trading technology and stock market liquidity by jain and johnson (2007)

Lhabitant c15.tex V1 - 09/11/2007 1:43am Page 287

CHAPTER 15Trading Technology and Stock

Market LiquidityA Global Perspective

Pankaj K. Jain, and William F. Johnson

Abstract: We characterize the technological revolution that swept financialmarkets around the world and assess its profound effects. Computerizationand satellite communication have transformed the industrial organizationof stock exchanges and dramatically improved secondary market liquidity.Trading turnover has undergone a manifold increase and transaction costshave declined sharply due to advances in technology and an increase innumber of stock market participants supplying liquidity. Greater liquidityin equities has made stocks a more attractive investment vehicle forinvestors, thus lowering the cost of equity for listed companies. Whiletechnology has had profound positive effects for investors and companies,there have also been negative consequences associated with theseinnovations. We identify some determinants of these positive and negativevariations in the effects of automation on liquidity.

15.1 HISTORY OF STOCK EXCHANGES AND TECHNOLOGY

At the most simplistic level, a marketplace is an arena for buyers and sellers toexchange goods, claims, or services. Stock markets are no exception. The firstorganized exchange for financial instruments was established in Germany in 1585to primarily facilitate currency exchange rates from multiple coinages circulatingthroughout Europe then. The initial stock exchanges typically began in auspiciouslocations the London stock exchange which was originally located around a cof-fee shop while the first exchange—what became the New York Stock Exchange

Jain gratefully acknowledges support from the Suzanne Downs Palmer Professorship andfrom the Center for International Business Education and Research. Sneha Kollepara provideduseful comments and suggestion.

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288 STOCK MARKET LIQUIDITY

(NYSE)—in the United States was organized along a ‘‘Wall’’ (erected to protectDutch from British and Indian attacks) in New York and was intended to refinancedebt from the Revolutionary War. Looking back, it would be impossible for theoriginal pioneers of financial exchanges to even imagine what their seemingly simpleactions would develop into today. As technology and financial instruments evolved,the exchanges that provided trading services for these products became ever moresophisticated and advanced. Today’s exchanges represent complex entities with awide array of activities ranging from listing services, information production, pricediscovery, secondary market liquidity provision for equities and derivatives, clearinghouse services, data warehousing, and settlement services.

Trading mechanisms have undergone a sea change. In 1817, the President ofthe NYSE would call out the security and then the traders would trade, each stockonly trading at one time. Share volumes remained low ringing 1,534 shares in June1837. The first true technological advancement happened soon after in 1844, withthe invention of the telegraph. For the first time, individuals could participate inthe security markets in real time and far outside of an exchange. In 1866, thetransatlantic cable was completed and investors in the United States and Europecould trade, creating tremendous arbitrage opportunities. In an effort to increaseliquidity, the NYSE introduced a ‘‘specialist’’ to facilitate trades in each securitythroughout the day ending the practice of trading single securities at set times duringthe day in 1871. New technologies also resulted in the expansion of trading hours.Trading was conducted from 10 a.m. to 2 p.m. in 1871 on NYSE. Since 2004,trading thrives between 9:30 a.m. to 6:30 p.m. during extended regular hours orfour off-hours crossing sessions. Volumes of trades continued to increase rapidly astrading systems evolved, averaging over 4 million by 1961.

When one tries to look for the pitfalls of new technology, trade disruptions andexcess volatility are potential concerns. Exchange closures due to heavy volumesor technical glitches have become rare events now compared to their frequencyin the past. NYSE was closed for three days in 1919 and 45 full or partial daysbetween 1928 and 1933 to allow back offices to catch up on work. Paperwork crisisresulted in four day weeks or curtailed hours throughout 1967 to 1970. Tradinghalts due to computer malfunctioning were witnessed seven times from 1974 to1975, but became less frequent subsequently (once each in 1977, 1980, 1983, 1995,1998, 2001, and 2005). Recent technology has almost eliminated trade disruptions,significantly enhanced trading volumes, and lowered bid-ask spreads. The spreads,on average, have come down drastically throughout the century and will most likelycontinue to decrease as technology improves an exchange’s ability to execute orders.

