PROFESSOR ROBERT SHILLER: Well,
today I wanted to talk about exchanges and
clearinghouses, primarily stock exchanges. So, these are places,
where shares in corporations are traded. And I think, it's good to devote
a whole session to them, because exchange is
central to economics. In fact, I was struck
recently. I was re-reading the
presidential address of my old teacher. When I was an undergraduate at
University of Michigan, I took a course by Professor
Kenneth Boulding. I suppose, I'm influenced
by him. When he was elected president
of the American Economic Association, he gave a
talk about economics. And he had an interesting
definition of economics. What is economics? There's a lot of definitions
given for the field, but one definition is the theory of the allocation of scarce resources. That's, by some definition,
what the essence of economics is. But Boulding said, that doesn't
sound right to him, because political science is
about the allocation of scarce resources, and so is -- even the family is an instrument of scarce resources. So, Boulding said in -- it was his 1969 presidential
address -- that economics is the
study of exchange. Obviously, it's prices and
quantities that economics emphasizes, and those are
parameters of an exchange. So let's say, that
equals economics. I'm reminded of another book. I'm talking in very general
terms first, and then I'm going to focus in on
stock exchanges. But I'm reminded of another
really important book, which I read so many years ago, by Karl
Polanyi called The Great Transformation. And that was written in 1944. What is the great
transformation? Well, for Polanyi, it's the
invention of exchange. He said, what is the most
important invention of man? Maybe, it's exchange. According to his history of
humankind, this was a relatively recent invention,
Neolithic or more recent than that. He argues that in primitive
societies, there is really no arm's length exchange. An arm's length exchange is one,
where you just quote a price and a quantity, and you
don't have any other business. The price and the quantity
sum it up. It's a business transaction. But Polanyi argued, that until
just something on the order of 10,000 years ago, there were
no business transactions. There was only gift exchange. There were relationships
people had. And you would solidify a
relationship by making a gift to someone else, and then
that person would later reciprocate, but there's no
price, there's no exchange. So, he claims that the
development of our civilization is really the
result of the development of the idea of exchange, and then,
an amplification of the idea as it became more
and more pervasive. By the way, I've since
learned -- I thought Polanyi was
very impressive -- but some anthropologists
question, whether there wasn't exchange more than
10,000 years ago. And they cite evidence. One kind of evidence that's
found of this is, that certain commodities, even in the
Paleolithic times, certain commodities are found far from
where they were mined. Like flint to make stone
tools, or ochre to make body paint. And they figured out where --
you can do a chemical analysis and you can figure out
where it was mined. And then, if you find that it
arrived somewhere 1,000 miles away, there must have been
exchange, right? The cave -- no? STUDENT: Couldn't they have
just killed someone? PROFESSOR ROBERT SHILLER: OK. It could have been, that they
just killed someone, right. So, I guess nobody knows. But anyway, some anthropologists
argue that there was exchange. Maybe, it was too pervasive. Of course, people did kill a lot
of people in those days, too, anthropologists report. So, maybe Polanyi had
it exactly right. But I think, he had it at least
approximately right, that exchange has become a
bigger and bigger part of our lives, and that's modern
civilization. I'm going to talk mostly about
financial exchange. That's the subject
of this course. But I can be a little
bit more general. I wanted to start by
distinguishing a broker and a dealer. What's the difference? It's a fundamental thing. A broker -- actually, I've got this
almost as a slogan -- a broker acts on behalf of
others as an agent to earn a commission. So, it's for others, trades for
others as an agent for a commission. A commission is a fee. What is a dealer? A dealer trades for himself
or herself, acting as a principal, not an agent, and
profits from a markup. So, I can give you an
example of each. When you buy or sell a house,
do you get a real estate broker or a real
estate dealer? That's almost obvious, right? Because you heard the
term real estate broker so many times. When you buy or sell a house,
you commission a broker, and you agree on a contract that
pays the real estate broker a certain sum of money --
maybe 6% of the value of the house -- if a buyer is found. And then, the broker doesn't
buy your house, right? So, the broker is an agent. And the 6% is the commission
that the broker gets, if he or she is successful in finding
the other side of the deal. What's an example of a dealer? An antique dealer. Suppose, you're buying a chest
of drawers for your apartment. You go to an antique store, and
there's someone there -- your antique dealer -- who has furniture, that he now
owns, having bought it, and makes a profit by selling it
to you at a higher price, namely with a markup. He marks up the price that
he paid for the item. But let me just ask you,
why is it that way? Why are antiques sold
by dealers and real estate by brokers? I recently had a discussion with
Guillermo Ordonez, who is an assistant professor here, and
we were wondering, maybe there are real estate dealers. Oliver helped us and found,
actually, in Germany, a couple of real estate dealers. But only like a couple, and we
