Finance is the management of money and other assets—often in very large amounts. It includes mainly public finance (the disposition of revenues by government) and corporate finance (the capital required to start and maintain a business).
Ever since the invention of money in the ancient world it has been a medium of exchange for goods and services and a means of storing value over time. Without the medium of money, and its management, it is not an exaggeration to say that the economic growth of the world would not have been possible. The major means by which money is managed are banking systems and stock, bond, and commodity markets. The following examines the history of those institutions and describes how they operate today.
The earliest examples of finance are short-term loans made in civilizations in the Middle East, North America, Asia, and Africa, in cities where money first emerged. The first banks were formed in Europe during the Renaissance, after legal and accounting systems had been designed that could track money. Banks allowed people to pool their money for large-scale transactions. By the 17th century, the first stock markets gave businesses and governments the chance to raise money by selling equity rather than borrowing money. The modern era of finance has been marked by the development of ever more sophisticated and technological vehicles for managing money. Globalization has spread this Western style of finance around the world.
Money
Money was developed by traders who understood the serious shortcomings of barter, which is the exchange of goods or services. In the barter system, a laborer might keep a share of the crop he helped harvest, or a farm wife could exchange eggs and butter for an ax. Barter works only if each party has goods or services that the other wants. Values have to be renegotiated for every transaction, keeping records is difficult, and proper accounting is impossible.
The use of money brought three big improvements to barter. First, money gives goods and services a stable value, allowing exchanges to occur more efficiently. Stability also allows record keeping and, in advanced economic systems, accounting.
Money also stores value. When goods or services are exchanged for money, the value is stored for long after the goods have been consumed or the work has been done. Over time, value stored in money can build up and become surplus wealth. Surplus wealth, especially when pooled, is called capital, and can be lent to fund the large projects on which cities and nations are built.
Finally, money provides a scale of value. A scale of value makes it possible to compare unlike objects: $10 could buy a book or a shirt; $100,000 could buy a fancy car or a modest house.
Earliest Coins Anywhere that cities arose, money emerged. Precious metals valued by weight became the basis for money in the earliest Mesopotamian civilizations, before 2000 B.C. Gold and silver were ideal because they were rare enough to be valuable, but common enough to be accepted. Precious stones have also served as money, as have cacao seeds in South America, and cowrie shells in Africa, India, and China.
The earliest coins were beads of electrum, an alloy of gold and silver. They were developed in the trading kingdom of Lydia in southwestern Anatolia, today’s Turkey. Though little more than nuggets, they were stamped with symbols to show their weight and origin. The electrum beads varied widely in ratio of gold to silver, and were soon replaced with flat, round, all-silver coins. Because the coins were certified by an authority and did not have to be weighed for each transaction, they made trade easier.
Lydian society reached its peak of affluence around 550 B.C. under King Croesus. The vitality of Lydian trade made its merchants and rulers wealthy and widely known. The expression “rich as Croesus” survives to this day.
Inflation In the fifth century B.C., Athens had ample supplies of silver, and city leaders issued more money to foster commerce. They discovered that when the amount of currency in circulation exceeded the needs of trade, the value of money decreased, an effect called inflation. Athenians also discovered that their coins, drachmae, had a higher value than the content because of their convenience and reliability. That premium, now called seigniorage, discouraged leaders from debasing the currency. It also encouraged them to use taxes to pay for public works, the arts, and defense, rather than causing inflation by issuing too much money.
Rome adopted Greek monetary principles, and a basic silver coin, which was called the denarius. To this day several countries’ currency is the “dinar,” and “dinero” means money in several languages. As the Roman Empire grew rich through conquest rather than productivity, however, corruption and dissipation undermined the economy. The empire’s infrastructure and bureaucracy were expensive, but Roman politicians knew that raising taxes was unpopular. They preferred to issue more money. The government put more gold and silver put into circulation, and adulterated coins by making them smaller or adding base metals. Inflation was a chronic problem for Roman emperors and bureaucrats.
With the rise of Islam after A.D. 622, the newly affluent societies at first copied classical coins—the Roman-derived dinar in Africa and the Near East, the Greek-derived dirham in Persia and central Asia—and then developed their own currencies.
China By about A.D. 50 Chinese money had adopted its classic form: round coins symbolizing heaven and square holes representing Earth. Paper money was first used by the Chinese about A.D. 1000. By the 13th century, the powerful Yuan dynasty had established a successful paper currency. Eventually, most societies adopted paper currency, as the need for capital to wage war outstripped supplies of hard currency.
The Renaissance
After the fall of Rome, most of Western Europe reverted to the barter system. Some Celtic and Germanic cultures used denominated coins, but most precious-metal transactions were by weight of bullion. Money re-entered most societies in Europe during the late Middle Ages. In Florence, trade was powered with gold from Africa, and by the mid-13th century, the gold florin was issued, and then the gold ducat.
Large silver deposits were discovered in Tyrolia, in Saxony, and in 1512 in Joachimsthal, Bohemia. The large silver Joachimsthaler coin soon supplanted the florin and the ducat, and the shortened name, thaler, or dollar, became generic. In the 1540’s, huge new supplies of gold and silver from sub-Saharan Africa and the New World began to flow into Europe. Large copper deposits entered production in Sweden, making smaller-denomination coins available. At that point even daily transactions began to leave the barter system.
Banking Many of the functions of today’s banks developed during the Renaissance as pawnbrokers, goldsmiths, and money changers began to lend at interest and to issue letters of credit. City and state governments in Italy and elsewhere in Europe began raising funds for large civic projects by issuing public debt—borrowing at interest from willing individuals rather than raising compulsory taxes.
Formal banks started when wealthy individuals or small groups put surplus wealth, capital, to use by making loans, building public works, or backing ambitious ventures. What made this possible were legal and accounting systems to record who had the money and where it went. Ironically, it is this “fixing” of the assets that frees the capital. In countries where the legal and accounting systems are weak, people are forced to keep physical ownership of their money, or buy and hoard nonperishable goods. Even a wealthy economy withers when capital is scarce.