Table 15.1 presents the liquidity levels surrounding the major stock marketevents. Our focus is on technological advancements (T) but we also considerregulations (R) and market sentiment or major scandals (S). All three types ofdevelopments are likely to have a significant affect on market liquidity. Our liquiditymeasure is the proportional bid-ask spread:

Proportional Quoted Spread = Ask Price − Bid PriceQuote Midpoint

∗ 100 (15.1)

where quote midpoint is calculated as (Bid Price + Ask Price)/2.Jones (2002) hand-collected a century of spreads from 1900 to 2000. We borrow

the numbers from figure 1 of their paper. We append the spreads from 2001 to 2006


Trading Technology and Stock Market Liquidity 289

TABLE 15.1 Technology (T), Regulatory Advancements (R), Financial Shocks, OptimisticSentiments or Scandals (S), and Liquidity on NYSE

Spreads(BP)from Change in

Year Description T, R, S Jones (2002) Spreads

1792 Buttonwood Agreement: 24 prominentbrokers gather on Wall Street agreeing totrade securities on a commission basis.The New York Stock Exchange begins.

R — —

1844 Telegraph allows brokers outside of NewYork instant access to exchange.

T — —

1866 Trans-Atlantic cable provides instantcommunication between Europe andU.S. markets.

T — —

1871 Continuous trading via specialists replacesthe older call auction trading system.

T — —

1878 First telephone installed on floor. T — —1881 The first annunciator board is installed for

paging members.T — —

1899 Listed companies required to submitregular financial statements.

R 70 —

1903 Move to current larger trading floor site. T 55 −151906 Dow Jones Industrial Average (DJIA)

Index set all time high record of 100.— 25 −30

1907 Financial problems at Knickerbocker Trusttriggers a run on banks.

S 77 52

1911 Kansas adopts ‘‘Blue Sky’’ law imposingregistration requirements on issuers andbrokers.

R 55 −22

1913 Federal Reserve System established tocontrol credit and bank stability.

R 45 −10

1914 World War I causes exchange to close for4 1

2 months.S 102 57

1918 An expanded pneumatic tube system goesinto operation. Also, America emergesfrom the war as a creditor nation, andWall Street supplants London as theworld investment capital.

T,S 76 −26

1920 Centralized clearing system established. T 80 41923 Fraud Bureau established to eliminate

stock market gamblers and fraudulentsecurity sales. Start of a bull market.

R,S 57 −23

1926 Listing rules tighten R 50 −71929 Central quote system installed to provide

instantaneous bid-ask prices by phone.Markets crash of 1929.

T,S 58 8

1930 High speed ‘‘black box’’ ticker introduced. T 53 −51932 Dow reaches bottom, 89% below 1929

peak.S 150 97

(continued overleaf )



TABLE 15.1 (Continued)



1933 The Securities Act of 1933. R 95 −551934 The Securities Exchange Act of 1934

establishes Securities and ExchangeCommission (SEC).

R 92 −3

1945 World War II ends with Allied victory. S 65 −271953 NYSE permits member firms to

incorporate, giving them greater accessto capital. Volumes consistently exceed1 million shares daily.

R,S 77 12

1956 Listed companies urged to include outsidedirectors on boards.

R 70 −7

1957 Ebasco service report suggests automatingthe trading floor with respect totransaction reporting and improvedstock clearing and quotation service.

T 65 −5

1959 NYSE discourages trading by companyinsiders.

R 63 −2

1964 900 Ticker System with twice the speedreplaces the Black Box system.

T 45 −18

1966 Transmission of trade and quote data fromthe floor is fully automated. Radiopaging begins. Congress createsSecurities Investor ProtectionCorporation to protect customers offailed brokerage firms.

T,R 55 10

1968 Central certificate service is established totransfer securities electronically. surgingvolumes precipitate paperwork crisis.

T 55 0

1972 Securities Industry AutomationCorporation Established.

T 60 5

1973 Oil embargo cripples markets worldwide. S 70 101975 Fixed commissions abolished. R 77 71976 Automated designated order turnaround

(DOT) system is introduced toelectronically route smaller orders.

T 50 −27

1978 Intermarket trading system launchesproviding electronic link between NYSEand competing exchanges, enablingbrokers access to all markets.

T 45 −5

1984 Launch of Super DOT 250 an electronicorder-routing system that links memberfirms to specialist posts on the tradingfloor.

