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February 1, 1999

The New Wall Street Computer

By John A. Byrne

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The increasing transaction volume on Nasdaq and the New York Stock Exchange was fueled by a seminal event the unbundling of fixed commissions in May 1975. Until then, Wall Street trading houses did not use their commissions to compete.

Whatever semblance of competition there was revolved around the value of prep-school connections, and gastronomic accounts at the most posh restaurants in town.

As soon as brokers started competing with commissions, however, two forces were unleashed: a steady increase in stock transactions as prices tumbled, and the closure of dozens of firms crippled by unproductive backoffices.

The backoffices of Wall Street were a source of constant crisis throughout the 1960s, when the deluge of manual processing threatened to overpower the capacity of the NYSE and its member firms. Soon after May 1975, a streamlined, sleek backoffice was an essential component of a profitable firm.

As commissions tumbled, the subsequent squeeze on profit margins reduced the subsidy available for handling stock transfers, recordkeeping and settling trades. And people in Victorian-era backoffices lost their jobs.

The unbundling of commissions had another effect: It triggered the start of the soft-dollar business in place today, as a safe-harbor law allowed brokers to claw back the cost of providing research and other services to institutions.

The Technology Curve

If the unbundling of commissions meant the elimination of inefficient firms, it did so as Wall Street trading firms scrambled to upgrade their processing and trading systems. At the same time, the microchip processor and digital communications were in the ascent, opening the way for unprecedented change.

Junius Peake, who in 1961 started running the 700-person backoffice at New York broker dealer Shields & Co., was scoffed at when he presented his blueprint in 1976 for the creation of a nationwide electronic marketplace.

His vision was in line with the unbundling of commissions and most importantly, the National Market System mandated by Congress a year earlier.

Today, the realization of a national market system linking investors, market makers and price-quote vendors with the best-available prices at the moment of execution, is taking shape.

And thanks to the intersection of technology and regulation, Wall Street trading desks are embarking on more change change unimaginable a few short years ago.

Peake, now a finance professor at the University of Northern Colorado, compares the current pace of change to curves joined and shaped like the letter "s." The left side represents the introduction of a new technology, which in this instance means the microchip in the 1960s.

At the beginning, the pace of change is slow, gathering momentum towards the middle, later peaking at the top. "We are about one-third of the way along this curve, and I would say we have about another 50 years to go before we will peak," he said.

The effects could be profound for Nasdaq market makers and other traders.

"There will be a strong dealer component in the marketplace over the next few years. But only a hundred market makers will be actively doing business," predicted Kenneth Pasternak, president and chief executive of Nasdaq market-making giant Knight Securities. Currently there are roughly 500 active market makers in the U.S.