First banks In 1609 the Wisselbank opened in Amsterdam to provide credit for local and regional governments and for the Dutch trading empire. Its notes—a bank’s promises to pay a specific sum to the bearer—circulated widely, and it is considered the first bank in the modern sense. In 1683 it was allowed to do business with individuals.
Sweden’s first bank arose out of the country’s use of copper, rather than gold or silver, for its currency. For Swedish coins to have value comparable to other nations’ coins, the coins had to be big. That was inconvenient, so in 1661 the Stockholm Banco, founded by Johan Palmstruch about five years earlier, got a charter to issue paper money. The temptation to print notes in excess of metal reserves was too great. By 1667 the notes were worthless.
The Bank of England was the first lasting and effective central bank, although it was not founded as one. The “Old Woman of Threadneedle Street” was proposed by William Paterson (1658–1719) as a joint-stock company, in which the capital of several people was pooled. The
bank issued the first national notes in 1694. They were backed by a loan of 1.2 million pounds sterling to King William III, formerly William of Orange, who had brought familiarity with banking and paper money from his native Holland.
The notes were accepted readily, and the new liquidity stimulated commerce. Historians credit England’s ability to raise capital and spread risk as a primary factor in the small country’s rise to empire.
The first paper currency in North America was issued in 1690 by the Massachusetts Bay Colony to pay soldiers for an expedition against Quebec. Over time, most American colonies issued fiduciary paper money backed by taxes. Though rich in resources, they lacked precious metals that would have enabled them to issue large amounts of hard currency.
American business was conducted in colonial pounds, shillings, and pence. Those were worth about three-quarters of the same denominations in England. However, hardly any British currency circulated in the colonies. The balance of trade favored the mother country, and by law coins could not leave Britain or be minted in the colonies. Instead, Spanish eight-real dollars, or pieces of eight, were the most common coins. A quarter dollar was two reales, or two bits—and is so called even today.
The legacy of the Spanish eight-bit silver coin remained part of the U.S. economy for more than 300 years. Stocks on the New York Stock Exchange traded in halves, quarters, and eighths of dollars until 2000, when the NYSE shifted from fractional prices to decimal trading, thus erasing this vestige of the colonial Spanish eight-bit silver coin upon which the U.S. dollar was originally based.
American Revolution As other wars had done, the American Revolution created a great need for fast money. Congress met the liquidity crisis with several issues of paper currency, collectively called continentals. They were so-called fiat money, backed by nothing but their status as legal tender, they were disdained from the start. First issued in 1775, continentals fell to half their face value by the end of that year, and to a low of $200 paper to $1 in gold by the end of the Revolution in 1783.
Under the Articles of Confederation, the federal government had no taxing authority; it could only ask the states for money. The result was economic chaos. Merchants and urban dwellers were hardest hit, while the countryside fell back on barter and self-sufficiency. The crisis came when a former officer, Daniel Shays, led other Massachusetts farmers in a tax revolt in 1786. The next year each state sent delegates to a Constitutional Convention in Philadelphia.
After leading the effort to have the Constitution adopted, Alexander Hamilton of New York, the first secretary of the treasury, proposed that Congress assume the states’ outstanding war debt, redeem the debased currency at the rate of 100 continentals to one new dollar, and issue new federal notes. Opposition, led by the Virginians Thomas Jefferson and James Madison, was fierce. Many former soldiers and farmers, paid in continentals, had sold them to speculators at around the prevailing rate, 200:1. Many people thought it was grossly unfair for the speculators to be rewarded at the expense of those who had borne the brunt of the conflict. Hamilton argued they had made the best deal they could at the time, and that it would be impossible to trace the notes to their original owners. Ironically, the demand stimulated by the speculators brought the value of the continentals up to the proposed rate of 100:1 within a few months.
More ominously, states that had paid off their debt, mostly in the south, objected to a plan that would relieve other states, mostly in the north, from their debts. In April 1790 Hamilton struck a bargain over dinner with Jefferson and Madison. In return for Jefferson’s support of assumption and a Bank of the United States, Hamilton would support legislation moving the U.S. capital from New York to a spot on the Potomac River that would become Washington, D.C.
The Bank of the United States The first Bank of the United States received a 20-year charter in 1791. Hamilton’s assumption and new currency plan went so well that English banks accumulated most of the new U.S. bonds originally bought by the French and Dutch. In effect Hamilton got the British to pay for the Revolution. But by 1811, when the Bank’s charter came up for renewal, sentiment had turned against Europe and hard-money backers in the U.S. Creditors, especially bankers and financiers,
favor tight, or hard, money linked to bullion, and low inflation. Borrowers, especially farmers, favor soft money, easy credit, and some inflation, which allows debts to be paid in dollars worth a little less down the road. Agricultural interests from southern and western states opposed the bank’s hard-money policies, and the bank was not rechartered.
In 1812 a second war with England broke out. When it ended in 1815, U.S. finances were again a shambles. By 1816 a second Bank of the United States was given a 20-year charter, and again brought financial stability. When that was due for renewal, the same southern and western interests again opposed recharter. The bill passed in 1832, but was vetoed by the populist president Andrew Jackson. This left local banknotes and the meager output from the U.S. Mint, plus foreign coins, as the only currency. Most banks issued sound notes, but many—primarily in the south and west—were undercapitalized and some were simply fraudulent. The period from 1836, when the Bank closed, to 1863, when Abraham Lincoln’s administration issued new federal notes, is called the “thirty years in the wilderness.”
Greenbacks The Gold Rush of 1849 allowed the banks of Sutters Mill, Calif., to provide liquidity in the decade and a half before the Civil War. For the first time in U.S. history, sufficient hard currency was circulating in most of the nation. However, the gold wasn’t enough to finance the Civil War, and in 1862 Congress authorized $450 million in fiat money. In contrast to the colorful and artistic local banknotes of the time, the government printed drab bills, black on the front and green on the back. The greenbacks lost value, as the continentals had, but not nearly as much: They trade at about 70 percent of face value after a Union victory, and as low as 30 percent of face value after a Confederate victory.