T 41 −4

1987 Dow loses 22.61 percent on October 19,largest one day drop.

S 57 16






1988 ‘‘Circuit breakers’’ installed to coordinateprocedures between NYSE and ChicagoMercantile Exchange to control extremeprice movements and share surveillancedata.

T 48 −9

1991 Off-hours trading until 5:15 p.m. introduced T 45 −31993 Integrated technology plan is begun to

enhance trading floor networks to handleover 1 billion shares per day.

T 35 −10

1994 Trading post upgrades to include handheldterminals, fiber optics, and cellularcommunications.

T 30 −5

1995 First large-scale application of high-definitionflat-screen video technology is installed tospeed market information and strengthentrading floor professionals’ ability tomanage orders.

T 26 −4

1996 Real time ticker available to all investors onCNBC and CNN-FN.

T 20 −6

1997 Trading in sixteenths tick-size. wireless datasystem installed to allow brokers to receive,access, and transmit market informationand trades from anywhere on trading floor.

R,T 16 −4

1999 NYSE requires domestic listed companies toseat at least three independent directors.NYSE unveils 3D trading floor, anadvanced trading floor operations center.DJIA tops 10,000 for the first time.

R,T,S 15 −1

2000 NYSE Direct + provides immediate automaticexecution of limit orders up to 1,099 sharesat NYSE quote. Decimal tick size tradingbegins. DJIA Index sees it biggest one daypoint rise and a month later biggest pointdecline.

T,R,S 19 4

2001 Complete transition to Decimal Trading. 9/11Terrorist attacks.

R,S 11 −8

2002 NYSE OpenBook launches, a new marketinformation product that provides off-floormarket participants a view of the buy andsell interest in all NYSE-listed securitiesbeyond the best bid and offer. TheSarbanes-Oxley Act, which aims to protectinvestors by improving the accuracy andreliability of corporate disclosures, goesinto effect.

T,R 10 −1

(continued overleaf )






2003 NYSE Liquidity Quote launches in a28-stock pilot, disseminating executable,sizable quotes outside of the best bid oroffer. Investors and market professionalscan use this product to find greatermarket size and depth. SEC approves theNYSE’s new corporate governancestandards for listed companies, requiringboards of NYSE-listed companies tohave a majority of independent directors.

T,R 7 −3

2004 NYSE expands Direct + systemsignificantly increasing the level ofpurely electronic trading.

T 5 −2

2005 NYSE and ArcaEx Agree to merge. S 4 −1

using our own calculations from the TAQ dataset. In the first column, Table 15.1contains all the years with at least one major technological advancement, regulation,market sentiment, or scandal. The description of these major events is in the nextcolumn. The third column identifies the nature of event. Liquidity level is presentedin the fourth column. The last column is the change in spread. A negative numberindicates a spread lowering or liquidity improving event whereas a positive numberrepresents deterioration in liquidity.

It is evident from Table 15.1 that technological and regulatory advancementshave ensured a secular decline in spreads over the last century. Spreads were 70 basispoints in 1900 and fell to 4 basis points in 2005. Nevertheless, markets have beensubjected to liquidity deteriorating financial shocks and scandals from time to time.For example, the Great Depression of 1929–1932 sent the spreads all the way up to150 basis points. We now discuss the effects of some of the more important eventson liquidity.

Optimism among investors results in high price levels and reduces proportionatespreads because of the denominator effect. Proportionate spreads declined by 30basis points in 1906 when Dow Jones set a record to close above 100 points for thefirst time. Soon after, however, financial problems at Knickerbocker Trust triggereda run on banks in 1907. There was a negative impact on liquidity with spreadsincreasing by 52 basis points. Subsequent regulation of issuers, brokers, and bankersameliorated the situation a bit. In 1914, World War I resulted in a prolonged closureof the markets. When markets finally opened, the average spreads were 57 basispoints higher. The emergence of United States as a creditor nation and investmentcapital of the world after the war, expanded pneumatic tube technology in 1918, theestablishment of Fraud Bureau in 1923, and the start of a bull market all resulted in asubstantial decline in spreads. Extreme pessimism and record volatility experiencedafter the great depression completely reversed the liquidity improving phenomenon



and increased spreads by a whopping 97 basis points in 1932. The Securities Actof 1933, lead to a 55 basis point reduction in spreads and proved to be a boon forthe ailing financial markets. Allied victory in World War II in 1945 led to furtherreductions in spreads.

