Technology and the Stock Market

On October 27, 1986, the London Stock Exchange introduced the Stock Exchange Automated Quotation System to replace the trading floor. The day became known in history known as the "Big Bang" - after the introduction of automated trading, the number of trades made in a month was around the number of trades made in a whole year before 1986. However, in past decades the stock market had been changing already. The point is, introducing computers into the equation wasn't a drastic change because the market had adjusted to technological innovation before. For example, take into account the effect of the telegram, which was introduced to Wall Street towards the end of the 19th century:

Wall Street, 1850s

Wall Street with Telegram Wires

I got these pictures from another blog about the stock market and it's history, nerdsonwallstreet.com.

Although the advent of computerized trading came across as a "Big Bang", it really wasn't. Researchers, academics, and those involved in the financial markets had seen this coming because they knew it was only a matter of time before computers became a fixture in our lives. Automated trading may have not been introduced until the 1980s, but even in the 1960s people like Gunter Rischer were making predictions about computers and their future involvement in stock trading.

In a 1961 issue of the Financial Analysts Journal, Rischer wrote a short essay on computers and the stock market. In it, he explained how it was pretty much inevitable that computers would eventually be employed by stock traders to perform calculations on masses of economic data. In the 1960s, the most widely used stock statistics were price-earnings ratio (P/E ratio) and dividend yield because they could be calculated the quickest. With computers, calculating anything and everything about a stock becomes easier - this gives everyone more information to judge a stock on. But who would get this information? Rischer considered two cases: (1) the information obtained from computers accesible just to a restricted group, or (2) to the public. In case (1), Rischer explained that he who has the computer has a "truly differential advantage over everybody else" without a computer. However, the more likely scenario would be case (2). In this case, every investor would profit from the advantage of more information but nobody would have an edge over anybody else; this in effect just raises the bar.

What I found most interesting about this essay by Rischer is his conclusion and predictions about future implications of automated trading. He wrote that with time, the financial analysts and investors need not worry about calculations on stocks and their current position because this would be done by computers. Thus, they could focus their attention to future outlook of companies and stocks. At the end of his essay, he points out that with computers, the competition will lie in the appraisal of the future rather than the appraisal of the past and present. "This does not seem to favor stability of the stock market", he said. "If anything it would make for greater instability."

This foresight by Rischer, back in the 1960s, amazed me because he was totally right. Currently, futures markets are a big player on Wall Street. Additionally, speculation about the future of a company's health can make or break that company's stock price. Last year, the European debt crisis affected Wall Street also on pure speculation. Nowadays, we are always talking about what will happen next, and this makes the stock market unstable.

Ultimately, the introduction of computers to the stock market was no big surprise. Just like the telegram, it "raised the bar", so to speak, giving investors and analysts more information on which to make decisions. Computers processed information about stocks efficiently and with ease, giving everyone more time to think ahead instead of looking back at the old numbers. But does this create instability in the market?

Sources:

[1] Karl Flinders, The Evolution of Stock Market Technology, Computer Weekly, Nov 2, 2007, http://www.computerweekly.com/news/2240083742/The-evolution-of-stock-market-technology

[2] David Leinweber, An Illustrated History of Wired Capital Markets, Nerds on Wall Street (blog), http://nerdsonwallstreet.com/illustrated-history-of-wired-capital-markets-132/

[3] Gunter Rischer, Computers and the Stock Market (A Comment), Financial Analysts Journal, Vol. 17, No. 4 (Jul-Aug, 1961), pp. 91-93, http://www.jstor.org/stable/4469230