The greenbacks were merely an expedient; by the next year, the federal government had come up with a way to get more federal notes into circulation. The National Bank Act of 1863, and amendments the next year, gave the government new taxing powers, including the first income tax, and a 10 percent tax on local banknotes. The tax drove the local banknotes out of circulation. Banks that wanted to issue notes had to get a federal charter requiring them to invest at least a third of their capital in federal bonds. They could then issue federal banknotes, up to the value of 90 percent of their bond holdings.
The Gold Standard After the Civil War, a dispute over whether to use gold or silver to back paper money intensified. Bankers favored gold because it better limited inflation. Debtors, including the recently returned soldiers of the North and South, favored silver to spur growth; vast new mines in the West promised plenty of material.
The country had been operating with a system of bimetallism. Unlimited coinage of silver and gold was authorized. The government bought any bullion brought to it; this policy meant that paper money was backed by gold and silver. When notes were redeemed, the metal entered circulation as coins. The only problem was that the ratio of silver to gold was set at 15:1, which put too much value on silver. Under Gresham’s law—bad money drives out good—people hoarded gold and spent silver.
Between 1837 and 1893 four contradictory laws were passed to tinker with the system, generally favoring gold and, thereby, lenders and businesses over borrowers and farmers. Saying to eastern plutocrats, “you shall not crucify mankind upon a cross of gold,” William Jennings Bryan (1860–1925) ran for president in 1896 on a populist platform of free coinage of silver. He lost to William McKinley, who signed the Gold Standard Act in 1900.
The U.S. remained on the gold standard for three-quarters of a century, with the exception of a period during Franklin Roosevelt’s administration. In 1971 President Richard Nixon took the U.S. off the gold standard for good, because the country’s foreign-exchange debt exceeded the country’s gold reserves. All U.S. currency, and virtually all money worldwide, is now fiat money.
J. P. Morgan and the Panic of 1907 The American economy emerged after the Civil War as an irresistible force. The transcontinental railroad was completed in 1869, and soon a sprawling network of rails brought the outputs of mines, farms, and grazing lands to eastern cities recently swelled by immigrants. The wealth created by unbridled capitalism led Mark Twain to title his novel of the era The Gilded Age.
It was the age of the great industrialists—Vanderbilt, Rockefeller, and others (See “Business”)—but the most powerful of all was John Pierpont Morgan (1837–1913), who established his own stock brokerage in 1862 and emerged after the Civil War as the most powerful financier in the country. His acquisitions consolidated many industries, especially railroads and steel mills. He reorganized General Electric, and his formation of U.S. Steel in 1901 created the first billion-dollar corporation in history.
Morgan put his fortune and prestige on the line to end the Panic of 1907. After several large corporations and stock brokerages went bankrupt, stock prices fell, causing
traders to withdraw money from banks to cover their losses. Bank failures and a nationwide recession seemed likely. Morgan, however, assembled a team of businessmen who shored up weak banks and invested in corporations that were sound, but needed help. The strategy worked, and the crisis passed. The bank and brokerage house that bears J. P. Morgan’s name merged with the Chase Manhattan Corporation in 2000. Now known as J.P.Morgan Chase & Co., it is still one of the largest financial firms in the world.
The Federal Reserve The grim reality that the federal government had to call upon a private citizen to solve a national financial crisis led to the passage of the Federal Reserve Act in 1913. It created the Federal Reserve Board, which later became the Federal Reserve System, commonly called the Fed. The system, which is one of the most powerful institutions in America, consists of a board of governors and 12 regional reserve banks. The Fed regulates the money supply by buying and selling federal notes. It also sets the discount rate, the interest rate at which it lends money to its commercial bank customers. The discount rate helps decide interest rates that the banks, in turn, charge their customers. Finally, the Fed also helps regulate commercial banks.
The Great Depression While the European landscape and economy were in ruins after World War I, the U.S. emerged from the conflict relatively unscathed. The postwar strength produced the roaring twenties, a decade in which social exuberance was matched by wild speculations in the credit and stock markets. The optimism was fueled by low interest rates and a prevailing belief that the Fed had firm control of the economy.
Few within the Fed saw the trouble that was coming. One exception was Benjamin Strong (1872–1928), head of the Federal Reserve Bank of New York. He raised interest rates in his district to try to slow the economy, but without the support of other board members, he had only a limited effect. On October 29, 1929, “Black Tuesday,” the stock market crashed.
A recession after such a crash was almost inevitable. Three factors turned it into the Great Depression. First, interest rates were left high even after the bubble burst, making it difficult for surviving companies to borrow. Then the administration of Herbert Hoover pushed through a massive tax increase to boost sagging federal revenues. Worst of all, Congress bowed to special interests and passed the protectionist Smoot-Hawley Tariff.
Other countries quickly retaliated, and global trade slowed to a trickle. Similar mismanagement in other countries turned the recession into a global depression. The 1930’s were the most traumatic times in U.S. financial history, as industrial output fell to half, unemployment reached 25 percent, and hundreds of banks failed, wiping out family savings across the country.
The New Deal and Reform Soon after taking office, President Franklin Roosevelt declared a bank holiday to give solvent institutions time to recover. Senator Carter Glass of Virginia (1858–1946) and Representative Henry B. Steagall of Alabama (1873–1943) sponsored the most sweeping banking reform in the country since the days of Hamilton. The Banking Act of 1933 created the Federal Deposit Insurance Corp., ending bank runs at a stroke by establishing an insurance system for depositors’ money. The act also separated banking and brokerage. Commercial banks were prohibited from underwriting stocks and bonds; investment banking firms were prohibited from taking deposits. Savings and industrial banks were allowed to join the Fed, and branch banking was allowed.
Under Franklin Roosevelt’s “New Deal,” massive relief efforts and huge public works projects kept the country from anarchy, but another recession struck in 1937, driven mostly by the failure of cotton crops in the South and the Dust Bowl in the West.
World War II helped to salvage the U.S. economy. All of the major corporations had mobilized to fight the war, and productivity soared. Unemployment declined dramatically and tens of millions of American workers were earning more money than ever before. Wartime restrictions, however, made consumer goods scarce or nonexistent (no new cars, for example, were built in 1942–46). When the war was won, the combination of the capacity and the pent-up demand produced the biggest boom ever. It was stoked by $200 billion in maturing war bonds and an upwardly mobile, college-educated workforce created by the G.I. Bill.