couldn't find any in the U.S. And we had searched around in
many other countries, and there was just virtually none,
no real estate dealers. Anyone have any idea why? I'm asking you to think. It's a little -- or does anyone come from a
country, where they have real estate dealers? And that would end
it, if you -- I bet not, right? Well, what about antique
brokers? Why not that? Have you ever heard of
an antique broker? Maybe, there are. But it's an interesting
question. It seems like some markets are
naturally dealer markets, and some are broker markets. We thought of one explanation,
why there aren't real estate dealers, at least in
the United States. We learned that a dealer has
to pay income tax on the profits from a deal, and that
is at a higher rate than a capital gains tax, and so
that closes people out. You wouldn't want to be a real
estate dealer, because you'd end up paying a higher tax. The other thing is, I wonder
if there's something about information, that someone who
deals in real estate -- it's just too hard to know
what to pay for a house. It's just so subjective. You can make big mistakes, if
you're going to buy houses, and then resell them at a
markup, because the market is just so variable, and it
ultimately changes quickly. Maybe it's too risky. I don't know. I'm trying to think. But of course, there are
real estate dealers, it's just very rare. So, we're going to talk
about stock markets. Which do you think stock
markets are? Are they dealer markets
or broker markets? Well, the answer is both. And now it's not as clear, and
I'll come back to this. The New York Stock Exchange, New
York Stock Exchange in New York is a broker market. Or they would say, an
auction market. It's a continuous double auction
market, where a broker facilitates the trades. The NASDAQ market is
a dealer market. So, you pay commissions to your
broker at the New York Stock Exchange, you pay
a markup to your dealer at the NASDAQ. [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER: I
thought I will start by talking about stock exchanges,
and historically -- And I have a lot to say. I can't cover it all -- I was going to start with
ancient Rome -- I think I mentioned
that before. But the -- I'm getting there
in my notes -- the ancient Roman stock exchange
is the first stock exchange, that, I think,
anyone knows about. But traders -- I'm relying on the research of
Ulrike Malmendier, who has studied the ancient Roman
stock exchanges much as can be studied. There's not that much
evidence about it. But the traders met outdoors
on the Roman Forum at the Temple of Castor. That's where you went to
buy and sell shares. The shares in Latin were
called partes -- I don't know if I covered
this or not -- and the companies were
called publicani. The peculiar nature of the
ancient Roman corporations is that they sold -- their
customers were the government. And so, they did services for
the government, like provide horses for the army, or they
would feed the geese on the Roman forum, on the
Roman capital. They always fed the geese there,
because the geese were hallowed in Ancient Rome,
because they once warned of an invasion by cackling. So, there was a publicanus
that was in charge of feeding the geese. And also, they would talk
about share prices. It's known, that they would go
up and down, even then, but there's no data on their
share prices. It seemed, that there was a long
gap for stock exchanges after the fall of the Roman
Empire, and the publicani disappeared. And there was a wide variety
of financial arrangements, some of them resembling
corporations. But the advent of the rebirth
of the stock exchange didn't occur until 1602 in Amsterdam,
when the -- I mentioned this before -- when the Dutch East India
Company started trading. And then, Jonathan's
Coffee House -- I like that story -- in London. Lots of people would get
together and talk there, and coffee houses became a big
thing in the late 1600s. And somebody started posting
stock prices on the wall at Jonathan's Coffee House by -- what was the date -- 1698. And so, the London Stock
Exchange grew out of Jonathan's Coffee House. And then, moving forward in
time, now we're going to get lots of countries, but
I'll mention the New York Stock Exchange. The traders of shares in the
United States met outside, in 1792, under a buttonwood tree. I'll put buttonwood. That's a curious name. I think that's just
a common tree that we still have around. And they signed the agreement
to form the New York Stock Exchange. What else? Next, in my little history. India. By the 1850s, there
were in Mumbai -- or then called Bombay -- there were traders under
a famous banyan tree. They were all outdoors. In Bombay. Banyan trees are
more impressive than buttonwood trees. But it was by 1875, the Bombay
Stock Exchange was founded. So, that's the BFC. So, that's been around
for over 100 years. But things have happened
more recently. One thing that's been shaking
things up -- these are very venerable old institutions -- what's been shaking things
up is the advent of electronic trading. And these were kind of
old-fashioned, venerable institutions. Do you know what happens at the
New York Stock Exchange, what happened then and
still happens today? There's a floor called the
trading floor, and the various brokers meet there, just like
in Jonathan's Coffee House. They actually physically come
to the floor and they stand around, and there are posts
for each stock. And if today you think, you have
a customer who wants to buy IBM stock, then you go over
to the IBM crowd, and there's a crowd of brokers
there who are trading. And you just do it, verbally. You talk to them and
you make a trade. That's really old-fashioned. There is something more
electronic and more modern about the New York Stock
