A Brief History of Online Stock Trading

One of my favorite movies is Wall Street with Charlie Sheen and Michael Douglas. If you haven’t seen it before, head over to Amazon and watch it right now! You’ll thank me later.

I love this movie because it’s all about the American dream. Work hard, set your sights high, and go for big goals. Unfortunately, for the main character, his method for achieving those goals wasn’t exactly legal.

Back when this movie was made, stock trading was very different. Stock brokers employed hundreds of brokers who worked more in telesales than they did in securities, and would call wealthy individuals to try to get them to buy stocks through their services.

That meant, that if you wanted to invest money, you had to pick up the phone and call your stock broker to place a trade. There wasn’t in and out online stock trading going on back then.

Times have changed. With the click of a button, you can be in and out of trades in a matter of moments. What used to take days to see moves happens, and required calls to your broker, you can now accomplish with an online brokerage and an internet connection.

How did we get to where we are today? Keep reading to learn the history of online stock trading.

Online Stock Trading and ECN’s

The NASDAQ was introduced in 1971, as one of the first electronic communications networks (ECN). It originally worked only as a pass through for information, such as bid-ask spreads and volume, to help traders receive information quicker and make better trades. The NASDAQ was not a favorite of brokers, as many of them made significant margins on the spreads between the bid and the ask. By making information like the bid and ask easily available, the spreads began to thin, and brokerage houses began to see margins thin.

The history of online stock trading begins with ECN’s like the NASDAQ. By developing the network to provide fast information, they set up the foundation for online stock trading years down the road.

While the NASDAQ was able to provide information faster than ever before, it was unable to actually complete stock trades until years later.

Why the Market Crash in 1987 Paved the Way for Online Stock Trading

Despite stock information being made electronic in the 1970’s, the ability to do straight-through processing (STP) was still not available until much later.

First there was the issue of settlement and risk.

The entire trade lifecycle, from initiation to settlement, is a complex labyrinth of manual processes, taking several days.  –Wikipedia

A trade could take anywhere from 3-7 days to complete. Brokers were responsible for minimizing settlement and operational risk. In order to perform electronic STP, brokers and ECN’s needed to improve the process for completing trades.

Second, there was the need for a widespread acceptance of a platform that would process trades electronically. In these days, it was easily understandable how any system claiming to perform electronic trades would be regarded with contempt or mistrust. Computers were barely prevalent in those days.

The first company able to complete electronic trades was Instinet, which formed in 1967. While the NASDAQ was widely accepted despite its inability to complete electronic trades, Instinet suffered from a terrible go-to-market strategy.

Instinet’s founders primarily targeted large institutions like banks and mutual funds. By offering computer links for performing electronic trades, these institutions could trade large amounts of stock on an anonymous and confidential basis.

It wasn’t until 1983, when the company was turned over to a former Pacific Stock Exchange operator, named Bill Lupien that the company started to see some commercial success. Lupien changed the company’s business model, and opened the platform up more to the broker community. This allowed the company to be more involved in both the buy and sell side of the market.

Instinet had opened the model for electronic trading for ECN’s, and electronic trading became more prevalent.

Then the stock market crashed in 1987. Remember, back then most people would call their broker to place their order. As the market was crashing, the money makers in the over-the-counter (OTC) market refused to pick up their phones, and delays in processing caused investors to receive prices different from what they expected. The erratic price movements caused frequent lock-ups in electronic trading (Ref: here).

As a result of market makers not answering their phones, the SEC established new regulations requiring them to buy a certain numbers of shares from small investors (i.e. you and me). The SEC also formed regulations allowing individuals to buy and sell shares that would allow them to directly connect to the market, and make the markets required to handle the transactions. These changes resulted in what is known as the Small Order Execution System (SEOS), the system that allows you and I to trade now (Ref: here).

How the Apple II lead to widespread use of online stock trading

Just before the formation of the Small Order Execution System, another major development began to form the groundwork for today’s online stock trading: the Apple II computer.

Introduced in 1977, the Apple II was the primary revenue source for Apple throughout the 1980’s. The Apple II was significant because it put computers in the home, on a mass scale, for the first time ever. At the time of the market crash, the Apple II was the most popular home computing device of the times.

The Apple II opened the door for software developers. In 1982 the first retail online trading software formed called Naico-Net. The software was primarily used by stock brokers, and was believed to be a loss-leader at first. Despite its popularity, it was insanely expensive considering the cost for phone usage and software registration fees.

The idea, however, gained popularity as individuals could do market research and access their accounts 24×7.

The Emergence of Online Stock Brokers in the 90’s

The widespread use of the Apple II computer at home, and the revolution of stock trading software like Naico-Net opened the door for many other trading platforms in the 80’s and 90’s. Growing use of the internet, home computers, and improved data speeds allowed for rapid expansion of the home retail market.

In 1985 a group of individuals formed Trade*Plus. Traders using dial up phone services could perform electronic trades, despite large charges for electronic trading. Trade*Plus would form a direct competition to Naico-Net.

One of the founders of Trade*Plus eventually left in 1991 to form a subsidiary called E*Trade. (Yup…you see where this is going now!)

The rest, as they say, is history. The 1990’s brought an online presence to several of today’s large retail brokers such as Charles Schwab, Fidelity Investments, TD Ameritrade, and so on.

A small company named thinkorswim formed in 1999. They would develop a revolutionary platform for options traders with extensive research and analysis tools. Thinkorswim was named the best trading platform in 2012 by stockbrokers.com, and would later be acquired by TD Ameritrade in 2009.

The Impact of Electronic Stock Trading

Online stock trading has had some significant effects on the stock market over the years.

Investors have access to more information than ever before, helping them to gain confidence to enter into trading. By the 1990’s, more than 20% of the country was involved in stock trading to some degree. Prior to, it was only about 5%.

Charles Schwab had $181.7 billion in assets when they introduced their online trading platform in 1995. By the end of 1996 it had swollen to $253 billion. By 1997 it was $437 billion. They more than doubled in size in two years, a very difficult task when you’re already $180+ billion company.

More and more competition came onto the scene during the 90’s as well. Brokerage firms like Scottrade.com had to use low commission fees in order the gain market share. Since the invention of online stock trading in the 1980’s, the cost of performing trades has gotten significantly lower.

Finally, the vast ocean of opportunity for traders has barely touched the surface. Only just today are we starting to see the emergence of mobile trading, where traders use iPhone and Android apps to research and execute trades.

Time will tell where the market takes us from here. But, looking back, you can see we’ve come a long way.

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