Stagflation The decade of the 1970’s was marked by the unprecedented combination of rising prices and slow economic growth. Economists coined a new term for the global phenomenon: stagflation. The factors that led to this malaise included the end of the gold standard in 1971, the Arab oil embargo of 1973, expanded social programs, and the war in Vietnam, which necessitated higher taxes. Inflation was 5–10 percent during every year of the 1970’s, reaching a peak of 13.5 percent in 1980.
President Jimmy Carter (b. 1924) got most of the blame for stagflation, but decades of fiscal policy had set the stage. It took harsh treatment to get the economy moving again. Federal Reserve Chairman Paul Volcker (b. 1927) reduced the supply of money in circulation by selling federal bonds. The contraction produced a sharp recession in the early 1980’s, but it ended stagflation.
Banking in the United States Today Globalization and the drive for profits during the economic boom of the 1990’s pushed the largest banks to consider acquisitions of insurance companies and brokerage houses, both extremely profitable kinds of businesses. In 1998, Travelers Insurance, one of the largest insurance underwriters, was set to merge with Citigroup, one of the largest banks. Such a deal was prohibited under the Glass-Steagall Act, but banking overhauls had been rattling around congress for many years. On cue, legislators passed the Financial Services Modernization Act of 1999, called Gramm-Leach-Bliley after its sponsors. Banks, brokerages, and insurance firms were allowed to compete with and buy each other, and to do business across state lines.
Today there are about 6,500 commercial banks in the United States (down from 10,000 in 2007), divided into three groups: small local banks, which are rapidly being acquired by larger banks; larger regional banks with networks that cover one or more states; and huge national banks. The largest banks, Citigroup, J. P. Morgan Chase & Co., and Bank of America, compete internationally with similarly huge Japanese, German, and British banks.
Investment banks including Goldman Sachs and Morgan Stanley distribute, underwrite, and originate new securities for governments, corporations and individuals. This raises needed capital for the clients while the bank profits by dividing the securities purchased into smaller units with higher prices. Other services include mergers and acquisitions, trading of derivatives and commodities and general investment advice for institutions, pension funds, and wealthy individuals. Investment banks do not accept individual deposits.
Stock markets are systems for raising capital and spreading risk. From the beginnings of civilization until the Renaissance rulers and wealthy families sponsored public works and ambitious ventures. Early in the Renaissance, joint-stock companies were developed under which individuals, families, villages, and trade guilds could pool their capital to underwrite new companies or trading expeditions. Trade guilds, in particular, became very powerful because of their strong organizations and ability to raise large amounts of money relatively quickly.
First Stock Market
Once ownership of a company or the right to the bounty of a trading expedition was in multiple hands, the shares became another valuable commodity that could be sold or traded. The world’s first stock market began informal business in 1602 on Damrak Street in Amsterdam, trading shares of the world’s first large multinational venture, the Verenidge Oost-Indische Companie (United East-India Co.). The oldest surviving stock certificates, just hand-written notes, are of the VOC from 1606.
Within a year or two futures and options on shares had been developed in Amsterdam. A futures contract represents immediate payment for future delivery of a security or commodity. An option is even more malleable; it is the right to buy or sell a commodity or security at a given price within a specific period. Once a futures contract is agreed upon, the commodity or security will be delivered. An option, however, can be left to expire unexercised.
Other Early Exchanges
The Frankfurt Stock Exchange traces its ancestry to 1585, but what existed then was a currency exchange. Bonds were added 100 years later, and stocks were not added until 1820. The London Stock Exchange traces its history to informal trading in shares in 1698 at Jonathan’s CoffeeHouse, where trading had been going on for some time. Meanwhile, the English physician, surveyor, and economist Sir William Petty (1623–87) was posted to Ireland, where he quantified an ancient concept that the fair market value of any land is equal to its production—from crops, timber, minerals, or livestock—over 20 years. In essence Petty around 1650 had formalized the most fundamental measure of any commodity or security, its price-to-earnings ratio, an essential value indicator to this day.
Speculators and Bubbles
An investor buys and sells securities for their inherent value. Speculators buy and sell because they want to bet that securities will rise or decline in value. A little speculation helps keeps markets active and provides capital for new ventures.
When speculation runs out of control, uninformed people flock to the markets in hopes of a quick profit. The results are invariably a crash and widespread economic distress.
Tulipmania The technology-stock bubble of the late 1990’s was the latest in a long line of financial crises dating back to tulipmania, which hit Holland in the 1630’s. The normally sober and industrious Netherlanders were overcome by a speculative fever. Fortunes were exchanged for rare tulip bulbs; the few clearheaded critics were ignored. Bubbles always burst when enough people lose their euphoria, and want to sell. The panic buying turns in a moment into panic selling. The tulip bubble burst in 1637, ruining many and bringing on a severe recession.
The South Sea Bubble Less than a hundred years later it all happened again, this time in England. The South Sea Co. was founded in 1711 as a legitimate trading firm. But when granted a monopoly from Parliament, the founders proposed to retire the national debt in exchange for company stock. Stories were planted about fabulous wealth; 50:1 returns were promised. Huge dividends were paid with the money pouring in, turning the company into a pyramid scheme. The house of cards tumbled in 1720, and even some members of Parliament were ruined.
Mississippi Co. Madness also prevailed in France. The Scotsman John Law (1671–1729), a brilliant scoundrel, got a royal charter from the regent of Louis XV to open a bank in 1716. His well-backed notes traded at a premium. He then chartered the Company of the West, commonly called the Mississippi Co., to operate the Louisiana colony. He further offered to sell shares for deeply discounted national paper money. Preposterous dividends were promised, just as for the South Sea Co. Overnight wealth gave birth to the term “millionaire,” and inflation soared. The Mississippi Bubble burst about the same time as the South Sea Bubble. The Bourbon dynasty was irreparably damaged, many nobles were ruined, land and tax reforms were abandoned, and the economy was in tatters.
The Industrial Revolution With the advent of the Industrial Revolution the European economic system rapidly acquired a strong need for capital aggregation to support the numerous new businesses being formed. Stock markets grew rapidly in all the major European cities led by London, Paris, and Amsterdam and over the course of the 19th century investors provided for the financing of factories, mines, railroads, ships, and the many technological advances made during this period.
