Why the grasshopper ate the market makers’ free lunch.
When the world moved to electronic trading, there was much resistance. Mostly from the people who had their license to print money taken away. Market makers used to be the only ones allowed to deal in financial securities as part of a wider exchange in pits and open outcry. Prices were quoted in units of eighths or sixteenths, which meant the spread between bids and offers was wide so margins were huge. Clearly things had to change, and I remember a time when a floor broker on the Frankfurt Stock Exchange would stop all trading because he had become hungry. It meant that stocks of large global companies such as BMW or Siemens could not be bought or sold until a certain someone had finished his lunch.
The UK feared it may never catch on, after all there had been market makers for hundreds of years. Therefore, both systems ran simultaneously for a while. Those who preferred to deal through the floor and others that traded on SETS, the new electronic means of accessing the market directly. What it really meant was that you had less liquidity as the market was split in half. However, wherever there is pain, there is also opportunity and the real revolution that occurred sometime in the early nineties was opening the door to algorithmic trading.
At first, we discovered that you could get one price from the market maker to sell British Petroleum, but simultaneously buy the same stock on SETS at a fraction cheaper. It didn’t always work, but knowing that there were truly risk free profits to be had, changed everything. Soon, more exchanges opted to go electronic, which meant we could trade the same stocks across more venues, in different countries and at slightly different prices every so often. Volumes exploded.
Computers were programmed to scan the markets in real time for any price discrepancies and orders could be executed automatically without the need of a trader. So called high frequency trading systems swarmed the markets like a plague of locusts in the late nineties trading millions of times per day across thousands of stocks, commodities, currencies and all types of financial derivatives. The only markets to be spared were in fixed income, but that’s another discussion (Asset Class Wars).
The returns on capital were ridiculous. Remember, when you are in and out of any trade within nano seconds and for every long you have exactly the same short, there simply is no value at risk. It was the purest form of alpha ever created. Nobody had ever seen anything like it, and then it stopped. At some point in the early noughties, all inefficiencies had disappeared. We can now trade our shares of Amazon across dozens of different exchanges all at the same price, at much lower costs and with even more liquidity. We have the machines to thank for that.