Exchange, but that specialist post behavior still persists. Most of the world is switching
over to electronic trading, and so things happen that -- so, for example, in India they
developed another stock exchange called the National
Stock Exchange, and that was in 1992. And the National Stock Exchange
was all-electronic, and so it was the
modern version. It's rapidly gaining on the
Bombay Stock Exchange. So, let me go a little
bit more forward. China, because of the communist
government, did not have a stock exchange
until 1990. And there were two stock
exchanges founded in China in 1990 -- Shanghai, Shenzhen. And at least the Shanghai Stock
Exchange is owned by the Chinese government, and that's
why Laura Cha, when she talked to us about that -- she was on the China Securities
Regulatory Commission, which actually
owned the Shanghai Stock Exchange. Oh, Latin America. Sao Paolo Stock Exchange,
1890. Mexico has only one stock
exchange, but it was founded in 1894. So, we seem to have like two
different kinds of exchanges. We have the old exchanges, which
are at least 100 years old, and we have the new
electronic exchanges. Things have really sped
up with the advent of electronic exchanges. So, I mentioned the New York
Stock Exchange, which started on the street outdoors and is an
old-fashioned exchange that has been slow to update. But more recently, we have -- I mentioned it already -- NASDAQ. It stands for, originally,
National Association of Securities Dealers Automatic
Quotation System, which was created in the 1970s. It's an interesting story
about NASDAQ. In the '70s, the New York Stock
Exchange with highly prestigious. It was the big board,
the place. And a critical element of as
stock exchange is, that, in order to get your stocks traded
on the exchange, you have to satisfy listing
requirements. So, the New York Stock Exchange
would examine any corporation that wanted to be
listed on the exchange, and it was the prestigious,
big exchange, so it had high standards. So, the company had to have a
history of earnings, it had to have the right kind
of management structure and board. A lot of things were checked out
by the exchange, and as a result, the way it would work
in the 1970s, a startup company could never
get traded on the New York Stock Exchange. It would be traded, instead,
by brokers off-exchange, or ''over-the-counter.'' So, OTC
means ''over-the-counter," that means not on an exchange. So, in the 1970s and earlier,
the over-the-counter brokers would deal with each other,
informally with telephone calls, or actually out
on the street. Meet each other out on the
sidewalk originally, and then they got telephones. And they had some record,
which they called ''pink sheets,'' because they
were traditionally printed on pink paper. These were lists of dealers' buy
and sell quotes on prices of over-the-counter stocks. The National Association of
Securities Dealers, then, was an organization of these
over-the-counter traders. And in the early '70s,
they set up the first computerized system. They decided that everyone's
telephoning everybody -- let's create a system that
really works and that gets us the information. And so, that was the NASDAQ
system, the first computer based system, which has now
increasingly taken over much of the world. I shouldn't imply that the New
York Stock Exchange was entirely a laggard on this. Electronics played a role in
stocks going back very early. The New York Stock Exchange
used telegraph in the 19th century to convey
prices, and they invented ticker tape machines. A ticker tape machine is an
electronic printer that would print out stock prices. And in fact, Thomas Edison,
the inventor, his first invention was actually a
ticker tape machine. That was in, I think,
the 1870s. It printed stock prices. But all it was, was a record of
what had traded recently. It wasn't a system that
helped you trade. You just reported what had
happened, it was historical. So, I wanted to show you, what
NASDAQ created in the '70s, and it's an order book, that
would be visible to everyone who trades on it. Prior to discussing that,
I want to tell you about different kinds of orders. If you buy and sell stock, and
you call up a broker and you say, I want to buy and sell, the
simplest kind of order is a ''market order.'' And you
would specify the quantity. You would say, I
want to buy -- and the name of the company,
of course -- I want to buy 100 shares of
General Motors, or I want to sell 100 shares. But you don't name a price. You'll find out, whatever
the price was. The broker will get you
the best price -- if he or she is a good broker,
will try to get you the best price, but it'll still be
unknown to you, because you didn't specify it. You might be unhappy
with the price. The price might be too
high [addition: if you want to buy shares]. And then, the broker will say
to you, well, if you're unhappy, you should've
told me. You could have told me not to
pay more than a certain amount for a buy, or not to take
less than a certain amount for a sell. So, the alternative is a ''limit
order.'' And so, with a limit order you give both
quantity and price. So, if it's a buy, I want to buy
so many shares but I don't want to pay more than such
and such a price. Then, the broker will keep
that on his or her books, until -- well, whatever the agreement
between you and broker is. It might expire after the day
is over, or you could ask to have it kept on the book. And when the price becomes
available, which is no higher than your specified
price, then the order will be executed. Otherwise, it won't
be executed. And then, for a sell order, it
would be the same thing. You specify both the quantity
and a price, and the order will be filled or
partly filled. They might not be able to get
all of your quantity, but they'll fill as much as
