch Web Applications

As a response to lost market share, leading global exchanges such as the CME launched web-based applications that enabled clients to trade exclusively using online trading platforms. In the case of CME, for the period of 1992-2004, one billion futures contracts were traded electronically on their CME Globex platform. In 2004, electronic trading represented 61% of all CME volume. By the year 2015, 99% of all futures contracts traded on the CME were done electronically.^[21] Many of these trades were directed by complex algorithms, a byproduct of advancing technologies.

Global Markets Evaluate And Embrace Industry's Future

The successful implementation of the trading infrastructure promoted by the NASDAQ and the NYSE SuperDOT forced the global capital markets to step back and evaluate the future of the industry. One by one, exchanges and trading venues saw the potential offered by an exclusively digital marketplace and sought to capitalise.

During the 1990s and early 2000s, the following major global equities and futures exchanges eliminated open outcry in favour of the electronic trading:

• Tokyo Commodity Exchange (TOCOM): 2003^[22]
• CME: 2015^[23]
• NYSE: 2014^[24]
• Intercontinental Exchange (ICE): 2008
• NASDAQ: 1971^[16]
• Toronto Stock Exchange: 1997^[27]

Summary: Open Outcry Vs Electronic Trading

Since the development of electronic trading systems, their implementation upon the marketplace has been a hotly debated topic. In fact, financial industry professionals are largely split on the subject. However, it is undeniable that electronic trading dominates the financial landscape and open outcry has been relegated to be a thing of the past.

For the displaced pit traders of old, the prospects of making a living in the electronic marketplace are bleak. Skills used in open outcry are often compared to those used in poker, while success on the "screen" is attributed to probability. It has been estimated that only 5% of established pit traders that have made the transition to the screen have been successful.^[28]

Advocates for electronic trading claim that technology has increased the overall efficiency of the marketplace. Some of the strongest arguments in favour of electronic trading are as follows:

• Greater liquidity
• Lower commissions and fees
• Tighter bid/ask spreads
• Ease of market access
• Diversity of tradable assets (everything from Bitcoin to soybeans)

Opponents of electronic trading claim that the exact opposite is true, with an unfair playing field having been created through the proliferation of the digital marketplace. Popular arguments made in the case against electronic trading are:

• The creation of enhanced market volatility
• Market fragility associated with technology failure
• Lack of transparency
• Ease of forex, futures and stock market manipulation

No matter what one's opinions are on the digital market or open outcry system, electronic trading is here to stay. Ultimately, the evolution of trading is dynamic; it's extremely probable that the capital markets of tomorrow will be unrecognisable to the participants of today.