Platform Series - Monolithic Market Makers to Automated Trading Platforms

A History of Improving Market Efficiency

The history of stock markets spans centuries, evolving from rudimentary systems to the sophisticated networks seen today. This journey has been characterised by a shift from centralised monolithic market makers to decentralised, automated trading platforms, resulting in increased market efficiency and improved liquidity.

The academic literature in finance has quantified these changes in a subfield known as market microstructure. One variable used in this literature is the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for a security and the lowest price a seller is willing to accept. It is a measure of the cost of trading a security, and it can be thought of as the compensation that market makers receive for providing liquidity to the market. Figure 1 illustrates a hypothetical trade.

Figure 1 – Illustration of bid-ask spread and market maker’s role

In this illustration, a buyer is willing to pay $101 to purchase a share of a given stock (bid) and a seller requires at least $100 to sell her share (ask). In situations where a market maker acts as an intermediary, it captures the difference in these two prices, creating a bid-ask spread of $1. In general, a narrower bid-ask spread is a sign of a more efficient market. In an efficient market, prices would reflect all available information, so there would be no reason for market makers or bid-ask spreads to exist.

Note that improved market efficiency also lowers prices. In the above example, the price paid for the share is $101, with $100 going to the seller and $1 going to the market maker. Allowing agents to transact with each other would result in a price paid of $100.50 (assuming equal bargaining power). Both agents are also better off despite the lower overall price– the buyer pays $0.50 less for the share and the seller receives $0.50 more. Therefore, improved market liquidity makes all agents better off while simultaneously lowering the market clearing price.

The size of the bid-ask spread, and therefore market efficiency, is affected by liquidity. In a liquid market, there are many agents (buyers and sellers), so it is easy to find a match for a trade. This means that the bid-ask spread will be narrower. In an illiquid market, there are fewer buyers and sellers, so it is more difficult to find a match for a trade. This means that bid-ask spreads will be wider.

As trading platforms have evolved through time to automate market making, we have seen bid-ask spreads narrow. This is because electronic trading systems disintermediate manual market makers. This removes a ‘choke point’ and makes it easier to match buyers and sellers. These evolved platforms also make it easier for market makers to compete. As a result, global markets are becoming more efficient, and investors trade more easily and cheaply.

Let's explore the key milestones in this transformation.

Monolithic Market Makers (Pre-17th Century):

The earliest form of stock markets can be traced back to informal gatherings of merchants and traders in key European cities. These gatherings served as marketplaces for trading commodities and shares of businesses. During this period, trades were often matched manually by a single individual or a group of intermediaries acting as market makers. The lack of regulation and coordination resulted in inefficient pricing and large bid-ask spreads.

Formation of Formal Exchanges (17th Century):

As trade and commerce expanded, the need for more structured and regulated marketplaces emerged. One of the earliest formal stock exchanges was established in Amsterdam in 1602 with the Dutch East India Company, marking the birth of organized trading. Other exchanges followed suit, such as the London Stock Exchange in 1801. These exchanges facilitated the buying and selling of shares through auction-style systems. However, stock markets were typically operated by a single market maker, who would match buy and sell orders. This system had a number of drawbacks, including the fact that it could be easily manipulated and that it often led to wide bid-ask spreads.

Introduction of Electronic Trading (Late 20th Century):

With advancements in technology and the rise of electronic communication networks (ECNs), the traditional open outcry systems used in stock exchanges started to shift towards electronic trading. The electronic era began in the 1970s, with NASDAQ beginning operations on 8 February 1971 as the world’s first electronic stock market. These trading platforms allowed for the matching of buy and sell orders from multiple traders, which led to a more efficient and transparent market. Bid-ask spreads also fell significantly during this period.

Decentralisation and Automation (Late 20th - Early 21st Century):

The introduction of electronic trading paved the way for a more decentralized and automated market environment. This allowed multiple uncoordinated agents, including individual investors and institutional traders, to participate actively in the market. Various trading platforms and brokerage firms began offering online trading services, empowering investors to trade directly without the need for intermediaries. This democratisation of access significantly increased market liquidity and efficiency while further narrowing bid-ask spreads.

Continuing Advancements in Automated Trading (Present):

In the present day, automated trading systems continue to evolve, incorporating cutting-edge technologies like natural language processing, machine learning, algorithmic trading, and sentiment analysis. These advancements enable machines to analyse news, social media, and other unstructured data sources to inform trading decisions, further enhancing market efficiency and narrowing bid-ask spreads.

Figure 2 - History of market efficiency

In conclusion, the history of stock markets demonstrates a remarkable journey from monolithic market makers to the current state of automated trading systems. The transition towards decentralised and automated platforms has significantly improved market efficiency and led to narrower bid-ask spreads, ultimately benefiting society through lower prices and better market efficiency. The landscape of financial markets remains dynamic, and further technological advancements are likely to shape their future trajectory.