they can of it at that price or lower. And there's another kind of
order, called a ''stop order.'' With a stop order, you
also specify quantity and price, but it's different. With a limit order, say it's a
buy limit order -- well, let's talk about sell. If it's a sell limit order, you
would sell the quantity at such and such a price
or higher. With a stop order, you would
sell that quantity at such and such a price or lower. Let's make that clear. A stop order, also called a
''stop loss order,'' is an order that you can place with a
broker to indicate, that I'm worried that this stock
might really collapse. I'm holding it, but I want you
to sell it, if the price starts falling a lot. So, suppose the price
is $100 today -- I could put in a stop loss order
at $80, and then, at least I know I can't lose more
than 20% of my investment, because the broker will
immediately sell it, when the price of that stock
falls below $80. There's also a buy stop order,
and that would be something that someone would rationally
do, if that person had shorted a stock. So, if you had shorted a stock,
and you were worried that the price would go up and
ruin you, you can leave with your broker a buy stop
order to sell it -- I mean, to buy the stock,
whenever the price exceeds a certain amount. And you would do that to prevent
yourself from having unlimited losses on your
short position. There's other kinds of orders,
but those are the main kinds of orders. Now, I wanted talk specifically
about limit orders -- that's the most
important kind. A lot of advisors say, never
place a market order. Why should you ever
do a market order? There's always some price that
you'd be unhappy with. You might as well say that. And so, some exchanges don't
even allow market orders. So, let's talk about
limit orders. And what I wanted to show you
was, what a NASDAQ level II customer sees. NASDAQ is an organization -- now it's a firm traded on its
own stock exchange, it's called NASDAQ OMX -- but if you want to subscribe
to NASDAQ, it's very expensive, I understand. So, you can subscribe at
level I or level II, which is more expensive. I was going to show you an
example of what you would see on your computer screen, if you
subscribe to NASDAQ level II, for a particular stock. So, this is a hypothetical
limit order book for Microsoft. What it shows -- this is not live, but it would
be live on your screen, and these numbers would be changing
before your eyes, flashing back and forth
before your eyes. And so, I've just frozen
it at a moment in time. So, what do we have? We have six columns here. This first column is
the shares that people want to buy. So, the first three columns
correspond to those. So, ''bid'' is the price
there, bidding to buy these shares. Remember, NASDAQ is
a dealer market. So, these dealers are making
these bids, or people are making them through a dealer,
and MPID is the marketplace ID, where these bids and
offers are being made. So, the first one shown, someone
is offering to buy 100 shares of Microsoft at a price
of $25.23, and that is listed on ARCX. ARCX, there's an
interesting -- I didn't mention
that exchange. It's now part of the New
York Stock Exchange. Maybe, I'll come back to that
in a minute, but let me just continue to explain
this slide. Now, you note that the bid
prices are arranged in declining order. They go down as you move down. The computer has sorted
all the orders. These are all the
unfilled orders. Someone called their broker and
said, I want to buy 100 shares, and the broker entered
the bid through ARCX, and it's now on the NASDAQ screen. Someone else had a much bigger
buy order, wants to buy 9,430 shares, and this came in
directly to NASDAQ, but it's a penny less, $25.22. So, you can just see what's
happening, when you go down. Now, the other side -- is that clear what we're
seeing here? The other side of the screen is
the buy [correction: sell] orders, and it's exactly the
same, except that here the numbers go up as you move down
the screen, because the computer has sorted them
in the reverse order. So, that represents what various
people are willing to buy [correction: sell]. So, somebody is willing to
buy [correction: sell] 2,400 shares at $25.24. Actually, there's two
different customers. This one placed the order first,
so I think that's the priority, it's by the one who
placed it first. Somebody else at the Cincinnati Exchange -- I guess that's what
that means -- offered to buy 8,200 shares at
the very same price, but it's listed as a separate
order, and so on. So, now you're sitting here
looking at the screen now, and you notice that this ask price
here, it's higher than the bid price there. So, what does that
mean to you? It means there's no
trade, right? Because someone is offering to
sell at $25.24, and somebody's offering to buy at $25.23. It's no trade, until somebody
changes their price. That's no surprise, because
these orders would be filled very quickly, if there's
a crossing. These two lines don't cross, so
it's like, if you plotted these curves, they're supply
and demand curves, right? We could plot the amount
at various prices. Well, you can see, I'd have
curves, a supply and demand curve, that don't cross. Normally, they have to cross
somewhere, and then, there's a market-clearing price. These things normally don't
cross, because, if they did cross, it would immediately
disappear from the screen. Someone would finish the order
and there'd be a sell. But you, sitting at the screen,
now have a pretty good idea what the price is. A NASDAQ level II is better
than an NASDAQ level I, because level I just gives
you the first row. It's cheaper to subscribe
to that. What NASDAQ level I gives you,
is the inside spread. It would tell you, that there is
