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A Brief History of Online Trading and Investing

The internet may seem like a new way to trade, but it is actually a mechanism for democratizing of the existing system of securities trading.

Electronic Communications Networks

In 1969, an aerospace analyst built the first ECN: Instinet. He saw it as way to eliminate the brokerage industry and the exchanges. In the early 1980's Bill Lupien, a Pacific Exchange specialist, took the company over. Lupien saw how much more efficient the system was, but instead of bypassing brokerage, he distributed the service only to brokers. The system made an already lucrative racket more efficient (Millman, 51).

By the time Reuters bought Lupien out in 1988, ECNs were becoming the way most NASDAQ stock were valued and traded. Instinet quickly became the preferred method for large-scale professional investors to trade in multiple exchanges and over-the-counter systems (Millman, 56).

ecn market share pie graph
Source: http://www.celent.com/PressReleases/20051227/ECNNMS.htm

Like many computer-based technologies, ECNs became more appealing and efficient as more people began to use them. More usage meant more liquidity (the ability to sell) and more data to collect and analyze. The prices of the securities on the system were more accurate and up-to-date than they were on NASDAQ (Ecommerce). The system was still only available to major traders like specialists and market makers.

In 1994, the economists William Christie and Paul Schultz published a paper that described an anomaly that they had discovered when examining computer-collected data of stock prices on NASDAQ. The brokers that are responsible for maintaining liquidity on NASDAQ are called market makers. They make their money from the difference between what the buy and sell prices listed on NASDAQ, known as the spread. Christie and Shultz found that the market makers where colluding to keep the spreads artificially high. The paper led to investigations by the Justice Department and rule changes by the SEC. The market makers used ECNs to carry out the truly competitive trading amongst each other, so the SEC made it mandatory for the ECN prices to be listed on NASDAQ, and they changed the order-handling rules to the benefit of small investors. The rule changes cleared the way for new ECNs that were available to anyone, such as Island.(Millman, 59-63)

By 1996 the World Wide Web was gaining momentum and discount online brokerages such as E-Trade and Ameritrade were becoming very popular. They offered extremely low commissions and complete control over your portfolio.

Conventional discount brokerage firms such as Charles Schwab and TD Waterhouse began offering more online services for less money, while still providing personal advice from its brokers (Ecommerce).

Electronic trading was becoming so popular; it was actually encroaching on the profits of traditional brokerages like Goldman Sachs and Merrill Lynch (Ecommerce). Although there is little chance these Wall Street powerhouses will ever stop making billions of dollars, at least the Internet has managed to loosen the grip such companies have had on the economy for over a hundred years.

While the growth of online investing has been explosive, (1.1 million in 2000 to 7.2 million in 2003) it has been limited the 40% of the population that already own stocks.(Ecommerce) If the revolution in the world of investing is going to translate into a redistribution of capital, more people are going to have to participate.