Technological improvements in the form of the 900 Ticker System in 1966,automated Designated Order Turnaround (DOT) system in 1976, and integratedtechnology plan of 1993, all led to double-digit basis point reductions in spreads.Further developments include the trading post upgrades of 1994 to include handheldterminals, fiber optics, and cellular communications; high-definition flat-screen videotechnology installed to speed market information in 1995; real time ticker on CNBCand CNN-FN in 1996; tick-size reductions to sixteenths in 1997; 3D trading floor in1999; NYSE Direct+ that provides immediate automatic execution of limit ordersin 2000; decimal tick-size trading in 2001; NYSE OpenBook launch in 2002 thatprovides off-floor market participants a view of the buy and sell interest in allNYSE-listed securities beyond the best bid and offer; and the NYSE LiquidityQuotedisseminating executable, sizable quotes outside of the best bid or offer in 2003. Allthese developments have squeezed the spreads down to 4 basis points in 2005.

Such dramatic reductions in spreads help reduce the cost of capital becauseinvestors demand a lower equity premium for more liquid financial securities(Amihud and Mendelson, 1986). Thus, liquidity can indirectly have far reachingeffects on capital formation and economic growth in a country.

15.2 EVOLUTION OF TRADING TECHNOLOGIES

15.2.1 Floor Trading

Floor trading was the basis for most, if not all early exchanges. Buyers, sellers andspeculators would gather in a predetermined place and time to trade securities. Priceswere negotiated and recorded manually. A floor trade follows a few simple steps.First, a customer places a trade with his broker, giving him specific instructionssuch as buying 1,000 shares of a stock at market or a limit price. Next, the brokercommunicates the order to their trading floor. The floor broker will then find anotherbroker wishing to sell 1,000 shares at the current market price or the limit price.The sale is then complete and the status of the order execution is communicatedto the customers. The typical methods used in floor trading are open outcry orcall auctions. Today, as in the past, floor traders function as ballast for exchanges,providing liquidity when it is dry. Trades executed using the floor method aretaken, handled and executed by humans, leading to trading errors, and tradinginefficiencies. Conversely, computer trading is void of any above-mentioned errors,but has its own caveats.

15.2.2 Computer Technology

The most dramatic tool introduced to the trading floor in the last century maybe the computer and related products/innovations. Computer technology has hada dramatic effect on trading volumes, efficiencies and helped create a whole newarena of investors and traders. Trading volumes were no longer restricted to how



many hands were trading or documenting trades, but computer technology allowedvolume to be determined by investors trading appetite. The efficiency computersbrought to the exchanges geometrically increased the number of shares traded ona daily basis, the number of investors in the markets and also the amount andaccuracy of information available to investors and researchers. Shortly after tradingwas computerized, trading volumes leaped, liquidity increased, and the number ofinvestors ballooned. It is possible for a case to be made that the computer put inmotion the equity bubble of the 1990s because so many new entrants were broughtto the market in such a short period of time. Precomputer, the floor-trading-onlymodel could simply not handle the influx of new money and investors to themarket. Internet technology has also revolutionized the way investors participatein the market. To be a market participant now only requires a computer andInternet connection. The benefits to this advancement are clear. Investors havealmost unlimited access to trading information, ability to execute almost any tradein an instant and move money around the world at the press of a button. Only 20years ago, these abilities were reserved for only the largest banking and investmentcompanies.

Table 15.2 compares the salient characteristics of floor trading with those ofelectronic trading. Most of the features of electronic trading offer considerablebenefits to investors and traders, vis-a-vis floor trading environment.

Jain (2005) reports a strong trend towards full automation of trading for theleading exchange in almost every country of the world. Although the technologicalinnovations took place in the United States in 1969, their commercialization initiallyaffected only the institutional trading platforms such as the Instinet. In fact, theToronto Stock Exchange took the lead in 1977 when it adopted screen-based trading.The Paris Bourse is another leading exchange that automated and then designedsystems which were subsequently sold to several exchanges around the world.The NYSE, the leading U.S. exchange, introduced the facility of fully automated

TABLE 15.2 Floor Trading Versus Electronic Trading

Characteristic Floor Trading Electronic Trading

Trader identity Face to face trading results inreputation building.