a 100 shares bid at $25.23 and ask at $25.24, and if you
want to hit that order, you could take either
side of that. But it doesn't tell you
the whole picture. If you know NASDAQ level II, you
know a lot more about the market, and if you're going to
play the game of trading, you want to know this. So for example, you know that
it might be hard for a price to fall rapidly below $25.22,
because there's a big buyer down there, and so it's going
to be hard for the price to fall below that. If you saw this screen in real
life, these numbers would be just blinking, changing
rapidly before you. And trades that were there
20 seconds ago would be gone in a flash. So, you've got to move fast
to execute these trades. On a fully automated system, the
trades would be executed automatically, and this
is becoming -- electronic trading is taking
over the world. And the orders can be executed
by computers that make it instant, so that the number
doesn't even appear on the screen long enough for
you to see it. So, one development that's
coming in now is, what's called ''high frequency
trading,'' HFT, which is trading that is done
by computers. Once you have a system
like this -- when you have to trade through a
floor broker on the New York Stock Exchange, it has to
proceed at human pace, right? The way it works is, you make
a telephone call to your broker, your broker makes
another telephone call to the representative on the floor of
the New York Stock exchange, that person walks over to the
crowd, and then discusses it, and indicates what -- it's like a poker game. You don't want to reveal your
hand, but you kind of feel people out, and then
after a little discussion you reach a trade. But when you have something
that you can hit on a computer, it just
goes instantly. So, people start programming
trading, and that's been an important phenomenon, because
you see these moving faster than you can -- these prices disappear and
reappear so fast that you can't quite know, you can't
act fast enough. So, we have algorithmic trading,
or program trading. So, that goes back practically
to the 1970s. Certainly by the '80s, program
trading was becoming a big and important phenomenon, and it's
becoming increasingly important now. High frequency trading now -- brokers will invoke what are
called ''millisecond strategies.'' You can actually
flash an order on some of the exchanges that lasts a
thousandth of a second. You can put a buy order or a
sell order, and retract it in a millisecond. This could be a trading
strategy, which you might employ. You could do that to discourage people from trading. If you want to trade only with
the computers, if you think people are too smart for me,
I don't want to trade with people, I want to rip off the
computers, then you write a millisecond trading strategy,
and then you can sort who trades with you. Now, the interesting thing about
millisecond trading is that it's favoring the
electronic exchanges. As time goes on, people are
getting more and more sophisticated about high
frequency trading, and so they want to trade on exchanges that
are fully electronic, so they can play all
of these games. And that means that the floor
exchanges are dying out over most of the world. By the way, the New York
Stock Exchange -- I was going to give you
a history of this -- the New York Stock Exchange
has been slow to adapt to these technologies. Let me just give you a little
history of -- electronic trading is an exciting thing for
many people, but, I think, it started -- or the really interesting
electronic trading started with the ECNs, electronic
communication networks, that were allowed by the Securities
and Exchange Commission as alternatives to stock
exchanges. Stock exchanges are highly
regulated by governments around the world, but in the
1990s, the Securities and Exchange Commission allowed more
sophisticated electronic trading, at least as
an experiment. So, they didn't call these
things exchanges, they called them ECNs. One of the most important ECNs
was a company called Archipelago. Another one was called Island. And these were actually just
websites, where you could trade, and they were
open to the public. They had a different culture. They had more of
a web culture. The web culture is, we're not
going to charge you to see the order book, we'll just put
it out to everybody. The web doesn't charge you
for a lot of things. And so, they became popular
trading sites for the general public. They grew up the way the
personal computer grew, so the New York Stock Exchange, when
they first saw Archipelago, they said, oh, this is a bunch
of college kids fooling around, some computer
game, sort of. And they didn't take
it seriously. But eventually, the New York
Stock Exchange had to take it seriously, because Archipelago
was growing so fast. So eventually, the New York Stock
Exchange merged with Archipelago. So, they're now -- I think most of their trades
go through ARCX. I'm not sure if that's right,
but a large fraction of their trades go through ARCX. So, the New York Stock
Exchange bought Archipelago in 2005. And at that time, ARCX was
breathing close on New York Stock Exchange for
trading volume. Things are happening fast in
the stock exchange, because the technology is changing. Whereas we had the New York
Stock Exchange in the old days, it was this single
prestigious exchange that lasted for over 150 years
without any substantive change, but now electronic
trading is coming in and everything is being shaken up. So, the New York Stock
Exchange merged with Archipelago in 2005, and then
they did another merger -- let's say this -- New York Stock Exchange, with
Euronext, which is another exchange in Europe, in 2006. And right now, they're going
through another merger process, apparently with
