From Market Making to High Frequency Trading: A Brief History (part 3)
Oct 11, 2010
Posted by Jody Eisenman | Filed under Uncategorized
We left off last time with the 1987 crash and the changes that the regulators had to make. In 1988, the Small Order Execution System (known as SOES) was adapted for 25 stocks. It later expanded to many stocks that trade on the OTC. The regulators were concerned that small orders were being prejudiced by large orders, and that (as I discussed in the last segment), orders were not getting executed at all. Prior to this rule, if a market maker had an order on his desk for 100,000 shares from an established client, and another order for 1000 shares for another investor, some market makers might favor the established client. SOES now prohibited this. The second part was met with much skepticism and opposition by the market makers. This new rule specified that market makers must meet their established quote for up to 1000 shares. Well, what’s the problem, you say? The problem was this: Lets say a market maker in ABC stock was the best bid at 25.All of a sudden, news came across the tape that was negative to ABC. Market makers frequently trade 30 or more stocks, so it could happen that the trader did not see this. All of a sudden, the stock was 24 offered, but he was still 25 bid. Now in pre-SOES time, the other market makers would realize he neglected to move and would alert him. The reason for this was twofold: it was sort of an old boy network, and because the same thing could happen to you the next day. However, with SOES, a trader could go short 1000 shares and force the market maker to accept the trade. Day trading firms began to appear that took advantage of this, Although the you couldn’t “hit” the same market maker more than once, nothing prevented 5 people different people from doing it. All of a sudden, the trader was long 5000 shares down a point, and looking at a $5000 loss. Worse, he couldn’t retaliate. These anonymous traders used electronic trading systems, and did not make markets. If you were on the floor of a large market making firm in the late 80s and early 90s, you used to hear the cry “I’ve been SOESed!” a lot. These anonymous traders were soon known as “SOES Bandits”. However, it got worse for the market makers. The SOES limits were raised for higher priced stocks. Lets say stock XYZ was trading 30 bid, 33 offered. The SOES limit was 2000 shares. Two SOES bandits working in tandem could pull the following:1 bandit would put in an order to buy 100 shares at 32 1/4. If the market maker did not have the stock in inventory, he would now be 32 1/4 bid. Bandit number 2 would then sell 2000 shares (generally shorting them) at 32 1/4. The market maker would be forced to execute that trade there. The market would go back 30-33. Bandit one would then put in a sell order for 100 shares at 31. Immediately, bandit number 2 would put in a buy order for 31, where he would get executed. Now trader 1 would have a point and quarter loss on his 100 shares, or $125. However, bandit 2 would have a riskless profit of a point and a quarter on 2000 shares, or $2500. They would then split the net profit of $2375 between them. The next day, they would do the same thing on another stock. Needless to say, the market makers were furious, but there was nothing they could do. Even if they wanted to, they had no idea who these bandits actually were. A lot SOES traders made out, well, like bandits for years. It is important to note that although what these bandits were doing may have been unethical, it was clearly not illegal. What finally happened was the market makers received permission to change their limits. Today, it is rare to see market makers showing size of more than 1000 shares; more frequently, the size is only for 100 shares. At that level, they could not get burned much. The SOES bandits eventually disappeared.
In my next segment, I will discuss the wild world of high frequency trading, where human involvement is rapidly becoming obsolete.