Trader identity can behidden or displayed.

Order flow transparency Order flow is hidden. Order flow is displayed.Quote transparency Best quotes only are known. All quotes can be displayed.Quote life Quotes evaporate and good

only until the breath iswarm.

Quotes are firm untilwithdrawn or consumed.

Trading speed Slower order transmissionand trade execution

Almost instantaneousexecution of trades

Settlement Slower settlement Faster settlementExchange viability Higher operating cost CheaperTransaction costs Higher transaction cost Deeply discounted brokerageRemote access Expensive remote access Better accessibilityCompetition among

liquidity suppliersReliance on single/few

market makersCompetition from numerous

value trades



trade execution, known as Direct+, only very recently in December 2000 althoughelectronic routing of orders on SuperDOT has been in place since 1985. Today, theleading exchange in 101 of the 120 sample countries in Jain (2005) has electronictrading. Of these 101 exchanges, 85 are fully electronic, with no floor trading.

15.2.3 Remote Accessibility

Traders from all over the world now have access to and can act on quote and tradeinformation at the same instant as if they if they were standing on the floor of theexchange. Conceptually, the trading post has extended as far as the internet canreach. Internet technology has enabled traders from around the world to participatein markets that best fits their needs and preferences, sparking competition amongthe different markets. With communication networks extended all over the globe,traders anywhere can investigate and exploit arbitrage opportunities, no longerbound by their location.

New pools of liquidity are thus becoming available in the secondary market.

15.2.4 Demutualization and Expansion of Membership

In the past, the ability to trade on a particular exchange was usually controlledby few members who owned a seat on the exchange. Typically, these membersmutually owned the exchange and would not let the membership expand easily. Thisgreatly restricted the access and forced investors to buy and sell through a smallset of traders, creating a bottleneck in the trading process. The modern era of thestock exchange industry has another defining feature, namely, the demutualizationof ownership of the exchange. This involves the separation of ownership and tradingrights. Demutualization frees the exchange management from vested interests oftrading members and gives ready access to vast amounts of capital. However, afor-profit structure can create conflict of interests between shareholders who ownthe exchange and regulators who are interested in public welfare. Nevertheless, if it isoptimal to expand the number of members with trading rights, the shareholders of ademutualized exchange will be more willing to implement policies along those lines.The Stockholm stock exchange was the first to demutualize in 1993. Most otherleading exchanges have followed suit with NYSE being the most recent one in 2006.

15.2.5 Network Effects and Competition

The network effect can be explained by a basic example of fax machines. What isthe worth of having only one fax machine in the world? Nothing. But a networkof 10 faxes is worth something, and increasing the number of faxes only increasesthe worth of each machine in the system. This is true for exchanges too. Anexchange without another buyer or seller is not worth anything, but as the numberof participants in the market increases, the value of the exchange increases. Adoptionof trading technologies has greatly increased the number of possible investors inany given market. With the help of technology, nearly anyone in the world has theability to invest in any developed stock exchange in the world thereby increasingthe number of possible investors immensely. As the developing world continuesto update and modernize their trading technologies and procedures, the number



of potential investors will also increase. Exchanges have become aware of thisdevelopment and have been competing to become the market providing highest-levelof liquidity possible for both buyers and sellers.

15.3 GLOBAL PERSPECTIVES

Security exchanges operate in every corner of the globe, intersecting all legal, ethical,and business cultures of the world. Such differences in financial environment implyvarying results when technology is adapted on different exchanges. In this section,we examine different results on trading and liquidity when new technologies areintroduced around the world on 71 different exchanges. Using data from Jain(2005), we investigate how floor automation has changed the trading characteristicsaround the globe. As with most technological advancements, we expect to seeobservable differences between countries to have varied reactions to the introductionof automated trading. On an average, automation has provided exchanges with notonly an increase in liquidity but also a drastic reduction in cost of capital. For all71 countries used in Jain (2005), average liquidity increased by 3 percent and costof capital was lowered by 1.2 percent. After automation 71 percent of exchangesexperienced a positive change in liquidity and 80 percent of the countries improvedtheir cost of capital. Table 15.3 gives the breakdown of positive and negativeinfluences of automation.

