Exchanging the Exchanges [Fool on the Hill] July 17, 2000

FOOL ON THE HILL: An Investment Opinion
Exchanging the Exchanges

he stuffy old trading floor full of white men shouting at each other in pits full of little pieces of paper is a dinosaur. The market is changing to a streamlined, computerized, 24-hour automatic system. And you know what? It doesn't make a whole lot of difference to long-term, buy-and-hold investors.

By Rob Landley (TMF Oak)
July 17, 2000

The New York Stock Exchange (NYSE) has been around for centuries. A "seat" on the exchange costs tens of thousands of dollars, even though from what I've seen nobody has a chair and everybody has to stand. What a seat on the exchange gets you is the right to personally wander in and shout buy and sell orders at market makers, waving little pieces of paper on which all the activity is tracked. Brokerages buy a seat and send an employee to go shout at people, and that's how they trade stocks. How quaint.

The North American Securities Dealers Automatic Query system (Nasdaq) does approximately the same thing: match up buy orders with sell orders for those participating, but it does it on mainframe computers. It was set up about 30 years ago and has gradually grown to rival the traditional method of losing your hearing to trade stocks with other brokerages. But Nasdaq lost a lot of credibility around four years ago due to a price fixing scandal, and in any case its goal was only to be better than the traditional paper exchanges. Not exactly aiming high.

Larger brokerages have been able to match up buy and sell orders between their own customers in-house for a long time. (A variant of this is how selling stock short works: you're borrowing it from another customer of the brokerage.) Since absolutely everything is computerized these days, it shouldn't surprise anyone that they set up networks of PCs to track and match up trades. And when the world at large noticed the Internet in the '90s, it was simple to connect up these networks to talk to other brokerages, bypassing the traditional exchanges entirely.

These new electronic communications networks are called "Electronic Communications Networks," or ECNs. (Nobody ever accused stockbrokers of being imaginative.) The largest of them is the Island system (, which Datek Online ( was founded to take advantage of, and which many other brokerages now use. This system makes a LOT of stuff possible. Twenty-four hour trading? Already happening. After the brokerages close, you can opt to have the Island system process your order. Trading stocks priced in pennies instead of 1/16ths? Just introduced.

If you go to Island's website with a Java-enabled Web browser, you can even see the "limit book" for a particular stock, listing all the outstanding orders and the prices at which they're waiting to be filled. It's kind of neat. The only downside of ECNs is that the traditional exchanges still have more volume, and so can sometimes provide better and more stable prices, but that's changing. And in any case, most brokerages check both systems and take the better offer.

But what does all this mean to buy-and-hold investors? Not much. The technology behind our trades is dramatically improving, providing faster responses and even slightly better prices, but we don't trade often enough for it to make a real difference. Day traders love this stuff, but buy-and-hold icon Warren Buffett is on record as saying he wouldn't mind if the exchanges closed for a year at a time. (This would be the "and hold" part.)

Still, since we all do have to trade stocks from time to time, it's nice to know about new developments. Very soon average investors will be able to fire up a Web browser and buy or sell shares of stock, priced in dollars and cents like any other commodity, at 4:00 in the morning if they want to. It's nice to know that individuals now have access to trading systems better than the professionals had 10 years ago.

Here's some links if you want to learn more about this:

  • 5/20/98 Rule Maker (formerly Cash King) article with a lot of background on this
  • Fool Special on after-hours trading
  • Good ZDNet article on ECNs and decimal trades

    - Oak