Unfortunately this market-based system was also subject to fiscal crises, panics, recessions, and depressions that had severe negative consequences not only for investors, but for the masses of people now dependent on wages for survival. During the 19th century these crises occurred just about every 10 years between 1816 and 1866, but they fell off with serious downturns in 1873, 1907, 1921, and 1929 when the world wide depression brought every economy in the world to its knees and forced governments to take serious action to regulate financial markets.
The U.S. Stock Market
The first stock exchange in North America opened in 1790 in Philadelphia, the second-largest city in the British Empire at the time of the Revolution. Markets hate uncertainty, so it is significant that the Philadelphia Bourse opened seven years after the end of the Revolution, the same year the federal government issued $80 million in Treasury bonds to pay off the debts from the Revolution.
NYSE The New York Stock Exchange (NYSE) was created on May 17, 1792, when 24 stockbrokers and merchants convened under a buttonwood tree on Wall Street. According to a two-sentence contract signed that day, known as the Buttonwood Agreement, the men would trade stocks and bonds only among themselves, fix commissions (at “one quarter per cent of specie value”), and participate in no auctions other than their own.
Market activity took a quantum leap after the War of 1812, as government debt again sparked heavy trading in federal certificates. In addition, scores of new banks and insurance companies were established in the next few years and were listed on the exchange by 1815; the sale of securities generated much of the venture capital necessary to fund these new enterprises. In March 1817 the original exchange passed a formal constitution with rules of conduct, adopted the name New York Stock & Exchange Board—shortened to NYSE in 1863—and moved into a rented room at 40 Wall Street.
AMEX Meanwhile, smaller exchanges in New York and elsewhere competed for business. Among the largest New York rivals was a group known as the Curbstone Brokers, which conducted its trade outdoors, rain or shine, beginning in the early 1800’s. Later known as the New York Curb Exchange, the group finally moved indoors at 86 Trinity
Place, just west of Wall Street, in 1921. Renamed the American Stock Exchange (AMEX) in 1953, it merged with NASDAQ from 1998–2004, when ownership again returned to private hands. In 2008 the parent company of the New York Stock Exchange, NYSE Euronext, acquired the exchange and renamed it NYSE Amex equities. It’s currently the third-largest stock exchange by trading volume in the United States, mostly dealing in small-cap stocks, exchange-traded funds and derivatives.
NASDAQ Opened to trading in 1971, the National Association of Securities Dealers Automatic Quotations (NASDAQ) was the world’s first electronic stock market. Initially a computer bulletin board system, with no contact between buyers and sellers, it gradually expanded to include trade and volume reporting, automated trading systems and was the first U.S. stock market to allow online trading. It merged with the London Stock Exchange in 1992, forming the first intercontinental partnership of securities markets. In 1998 it merged with AMEX, forming the second-largest U.S. stock exchange, although that partnership lasted only six years. NASDAQ Stock Market, Inc. was formed as a public company in 2000. NASDAQ is known for specializing in technology based stocks, although virtually every industry is listed.
Stock Indexes
By the end of the 19th century, the NYSE had grown so large and had so many investors that it needed an easy-to-understand measurement of how the market was doing. As the stock market grew even more after World War II, the need for more and more information became obvious.
Today there are many stock indexes each measuring a specific part of the market. The NASDAQ Composite is an index of all of the common stocks and similar securities that are listed on the NASDAQ stock market, over 3,000 companies. The S&P 500, maintained by Standard & Poor’s, is a free-float capitalization-weighted index of the prices of 500 large common stocks traded in the United States. These stocks are chosen by committee in order to form a representative slice of the industries of the United States economy. Many investors consider it the best overall measurement of American stock market performance. Another index, the Russell 3000, measures the performance of the largest 3,000 U.S. companies, representing approximately 98 percent of the investable U.S. equity market. The Russell 1000 measures the performance of the large-cap segment of the U.S. industry and contains approximately 1,000 of the largest securities, based on a combination of their market cap and current index measurement. The most well-known index is the Dow Jones Industrial Average.
Dow Jones Industrial Average Strictly speaking, the Dow is an index, not an average. To arrive at the index, the combined stock price of the component companies is divided, not by the number of stocks, but by a number which is adjusted to account for stock splits, mergers, and historical activity.
Although the Dow Jones Industrial Average included only a dozen industrial stocks when it was first published in 1896 in The Wall Street Journal (Dow was the founder and editor), it has since grown to 30 and now reflects a variety of sectors outside heavy industry. Of the original twelve stocks, General Electric is the only one currently in the Dow. The index is selected from among blue chip stocks by editors of The Wall Street Journal and is seldom revised; the last revision was in 2006. Also called the Dow, DJIA, or Dow 30, it is the oldest index and remains a key indicator of the overall robustness of the U.S. stock market.
Boom and Bust Cycles
Rapid economic growth and westward expansion in the first half of the 19th century brought dramatic increases in trading volume and the number and value of available stocks. Average daily volume on the NYSE hit 8,500 shares in 1830, representing a 50-fold increase in only seven years. The number of publicly traded companies rose from 20 in 1800 to more than 120 by 1835. After the first railroad stock was issued in 1830, the acceleration of track construction caused market growth in the ensuing decades. Railroads remained the nation’s largest and most powerful companies throughout the 19th century, with mining, farm equipment, steel, and other manufacturing companies prominent on the exchange by the 1870’s.
The financial markets proved volatile. Wall Street’s first major “panic” began in 1836, amid wild speculation in federal land and commodity imports. The government responded by issuing a “specie circular” for the purchase of public land (requiring payment in gold or silver), which led to a collapse in prices and the failure of thousands of banks and businesses. Production and employment fell off rapidly, and the nation suffered a six-year depression.
Overinvestment in land and railroads produced another wave of panic selling in 1857–58. Gold prices, run up during the attempt of the financiers Jay Gould (1836–92) and James Fisk (1834–72) to corner the supply, dropped precipitously when the federal government released its own gold into the market—causing a financial debacle on September 24, 1869, known as “Black Friday.”