Although the effects of automation are largely positive, not every country hasexperienced the same level of liquidity improvement or cost-of-capital reduction.In Table 15.4, we explore various determinants of the magnitude of effects ofautomation. Panel A of the table categorizes the sample countries from Jain (2005)into various regions of the world. The liquidity effects of automation are thestrongest in Europe, where liquidity improved by 6.69 percent followed by Africaand Asia. They are the mildest in South America where liquidity is actually somewhatworse in electronic trading environment although the region leads in the cost of

TABLE 15.3 Automation Affects Liquidity and Cost of Capital Around the Globe

Change in Liquidity Change in Cost of Capital

Average Response toAutomation: Entire Sample

3.02% −1.23%

Number of exchanges withpositive change

47 14

Average change in positivecountries

5.70% 0.79%

Number of countries withnegative change

19 57

Average change in negativecountries

−3.63% −1.73%

Note: Turnover data is provided for 66 countries and cost of capital for 71 countries by Jain(2005). Changes are calculated by subtracting the level of liquidity or cost of capital beforeautomation from their respective levels after automation.



TABLE 15.4 Determinants of the Effects of Automation

Panel A: Regions of the World

Cost of CapitalRegion Liquidity Improvement Reduction

Americas −0.89% −0.71%Africa 3.06% −1.93%Asia/Pacific 1.23% −0.85%Europe 6.69% −0.73%Middle East 0.99% −1.67%South America −0.92% −2.33%

Panel B: Economic Development and Effects of Automation

Liquidity Cost of Capital

Developed countries 5.90% −0.28%Emerging markets 1.58% −1.68%

Panel C: Laws Prohibiting Insider Trading and Their Enforcement


Laws prohibiting insider trading do not exist −1.99% −3.00%Insider trading is prohibited by law 3.52% −1.01%Actual prosecutions have been successfully

undertaken against violators3.59% −0.96%

Panel D: Shareholder Rights Index


5 (best) 5.64% −0.75%4 6.23% −1.11%3 3.52% −0.94%2 3.36% −0.79%1 (least) 0.90% −0.71%

Panel E: Partial or Full Automation


Full 3.26% −1.17%Partial 1.81% −1.58%

capital benefits of automation. Panel B of Table 15.4 differentiates the samplecountries by their level of economic development according to Morgan StanleyCapital International classification scheme. Here we can see that automation helpsincrease the liquidity more in developed countries but liquidity also improves inemerging markets. Preautomation cost of capital is very high in emerging markets



and they see a bigger impact of automation in lowering the cost of capital for listedcompanies.

Next we look at the legal environment in each country to assess its interactionwith the role of automation. Specifically, in Panel C of Table 15.4, we ask the questionwhether a country has laws that prohibit insider trading laws. It is also importantto note whether the laws are actually enforced in practice because corruption andlax enforcement can defeat the purpose of any law. Although the United States hasthe reputation of putting people with celebrity status behind the bars for insidertrading violations (e.g., Martha Stewart case), in many other countries tradersfreely trade on insider information without much fear of prosecution. Data forexistence and enforcement trading laws is obtained from Bhattacharya and Daouk(2002). Our analysis shows that a sound legal system is necessary for the liquidityeffects of automation to materialize. Liquidity improves by over 3 percent afterautomation if insider trading is banned. Enforcements amplify the liquidity effects ofautomation. In contrast, automation hurts liquidity in the absence if insider tradinglaws. Nevertheless, automation has a positive role in reducing the cost of capitalirrespective of the legal situation.

Continuing on with the analysis of legal environment, in Panel D of Table 15.4,we categorize the sample countries based on a shareholder’s rights index created byLa Porta et al. (1998). The index scales from 0 to 5 with zero representing no rightsand 5 representing most rights for public shareholders. The impact of automationon both liquidity and cost of capital generally increases with the degree of protectionprovided to the shareholders by law.

Finally, we examine the differences between full and partial automation. Someexchanges, such as the Paris Bourse, entirely rely on electronic trading and abol-ish the trading floors whereas others, such as the NYSE, partially automatetrading and retain their trading floors. Panel E of Table 15.4 shows that liq-uidity improves substantially even with partial automation but full automation hasalmost twice the impact. Cost of capital benefits are obtained with full or partialautomation.