the Deutsche Boerse. And that's 2011. It's not finalized yet. And now NASDAQ is getting in,
NASDAQ is making an offer for the New York Stock Exchange,
and so is another exchange called the Intercontinental
Exchange. [addition: The description
of these events is as of April 13, 2011.] But the little guys are buying
up the old-time big guys, so it's -- Laura Cha was saying in her
lecture, that she was struck, that we used to think of stock
exchanges as like utilities, each country has its own stock
exchange, it's the pride of each country, but now it's
not happening anymore. And this reflects a bigger and
broader trend that economies are becoming more and more
integrated across the world. So, the idea that there would
be a stock exchange for each country is becoming dated. So, the New York Stock Exchange
may soon be a German company, but that's what happens
in modern times. I want to talk about some
problems with high frequency trading, as things get
so electronic. Let me give you one example. In 1987, this was the early days
of electronic trading, but still it had advanced
pretty far. On October 19 of 1987, the stock
markets in the United States fell, according to the
S&P 500, over 20% in one day. The government did a study,
President Regan ordered a study, and put it in charge
of Nicholas Brady. And so, the so-called Brady
Commission did a report on why the stock market -- that was
the biggest single stock market drop in U.S. history. And the Brady Commission did a
report on that stock market drop, and concluded that program
trading, computer trading, had played a big
role in the drop. There had been a development of
programs that were called ''portfolio insurance sell
strategies.'' They called it portfolio insurance, but it
wasn't really insurance. It was an automatic
sell strategy. It's like a stop loss order, but
a more sophisticated one that could be executed in
continuous time by a program. And that led to an instability
in the market that was not anticipated and shocked
the world. So, the Brady Commission made
a number of recommendations, notably the commission
recommended that the exchanges impose trading halts that would
prevent stocks, the whole market, from crashing. So, the New York Stock Exchange
and other exchanges, after the Brady Commission
report, instituted what are called ''circuit breakers.'' And
these are automatic market halts that stop the market, when
prices are falling, to help prevent another 1987-type
stock market crash. But the system is getting
complicated. Even before this, the
United States government had created -- had passed a set of rules in
response to complaints about people not being given
the best price. So, here's the problem. We have multiple exchanges. The New York Stock Exchange is
one of many, and if you call a stockbroker, the stockbroker
has discretion over which exchange the broker will
use to fill your order. And so, the broker might
choose an exchange that doesn't give you
the best price. The broker can, in effect,
rip you off as a broker. In fact, there's a practice
called ''payment for order flow.'' So, a stockbroker, who's
receiving orders from retail clients, may find that
there is a dealer that's willing to pay for order flow. When a customer asks to buy
the stock, don't put it through the New York Stock
Exchange, give it to me. And I'll give you, the broker,
a fee for directing the order my way. And that may not serve the
client well, because the client then might end up
paying a higher price. So, there were a lot of
complaints about this, and it's a difficult problem,
because it's hard to monitor everything that people do. And there might be
justifications for payment for order flow. But there've been efforts
to try to make it a fairer system. And in 1975, the U.S. Congress
set up something called the National Market System. So, NMS is the National Market
System, and the ITS is the Intermarket Trading System. What the government in the
United States did is, it said that brokers have to get the
best price, what's called ''best bid, best offer'' for
their clients, and they have a responsibility for their clients
to take the market with the best price. In conjunction with this, the
exchanges built something called the ''consolidated
quotation system,'' that allows brokers to see prices
on various exchanges and direct the order of the client
to the exchange that's showing the best price. So, that is the system that
was started in the United States in 1975, and brokers
still have an obligation to get the best price for
their customers regardless of exchange. But the obligation is hard for
the government to monitor, and it gets complicated. For example, if you're
confronting this system, and your broker wants 500 shares,
well, I can't fill them all at the same price, right? Well, actually I could here. If the broker wanted 10,000
shares, they'd be all different prices, because I
have all these different customers asking different
amounts. So what do you want
us to do, SEC? And so the SEC recently
clarified this. I think, it was in 2006. Well, we only mean that
you have to get this, this one up here -- 2,400 for $25.24. How do you fill the others? Well, we can't get into that. So, it's not a complete
protection for customers, but there still is this obligation
for brokers to use the National Market System to
get the best price. But the system is complicated
and confusing, because there's so many computers involved,
there's so many different exchanges, and there's
so many rules. It's hard for people to
keep up with it all. On the reading list I had
a report that I -- I found the report. It was very much in the
news a while back. This is a report
on May 6, 2010. Do you remember what
happened then? That was not that long ago. The stock market, as of around