The boom that powered the U.S. economy after the Civil War was no bar to instability. The worst financial crisis of the 19th century began in 1873, when heavy speculation in securities and the failure of Jay Cooke’s banking house toppled business after business, forced the NYSE to close for 10 days, and triggered a six-year depression. In 1893, a series of railroad bankruptcies caused hundreds of banks to fail, thousands of companies to shut down, and widespread unemployment to persist for the next four years.
Securities Regulation Amid the boom-and-bust cycles, a host of innovations brought tighter regulation and improved efficiency to the securities markets. In 1853 the NYSE began requiring listed companies to file complete statements of outstanding shares and capital resources. In 1868 memberships on the exchange were put up for sale, rather than reserved for life. And the following year, to keep companies from issuing too many stocks (“watering”), the NYSE began requiring them to register shares at a bank or another appropriate institution. Also in 1868, the first ticker tapes were introduced on the trading floor.
The year 1871 began an era of change for the NYSE, as the traditional “call market” (in which an auctioneer called out the name of each stock and brokers shouted their offers to sell or buy) was replaced by today’s continuous auction market. By 1899 all listed companies provided regular financial statements both to the NYSE and to stockholders (in 1910 the exchange discontinued trading in unlisted securities).
The Crash and the New Deal The NYSE relocated to its current location at 11 Wall Street in 1922, and the move was soon followed by a historic bull run. Beginning in 1923, stock prices and trading volume surged, virtually unchecked, for more than six years. In 1928, single-day share volume on the NYSE broke the 5 million level. The crash of October 29, 1929 (“Black Tuesday”) produced a record volume of more than 16 million shares—most of them sales. The Dow Jones average dropped 11 percent in one day.
The Dow hit bottom, down 89 percent from its 1929 peak, in July 1932. The New Deal brought some relief and much reform: the Securities Act of 1933 required full disclosure to investors and prohibited fraud in the sale of securities; the Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to oversee the markets and protect investors against malpractice.
Modern Era
Industrial mobilization during World War II restored the economy, and the postwar period brought sustained financial growth. A bull run that began in 1949 was the longest to date, with stock prices rising almost without interruption for the next eight years. The Dow shot past the 500 mark in 1956.
Old-line brokers and investment bankers opposed the reforms of the mid-1930’s as government interference in private enterprise, but some saw a new horizon opening. In the 1940’s Charles E. Merrill (1885–1956) hired hundreds of investment advisers, paid them a salary, and had them solicit business from the burgeoning middle class. Until then most brokers worked largely on commission, and only wealthy clients were worth these brokers’ time. Merrill also began to advertise in 1948. By 1960 Merrill Lynch had more than half a million clients and was four times the size of the next-largest brokerage.
Mutual funds also became prominent after the war. The first, the Massachusetts Investors Trust, was launched in 1924. But mutual funds first began to be popular in the 1950’s. People of modest means were not willing to invest their small savings until the regulatory reforms of the 1930’s took hold and the “mass affluent” had begun to respond to the enticements of Merrill Lynch and its competitors.
With people and money pouring into the market and manufacturing running at capacity, stocks broke the pre-crash levels in 1954, and soared higher. The NYSE had its first billion-share day in 1959. The boom rolled on, but by the late 1960’s several factors began to drag at equities. Technology failed to keep up with volume, and markets became victims of their own success. Inflation, domestic unrest, and international troubles also took their toll.
The incorporation of the NYSE and the creation of an interdealer, over-the-counter (OTC) market—NASDAQ—both in 1971, opened the modern era in U.S. securities trading. NASDAQ, the first stock exchange to rely on sophisticated computer and telecommunications systems, traded and monitored millions of securities across the globe in real time.
Dow Jones Industrial Average Timeline
| Jan. 19, 1906 |
Dow closes at 101.55, first time over 100. |
| July 31 -Dec. 15, 1914 |
Stock exchange closes during the opening months of World War I |
| Dec. 12, 1914 |
Largest one-day percentage loss:–24.3 percent |
| Dec. 12, 1927 |
Dow closes at 200.93, first time over 200 |
| Sept. 03, 1929 |
Dow closes at high of 381.27, and will not surpass this mark until 1954 |
| Oct. 24, 1929 |
Black Thursday, beginning of “Black Days” that mark the end of 1920’s bull market. |
| Nov. 1929 |
Stock market crash marks beginning of the Great Depression |
| Oct. 6, 1931 |
Largest one-day percentage gain: 14.87 percent |
| July 8, 1932 |
Dow closes at 41.22, lowest point during the Great Depression |
| Dec. 1, 1954 |
Dow closes at 400.97, first time over 400 |
| March 1, 1956 |
Dow closes at 500.24, first time over 500 |
| Feb. 1, 1959 |
Dow closes at 602.21, first time over 600 |
| May 1, 1961 |
Dow closes at 705.52, first time over 700 |
| Feb. 1, 1964 |
Dow closes at 800.14, first time over 800 |
| Jan. 1, 1965 |
Dow closes at 900.95, first time over 900 |
| Nov. 1, 1972 |
Dow closes at 1003.16, first time over 1000 |
| 1974 |
Dow drops nearly 400 points from beginning to end of 1974 |
| Dec. 1, 1983 |
Dow closes at 1511.7, first time over 1,500 |
| Jan. 8, 1987 |
Dow closes at 2002.25, first time over 2,000 |
| Oct. 1987 |
Dow drops 800 points during 1987 crash |
| Oct. 19, 1987 |
Black Monday, second largest one-day percentage drop in Dow,–22.61% |
| Apr. 17, 1991 |
Dow closes at 3004.96, first time over 3,000 |
| Feb. 23, 19 95 |
Dow closes at 4003.33, first time over 4,000 |
| Nov. 21, 1995 |
Dow closes at 5023.55, first time over 5,000 |
| Oct. 14, 1996 |
Dow closes at 6010, first time over 6,000 |
| Feb. 13, 1997 |
Dow closes at 7022.44, first time over 7,000 |
| July 16, 1997 |
Dow closes at 8038.88, first time over 8,000 |
| Apr. 16, 1998 |
Dow closes at 9033.23, first time over 9,000 |
| Mar. 29, 1999 |
Dow closes at 10,006.78, first time over 10,000 |
| May 3, 1999 |
Dow closes at 11,014.69, first time over 11,000 |
| Mar. 16, 2000 |
Largest one-day point gain: 499.19 |
| July–Oct. 2001 |
Dow drops 2000 points during slump exacerbated by terrorist attacks. |
| Sept. 17, 2001 |