15.3.1 Limitations of Technology

Every technological advancement from the telegraph to the Internet has had tremen-dous positive effects on market liquidity and increased the number of investors whoparticipated on the exchanges. Along with these benefits, however, there are somedangerous episodes and painful consequences from these advancements. In the last20 years, two major market disruptions were facilitated due to technology intendedto increase liquidity, but for a short time, actually had the opposite effect. Thefirst event being the 1987 market crash, where program trades intended to protectinvestors from large losses actually caused investors huge losses and specialists, whoare supposed to provide liquidity, failed in that duty.1 Precisely when liquidity wasneeded, it dried up and with no buyers, the market had nowhere to go but down.Since then, new measures and procedures have been implemented to avoid a similarcrisis. Since 1987, the U.S. exchanges have in fact weathered much more seriousevents without full-scale market selloffs.

The second event was the Asian contagion in 1997, where liquidity, which wascreated by connecting traders from all over the world in far-flung trading networks,



was almost instantly withdrawn, causing major market dislocations that can still befelt and observed in some affected countries today. Leading up to 1997, developingeconomies in the Asia-Pacific region benefited greatly from the extension of tradersability to place trades anywhere in the world. Foreign capital flowed in countriessuch and Thailand, South Korea, and Indonesia at unprecedented rates. Flush withthe new investments, businesses flourished in these countries—it was like a marriagemade in heaven. This situation continued until the situation entered a dangeroustipping point, when foreign investors started withdrawing their funds, in effect,closing off liquidity in the system. The ramifications of this were tragic for the Asianeconomies that became dependent on the liquidity provided by foreign investors.Without the newfound inflow of foreign money, their economies sank and requiredemergency actions to fend off financial disaster.

Technology has some other minor limitations too. Over reliance on computersmeans that if the system malfunctions for any technical reason, then trading has tostop. Such teething problems usually disappear after a few occurrences as solutionsand alternatives to address the problems are developed.

Longer trading hours and speedier execution also mean that stock pricesdemonstrate lot more volatility today. However, this is more a reflection of the factthat with automation we can accomplish volumes of trading within seconds thatwould have taken years in the past.

15.4 FUTURE ADOPTION OF TECHNOLOGYAND POSSIBLE IMPLICATIONS

New technologies come with greater responsibilities. The most recent trading tech-nology, which increased market liquidity, is the wide-ranging use of financialderivative products. Some have predicted, including Warren Buffett, that deriva-tives will have as great or greater negative consequences on the markets in thenear future as any other advancement to the market. Regardless of what causesthe next liquidity crises or when it happens, the market will most likely reboundand investors will discount and readjust to the new risks the excess liquidity hasprovided the market. Gone forever are the days of the original exchanges wheretraders waited to trade one stock at a time. Now traders, investors, and companiesbenefit from the exchanges ability to deliver an ever increasing array of financialproducts throughout the world—24 hours a day and nearly 365 days a year. Recenttechnology innovations have created markets today that would appear foreign totraders only a few decades ago. The adaptation of new technology to the exchangeswill continue to improve market operations and liquidity levels in ways that may beunimaginable today. The liquidity we observe today could not have been dreamedof years ago because the technology did not exist.

Increased global competition and global consolidation is likely to be the orderof the stock exchange industry in near term future. The trend of exponential growthin volumes will only accelerate as multitudes of new investors engage in cross borderinvestment activity. Increased liquidity will make it easier and more rewardingfor equity researchers to trade. It will not be too perilous to predict that furthertechnological advancements will result a healthy and thriving stock markets in theworld.



REFERENCES

Amihud, Y., and Mendelson, H. (1986). Asset Pricing and the Bid-Ask Spread. Journal ofFinancial Economics, 15(1–2):223–249.

Bhattacharya, U., and Daouk, H. (2002). The World Price of Insider Trading. Journal ofFinance, 57(11):75–108.

Jain, P. (2005). Financial Market Design and the Equity Premium: Electronic versus FloorTrading. Journal of Finance, 60(6):2955–2985.

Jones, C. (2002). A Century of Stock Market Liquidity and Trading Costs. Working Paper,Columbia University.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (1998). Law and Finance.Journal of Political Economy, 106(6):1113–1150.

trading technology and stock market liquidity by jain and johnson (2007)

Documents

trading technology

trading services

stock market liquidity

stock markets

trading mechanisms

trading halts

trading turnover

trading systems