From Market Making to High Frequency Trading: A Brief History (part 2)
Sep 22, 2010
Posted by Jody Eisenman | Filed under Uncategorized
I’m going to share with you something few investors actually know. Most people are familiar with the market crash of 1987. What most people don’t know are the circumstances regarding the over the counter market. First, a bit of background. October 19, 1987 is now known as Black Monday. The stock market had been slowly declining since the beginning of the month. On Wednesday October 14, the DJIA closed down 96 points, which was almost a four per cent decline. The next day, we were down 57 points, and the following day (Friday), we dropped another 109 points. Thus, in three trading days we were down 262 points, or over 10 per cent. Investors were skittish over the weekend, as the market decline accelerated into Fridays’ close. However, this was just the prelude to Black Monday. On that day, I remember sitting in my office at 14 Wall Street, and listening to the intercom on my desk that told me pre-opening information. Usually, they would say things like “We see small sellers”. This was before the internet and CNBC. On this day, all I heard were massive sellers coming in. By the time we closed, we had lost 508 points, or over 22% off Fridays close. It was pretty shocking. I still remember coming home and watching the news, where it was the lead story on every channel (there was no cable then!). The newscasters then stated that everyone looked to Asia, to see how the markets there would open. Of course, the markets plunged in record volume. One guy in my office attempted suicide over his losses.
However, the real fun came later. The way trading was done was through market makers as described yesterday. However, virtually all trades then were done via telephone in those days, and not electronically as today. Therefore, in order to consummate a trade, your trader had to physically call the other market maker in order to confirm the trade. Pretty soon, the large firm market makers like Merrill and Smith Barney realized that they were facing huge sell orders from their brokers, Normally, they would turn to market wholesalers (NITE does a lot of this today) to sell their positions. However, the wholesalers soon realized the magnitude of the decline, and they were unwilling to take in any stock. Therefore, in many cases, they simply refused to answer their phones. However, no one moved their markets. To put this in prospective, I tried to sell 1500 shares of a stock called Phoenix Reinsurance on the Tuesday following the crash. I could not. My trader would not take the stock, something that would not happen today. The stock was trading around 14. I finally sold it 10 days later at 10! I know that sounds crazy, but there were no other options. Essentially, the entire over the counter market failed. Investors could not sell, and the prices on the screen bore no connection to reality. Had investors at the time realized this, it might have caused a severe panic. The regulators knew they had to act.
In my next post, I will discuss the changes that were made.