Largest one-day point loss:–684.81 |
| Oct. 19, 2006 |
Dow closes at 12,011.73, first time over 12,000 |
| Apr. 25, 2007 |
Dow closes at 13,089.89, first time over 13,000 |
| July 19, 2007 |
Dow closes at 14,000.41, first time over 14,000 |
| 2008 |
Dow drops 8,776 points (33.84percent) making it the third worst year in Dow history |
| Sept. 29, 2008 |
Largest one-day point loss:–777.68 |
| Oct. 13, 2008 |
Largest one-day point gain: 936.42 |
| Oct. 15, 2008 |
2nd largest one-day point loss:–733.08 |
| Oct. 28, 2008 |
2nd largest one-day point gain: 889.35 |
| Mar. 2009 |
Dow drops to under 7,000 points for the first time since April 1997 |
| Apr. 12, 2010 |
Dow closes above 11,000 for first time since September 2008 |
| May 6, 2010 |
Dow plunges 998.5 points before recovering almost immediately. Known as the “Flash Crash,” it was the largest intra-day fall ever |
| Feb. 1, 2011 |
Dow closes over 12,000 for the first time since June 2008 |
| Source: www.djindexes.com |
In the 1970’s and 1980’s, the spread of regulated, high-tech exchanges in Europe and Asia contributed to an expanding financial base. The abolition of fixed commissions (1975), the popularization of mutual funds and pension funds, and the advent of online brokerage brought tens of millions of new U.S. investors into the market. Single-day share volume on the NYSE hit 100 million in 1982; the Dow passed 1,000 in 1972 and 2,000 in 1987.
Unsurprisingly, given the history of financial markets, such exuberance was soon accompanied by shady deals, manias, and bubbles.
Leveraged buyouts In most bull markets there is some new wrinkle, and in the 1980’s it was leveraged buyouts. Corporate raiders borrowed against the stock of the company they were planning to acquire. They also raised huge sums with unsecured or “junk” bonds. In October 1987 markets experienced one of the worst one-day falls.
However, the expected recession never occurred; the Fed cut interest rates and increased cash in the system, so individual investors did not panic. The market recovered quickly, leaving investors and money managers alike with the mistaken idea that the Fed could prevent any market fall.
S & L crisis A change in the regulatory structure in the 1980’s allowed savings and loan associations to sell their consumer and commercial loans and Wall Street immediately stepped in. These large banks bought multiple loans and bundled them together as bonds backed by government institutions such as Fannie Mae and Freddie Mac. The S&L’s would then buy back these bonds, paying huge transaction fees, holding $150 billion worth by 1986. When customers began to default and go into bankruptcy, these institutions were crippled. The Federal Savings and Loan Insurance Corporation stepped in and closed or resolved 296 institutions with assets up to $125 billion by 1989. With the government formation of the Resolution Trust Corporation, 747 more S&L’s were closed by 1995. The United States government ultimately spent $124.6 billion to resolve this crisis.
Long-Term Capital Management Founded in 1994 by a group of wealthy investors, this hedge fund was managed by several very successful financiers including Robert C. Morton, a Nobel Prize winner in Economics in 1997. Although it had a very high ratio of debt to capital based on an initial loan of $125 billion, the fund’s initial success induced several large banks to lend them more and more money. In 1998 when an enormous investment in emerging market bonds went sour the fund faced bankruptcy. But as a sign of things to come, the U.S. government intervened because of fear that the fund’s collapse would ripple through the system and cause untold damage. The government convinced the large banks to rescue Long-Term Capital and take ownership of it. “Too big to fail” had been born.
Dot-com bubble In place of the LBOs of the 1980’s, the new fad of the 1990’s was the initial public offering (IPO). Tiny technology companies had their initial public offerings and saw their share prices reach the stratosphere on the first day of trading. The Dow soared from 5,000 in 1995 to 11,000 in 1999 before plummeting to below 9,000 in 2001. “Dot-com” companies, which sold goods and services over the Internet, led the technology boom.
As the frenzy built, some executives took to manipulating their company’s financial results to sustain their stock prices. Many big accounting firms were now consultants to the same firms they audited, but denied that there was a conflict of interest. A little shuffling of costs and revenue soon gave way to wholesale fraud at some firms, aided and abetted by their erstwhile auditors. When the bubble burst, and the profits were found to be fake, huge firms, including Enron, went bankrupt and some of their executives were brought to trial.
The Bernie Madoff Ponzi scheme On December 11, 2008, Bernie Madoff, founder of the firm Bernard L. Madoff Investment Securities LLC, was arrested as his decades long Ponzi scheme began to unravel. Thousands of institutions and wealthy individuals gave billions of dollars to Madoff who in classic Ponzi scheme style took the money and paid it to the previous investors as well as to himself and his family. When the financial crisis hit he quickly ran out of money. The former chairman of NASDAQ, Madoff was able to fool individuals and large international banks into believing his high-performing fund’s profits, often of 20 percent, were legitimate. Despite many red flags and several S.E.C. investigations, the massive fraud was not discovered. Many investors lost life savings and banks such as HSBC in England and BNP Paribas in France suffered massive losses. Although the exact amount of losses will never be known estimates range as high as $65 billion. Several fund managers that had invested with Madoff have since committed suicide, as did his son Mark in 2010. In 2009 he pleaded guilty and was sentenced to the maximum of 150 years in prison.
The great financial collapse of 2008 The collapse of the world financial system in the last half of 2008 was at its heart a fiscal crisis brought on by an exponential
increase in the amount of debt held by hundreds of thousands of institutions, including banks, hedge funds, pension funds, states, cities, foreign entities, and individuals. The crisis began in the United States as the stock market rebounded from the dot-com bubble, and access to money through relaxed standards of lending by banks and credit card companies rapidly drove the economy into an upward spiral. Within a few years the ratio of debt to disposable income in the U.S. rose from 90 percent in the 1990’s (a high figure itself) to a dangerously high 133 percent by 2008. From 2000 to 2008 consumer debt rose by 20 percent to $2.5 trillion.