2:30 in the afternoon in the United States, had fallen 4%,
and then, within a matter of minutes, it dropped another
6%, and then, it rebounded quickly. Some individual stocks dropped
practically to nothing, and you could buy a $30 stock for
$0.30 something like that. And then, they rebounded. So what happened? Why did we have this
very brief crash in the stock markets? It wasn't like 1987, where
the market went down and stayed down. If you look at closing prices,
nothing much happened. It was this brief glitch,
which probably cost some people huge amounts of money,
because, if you were trading right at that moment, you'd
have a problem. So, I have as an optional
reading on the reading list a study, that was made of May
6, 2010 by the SEC and the Commodity Futures Trading
Commission, trying to understand what happened then. And the study does focus on
high frequency trading. There were a lot of computers
trading automatically at that moment in time. So, what apparently happened
on May 6 is, the market was already in a stressed
mode before 2:30 PM. The VIX index had shot up. There was some bad news --
the market was down 4% -- there was some bad news. So, that meant that some
traders were wondering, what's going on? And maybe, they decided to drop
out for a while and just be cautious, but the computers
were still trading. And then, something happened. The computers started trading
back and forth in milliseconds. And I don't know what the
programs were supposed to do or what they -- maybe nobody knows the
whole picture -- but the volume of trade just
went to an astronomical level, and it scared people off. And so, there were a lot of
trading pauses that were put. Exchanges have rules about that,
and individual dealers will say, I'm dropping out. I see all this volume, I'm
not in here anymore. So, it remains that the trading
that was left was substantially computer trading,
and the market became very illiquid. So, this study has recommended
fixes for this, but it doesn't recommend ending high
frequency trading. A lot of people would recommend
doing that. There's a popular anger,
especially since this May 6, 2010 crisis occurred during
the period of financial crisis, and people
kind of imagine that the two are linked. I think, they're kind
of independent. I think the May 6, 2010
phenomenon was due to some kind of anomalies, or
unfamiliarity with high frequency trading. It's a glitch and not a major
fault, but it lead to a lot of anger about high frequency
trading. I've talked to some people
at the Chicago Mercantile Exchange and others, who think
that the public anxiety over high frequency trading
is misplaced. It's kind of inevitable. The future is computers. They're replacing
people all over. Not in a judgment thing. You know, someone was saying
at the CME meeting, where I was, that the basic business
that we're doing is still the same as it was 100 years ago,
but now we have laptops. It's just like, when you
write a term paper. It's basically the same thing
that somebody would have done with a feather pen and a piece
of paper 200 years ago. Right? It's basically the same. But we live in a computer
age now, and we don't want to go back. And so, high frequency trading
means that we have to be able careful, things can happen
with lightning speed, but we'll learn. There hasn't been another
May 6, 2010 since. It was just an anomaly, because
people were unfamiliar with that kind of event. So, I think it will
be all right. One thing that it does,
however, is it's changing the geography. It used to be, that in the 18th
century, a stockbroker had to live in London or Paris
or New York in order to be close to the trading, because
they didn't have any way to make phone calls. When they invented the
telephone, people said, fine, I don't have to live in
New York anymore. I can live in anywhere,
and I can just send my call by telephone. But now, high frequency trading
is bringing it back, that people have to live close
to the exchange because the trading goes so fast, that your
electronic signal -- if you try to set up a high
frequency trading operation in St. Louis, and your operating by
wire to New York, the time it takes for electricity to get
from St. Louis to New York is too big, and you will
be behind on the trade. So, you want to get as close as
physically possible to the exchange, to the computer. The regional exchanges, there
used to be exchanges in every big U.S. city. And they were there, because of
social reasons, that people in Chicago wanted to talk
to a broker in Chicago. They wanted to be able to go to
his office and see him, so there were social reasons
for connection. But now we're coming up with
a new electronic reason. And because of basic theoretical
physics, you can't move anything faster than
the speed of light. This is going to be with
us now that we have microsecond trading. I wanted to talk a little bit
now -- and I think maybe this would be the last topic -- about how you think about
trading as a dealer, who is confronted with this
kind of book. As a dealer, you can put orders
on this book, and enter them, and leave them there. That's basically what you do. So, you see various dealers, and
their names are shown, and for example, well, I don't know
who these people are. But each dealer is going to be
posting a bid and an ask, and a quantity for these. And if you do this, if you're
sitting at your NASDAQ screen, and you're a dealer, you can
enter your own number on either the bid or the
ask or both of them. So, you have your own
bid-ask spread. It's the same thing as
an antique dealer. An antique dealer
has an idea -- maybe it's not posted -- of how
much he or she will pay for a chest of drawers from a
Yale student at the end of the semester, and how much he will
charge to sell that. And the difference between the
