Historical overview of stock exchange evolution and rise of quantitative trading

The Original Big Short The Amsterdam Stock Exchange, founded by the Dutch East India Company in 1602, is recognized as the world’s oldest stock exchange. It facilitated a secondary market to trade stocks and gave rise to trading clubs during the mid- 17: century where speculators would congregate. Messengers would rush to and from the exchange to update pricing to customers. In 1867, the invention of the stock- ticker machine, also known as the ticker tape, obviated the need for messengers. Stock transaction data was transmitted by telegraph to a ticker tape that would continuously print out abbreviated company names (ticker symbols) followed by the price and volume data. Thomas Edison later upgraded the system to reach a printing speed of one character per second. Ticker tape eliminated the need for messengers and allowed people to trade in “real time” from long distance. In 1900, 14 year-old Jesse Lauriston Livermore started working as a quotation board boy in the Boston office of Paine Webber. His job was to update the board with information coming off the ticker tape. He became interested in the behavior of stock prices and began recording price movements that enabled him to spot patterns prior to sizeable advances and declines. A fellow office boy later talked him into speculating on a stock on margin at a bucket shop. Two days later, Jesse sold the position with a $3.12 profit. He soon quit his job and started trading for a living. Jesse made his first $1,000 (around $27,600 in today’s dollars) at the age of 15. He was later banned by most bucket shops in Boston as he had outfoxed many of the shady operators. By the age of 20, he had accumulated $10,000. Then came the big payday — the Panic of 1907 — during which Jesse shorted the market and made $1 million ($25 million in today’s dollars). He would top this feat and live up to the reputation as “The Great Bear of Wall Street” by shorting the market in 1929 for an astounding $100 million profit ($1.43 billion in 2017!), making him one of the richest men in the world. The combination of elevated investor complacency and a tightening Fed makes the market vulnerable to a pullback. Unfortunately, the concept of diversification probably never crossed Jesse’s mind. He somehow managed to lose all his money and was bankrupt by 1934. The bankruptcy resulted in an automatic suspension of his membership on the Chicago Board of Trade. In 1940, the legendary trader, suffering from depression, shot himself in the cloak room of Manhattan’s Sherry-Netherland Hotel. Rise of the Machines How things have changed from those simpler days when humans were doing the trading. Today, with the advent of technology, market activity is dominated by passive and various quantitative strategies. It is estimated that fundamental discretionary investors now account for only 10% of the trading volume. Big inflow into major ETFs prompted buying across the board regardless of company specific issues and valuations. Big data and machine learning are the new buzz words. Forbes recently featured a quant fund run by three twenty-somethings. Their assets under management was in the low tens of millions of dollars, yet they averaged $1 billion in transactions, or 10,000 to 40,000 trades each day. Since there are only 86,400 seconds in a day, this fund would generate a trade every 2.16 to 8.64 seconds if it worked around the clock. Much of the decision making and trade execution, of course, has been taken over by software algorithms. These whiz kids employed statistical arbitrage trading strategies in stocks and currencies, and closed out all trading positions at the end of each day. The allure of sophisticated computer models trouncing their human competitors has continued to attract inflow to quant funds. It is estimated that quantitative hedge funds now manage more than $1 trillion, about one-third of the $3 trillion hedge fund industry. While there are indeed brilliant quant managers who have delivered strong returns over a long period of time, the sheer size of the industry means there are likely more pretenders than contenders. Given that many funds employ similar strategies (e.g., trend following), a reversal in trend could create disruptive market movements, not to mention the threat of rogue algorithms wreaking havoc on the market. MONTHLY MARKET REVIEW NOVEMBER 2017 2 HOUSE_OVERSIGHT_012096