How technology has changed trading

There can’t be a single aspect of our lives that hasn’t been affected by advances in technology. Not only that, but these advances are taking place at an accelerating rate. Trading itself has been near the frontline when it comes to technological improvements, and that’s what we’ll focus on in this blog.

Early days

The first stock to be traded publicly was in the East India Company in 1602. In the early years of stock trading, business was done in coffee houses and in person. Eventually this led to the formation of stock exchanges that still operate today in London, the US and across the world. In essence, very little changed over the best part of 400 years, other than the rules for doing business were expanded and codified.

The end of open outcry

Right up until the mid-1990s, the vast majority of trades in equities, government bonds and commodities were carried out on physical exchanges by open outcry. That is, human beings buying and selling to each other on behalf of financial institutions, private individuals or on their own account. But by the start of the new millennium, the trading pits and the traders had largely disappeared as the exchanges went electronic and online. Banks and financial institutions were prepared to pay up when it came upgrading systems, whether these be for faster communication, or storing data. They could also see the savings that could be made. Trading was perfectly suited to a move online. For a start, most trading contracts were already standardised, so everyone knew what they were buying and selling.

Speed and volume

As trading became more automated, prices could be updated more frequently. This helped increase the speed of execution which in turn drove up trading volumes. The costs associated with trading were slashed while pricing transparency increased. Commissions fell as volumes rose, and generally, the dealing spreads (that is, the difference between the selling and the buying price) also declined. Automation brought down the cost of trading and it also encouraged fresh competition amongst providers.

Less human involvement

As the various exchanges upgraded their technology, humans played less of a role. Instead, there was direct contact between the computers that “clear” the trade, and this also reduced the number of back-office staff who previously had reconciled positions by hand. Then came a move away from market technicians who analysed charts and price movement. This was taken up by mathematicians who produced algorithms, which are formulae designed to trigger trades based on specified and programmed patterns of market behaviour. A greater amount of business was transacted outside of the recognised exchanges as banks and other large financial institutions operated ‘dark pools’ where they mixed up their own trading with that of their clients.

High frequency trading

Often these pools were made accessible to favoured clients. They promised even tighter spreads and faster execution – things that High-Frequency Traders were quick to capitalise on. These traders were able to establish an advantage by funnelling their orders into the market faster than other operators. Not only that, but some were able to ‘front run’ the market as they got sight of other large orders before they hit the pool. Speed became everything and without doubt some serious market abuses took place. Not only that, but liquidity could suddenly disappear, and the complete lack of human involvement led to several very damaging “flash crashes”. This typically happened when a trading algorithm cancelled a string of orders causing an imbalance and leading to prices collapsing, or sometimes soaring, in milliseconds. Investors began to lose confidence in the way trading was being carried out. However, in recent years the rules have been tightened up and confidence has returned.

More to come

Overall, most of the technological trading advances have been positive for traders and investors alike. Large transactions can be executed in a fraction of a second at low cost. This has led to a surge in trading volumes, helping the exchanges to protect their businesses. At the same time, it has never been easier for private individuals to access these markets and trade for themselves. And no doubt advances in computer power will give us even greater flexibility in how we go about trading in the future.

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