ask and the bid is called the spread, or the bid-ask spread. So, I wanted to just think
a little bit about the theory of this. How do you decide of the bid-ask
spread of what to do? And why is it what it is? The spreads are obviously very
tight here, because they're off only by $0.01 on the inside
spread, but it doesn't correspond to one person. Maybe some of these
are customer orders and aren't dealers. But think of placing an order as
a dealer and leaving it on the screen, so that anybody
can come and -- the risk that you face is, that
you will be picked off by people with superior
information. And let me put it in the context
of an antique dealer. One thing, antique dealers
don't like is, when professional antique dealers
come shopping in their store. So, what do they do? You know, if you're a good
antique dealer, you go to all the antique shows, you try to
disguise yourself, because they don't want you,
if you're a dealer. What do you do? You look through all their stuff
and you find anything that's mispriced. You know, there will be some
chest of drawers that you recognize as an 18th
century -- by a famous furniture maker. So, you buy that at
the guy's price. You pick him off, right? So, he doesn't want to be picked
off, because somebody will come by, who knows more,
and will pick off all the good stuff, and buy it, and leave
you with the junk. So, how do you prevent that? Well, you might think that you
could prevent it by just being smarter, but you can try it,
try to be as smart as you want, and read up about all
the antiques, but it's impossible. You cannot be the smartest
guy out there. Impossible. There's just too many antiques,
and there's too much inside information. So, that means you have to set
your bid-ask spread wide enough, that you can be picked
off and still make a profit. You know you're going to get
picked off, and it's the same for stocks. If you're going to put a bid-ask
spread up on the screen for some stock, you're
just a sitting duck, because there'll be some news story
that's either good or bad, and if it's either way, somebody
else is going to hear of it first, and when you get a hit
on your order, it's going to be deadly, because it'll be
at the wrong time for you. So, that's the theory, that you
have to make the bid-ask spread wide enough. I wanted to then just give you
a little bit of math -- I shouldn't end a lecture on
mathematics, but that's what I'm doing here this time. And I wanted to just
talk about the frustrating life as a dealer. I was telling you about
frustrations in life as an investment banker. There are different frustrations
in life as a dealer, and I'll tell you what
is the difference is. Life as a dealer is very
different than life as an employee or something. You are a dealer and you have
whatever money you make. And the problem is, you can
get ruined, and this is a classic -- in other words, you can be
working as a dealer for 20 years, and you see your
portfolio growing, because you're making a lot
of money selling. But you know, all it takes is
a few bad moves, and you can be wiped out. You know, 20 years of work,
and you are ruined. So, I wanted to just think about
that, and this is my last bit of mathematics. This is the mathematics of
Gambler's Ruin, and it's also a mathematics of
Dealer's Ruin. And so, here's the theory. If I start up with S dollars,
S is my initial amount of money as a dealer. And let's say I take a series
of bets, which have a probability -- p is the probability of a win. What is the probability
of eventual ruin? Oh, and I make $1 on each win
and I lose $1 on each -- minus $1 on each loss -- I'm doing a sequence
of bets -- on each loss. What is the probability that I
will eventually be ruined? That probability, and I'm not
going to derive this, but it's simple to derive, actually. 1 minus p over p, to the
Sth power, if p is greater than 1/2. So, if my probability of
winning is 1/2, the probability of my being ruined
eventually is 1. And if my probability of winning
is less than 1/2, my probability of being ruined
eventually is also 1. I have to somehow raise the
probability of winning on each particular sale above 1/2, but
even if I do that, if I make it, say, 0.6, if I make the
probability 60% on one bet, then 1 minus 0.6 is 0.4 over
0.6, then my probability of eventual ruin, starting
out with $1 is 4/6, if I did that right. Goes down with the number of
dollars I start with, but it never goes to zero. So, the theory of a dealer is
that a dealer has to be thinking about being
ripped off. I've got to set my bid-ask
spread high enough, that the probability of winning on each
of these little trades that I make is sufficiently above a
1/2, that my eventual ruin probability is satisfactorily
low for me. But it's never going
to be zero. This is the irony of
being a dealer. You don't sleep well at night,
because you never know that it won't eventually unwind. And it's a competitive business,
because you can't just set your bid-ask spread
arbitrarily high, because then you lose all the business
to other people. So, you've got to kind of fix
the bid-ask spread enough, that you get business, but you
don't want to fix it too narrowly, so that this
probability falls too close to 1/2, because then you're
courting the risk of disaster, and eventually having
all of your life's work being wiped out. So, that was kind of a quick
description of the -- I've said, different
personalities go into different parts of finance. You have to be kind of a game
player, someone who is not bothered by the possibility of
eventual ruin, in order to go into becoming a dealer. Very different from other
aspects of financial life. All right. I'll see you soon with -- we're getting close to the
end of the semester. Some wrap-up lectures coming.
