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October 14, 2008

Old Guard to Vanguard

By Michael Scotti

That flickering quote on your screen is delivered to you by some of the smartest minds on Wall Street: automated market makers. Using a range of methods commonly referred to as black box trading, these automated market makers use quantitative models to make tight and efficient markets. Their flickering quotes are caused by the huge number of cancels and replaces they employ in their strategies. And you can bet that they are profitable-otherwise, why would their ranks continue to grow?

This group of high-velocity trading firms IS the marketplace today. Some believe that they are involved in more than half the trades. You can read more about how automated market makers have altered the equity trading landscape and further analysis on the subject in this month's cover story.

The computer's role in the evolution of trading has been nothing short of astonishing. The manual market maker's slide began with the SEC's Order Handling Rules in 1997, which created the ECN and competition for dealers. It was clear the old order had officially ended when OMS pioneer Bob Greifeld was named president and CEO of Nasdaq in 2003. Greifeld, coming from the processing side of the business, had this to say when he was hired: "What the Nasdaq has to bring to market is fast execution, depth of liquidity, and all at a low transaction price. If we do that well, all good things will come." It is safe to say that his prediction has come to pass.

Nasdaq's Small Order Execution System, or SOES, was a distant memory by the time Greifeld took the reins at Nasdaq. SOES, by today's standards, was a rudimentary auto-ex system on Nasdaq that gave retail investors guaranteed fills at a time when most trading was phone-based. It was the perfect system for good traders to game. So it didn't take long for a group of quasi-retail investors throughout the 1990s to take advantage of this edge. Harvey Houtkin, one of the most vocal proponents of SOES trading, died this past summer. There's a piece this month on Houtkin and his place in electronic trading history.

Lastly, Peter Chapman's story on MiFID outlines how the U.S. model for trading equities is being exported to Europe. Under Europe's new equity landscape with MiFID, competition to established exchanges is ramping up. Just like ECNs and competing exchanges sprang up in the States, Europe is getting its own version of trading rivalries. These competing systems are called MTFs, or multilateral trading facilities. If you doubt that equity trading is in the midst of a technology arms race, just ask yourself whether multilateral trading facility sounds like a weapon under development at the Pentagon.

Michael Scotti

Editorial Director

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