During this period the nation’s largest commercial banks (such as Citibank, JPMorgan Chase, Bank America, Washington Mutual) and the largest investment banks (Goldman Sachs, Morgan Stanley, Lehman Brothers, for example) also took on large amounts of debt, much of it in arcane financial instruments called derivatives, including a form of insurance against risk called credit default swaps. Moreover, according to economic historian Niall Ferguson, the 2004 rule change by the Securities and Exchange Commission allowing these banks to exceed the debt-to-capital ratio of 12:1 was instrumental in bringing ever more debt into the system. As a result of the relaxation of rules regarding debt, more and more money began to pour into the U.S. financial system, a great deal of it from Europe and Asia, all of it searching for the highest returns.
A large, complex, and very efficient system already existed to handle this surge in liquid capital including thousands of banks, brokerage houses, hedge funds, and mortgage brokers. The latter would play a key role in triggering the implosion that took down the U.S. and much of the world economy. Aided and abetted by the reckless and aggressive behavior of the two giant government guarantors of mortgage loans—Fannie Mae and Freddie Mac—mortgage brokers throughout the U.S. wrote millions of mortgage loans for people who could not afford them. The banks issuing these loans did not actually assume all of the risk because those mortgages were soon bundled with hundreds of thousands of other mortgages into bonds that were sold and traded just like other bonds. Unfortunately the leading rating agencies—Standard & Poor’s and Moody’s—gave a very large number of these so-called “collateralized mortgage obligations” (C.M.O.s) a triple A rating, even though they were packed with sub-prime mortgages.
The predictable results of all this easy money to help achieve the “American Dream” of home ownership was the creation of yet another bubble, as home sales soared and with it rapid price increases that resulted in those prices doubling and tripling in value in only a few years. That bubble began to lose air by 2007 but no one predicted just how quickly everything would fall apart and how devastating the long-term effects would be.
In the summer of 2008 the first signs of disaster appeared when three powerful Wall Street institutions essentially went bankrupt. Debt-ridden Merrill Lynch and Bear Stearns were in such distress that with the federal government’s help they were sold off to banks for pennies on the dollar. But the huge and highly respected investment bank, Lehman Brothers, simply went into bankruptcy, leaving its investors with losses totaling billions of dollars. Because of Lehman’s enormous size and long reach across the globe a financial bubble suddenly turned into a serious crisis as the interconnected nature of the system revealed its inherent weakness. Major commercial and investment banks were forced to absorb huge losses as were the high flying hedge funds, many of whom collapsed.
Before the Bush administration left office in early 2009, the Treasury and the Federal Reserve gave over $700 billion of taxpayer money to banks across the nation to help stabilize the financial system. This approach did stop the death spiral, but then much of the economy collapsed as employers immediately began to lay off millions of workers. Consumers who still had a job stopped spending out of fear and the credit markets simply stopped functioning. In less than a year the Dow Jones Average declined by 39 percent from 14,164 to 8,579.
During the first two years of the Obama administration the federal government continued to support the general economy by providing $787 billion in stimulus funds which in the end proved to be too small to have a meaningful effect. The long-mismanaged U.S. auto industry was saved by a financial bailout to help preserve hundreds of thousands of jobs in large part because unemployment had risen above 10 percent. In addition, literally millions of homes soon fell into foreclosure as the bubble-inflated prices quickly tumbled by over 30 or 40 percent in Florida, Arizona, Las Vegas, and parts of California. By 2011 there were few signs that the economy was recovering as unemployment appeared to be mired at just over 9 percent and home values continued to decline. Oddly enough, however, the stock market had rebounded, the Dow rose to over 12,000, and banks and
investment houses posted enormous profits.
On the New York Stock Exchange the average daily volume of shares traded jumped from 1.6 billion in 2005 to 2.4 billion in 2010. In 2010 congress had passed the Dodd-Frank Wall Street Reform and Consumer Protection Act designed to end some of the less attractive practices that had helped create the crisis. A year later not very much had happened as hordes of lobbyists descended on House and Senate members to show why reform would be counterproductive. As of 2011, it seemed that not even the $600 trillion derivatives market, so central to the collapse, would not be subject to scrutiny.
Many informed people have expressed serious concern about these developments but the financial community has won the battle over regulation in the past. And the ever-improving efficiencies brought about by the Internet have pushed the financial system into a new realm but not every part of it is beneficial. Computer servers with unprecedented power enable stock, bond, and commodity trades to be made in milliseconds anywhere on the globe. This has fostered much more trading as opposed to long-term investing. The fact that these trades are frequently initiated by the computers, not the people, is proof of that. Very often the profit per share in such trades is very small but when multiplied by millions of shares the result can be very positive. Yet so-called flash trading-caused problems in the financial system—including a 1,000 point drop in the Dow in May 2010—that are attributed to a large trade are most likely made inadvertently.
Mutual funds date back to the 1800’s in England and Scotland, but did not become available in the United States until 1924. Their popularity surged in the 1980’s, when many companies dropped their traditional pension plans and more Americans became responsible for planning for their own retirement incomes. When the Investment Company Institute, the trade organization of the mutual fund industry, was created in 1940, its members included 68 funds worth a total of $2.1 billion. In 2010, the ICI counted approximately 8,500 funds, representing more than 90 million shareholders, and with total assets of more than $11 trillion.
A mutual fund is a type of investment in which investors pool their money and then collectively invest that money in a variety of stocks, bonds, or other money instruments. Every mutual fund has a particular strategy that determines how much to allocate to each type of investment. For example, a fund seeking higher rewards might invest only in stocks, while a fund seeking very low risk might invest in a variety of bonds. Each mutual fund’s strategy, as well its fees and information about how to buy and sell shares, is outlined in the fund prospectus.
The strategy of each mutual fund is determined by the fund manager. The fund manager is a professional investor who monitors the financial markets and continually reallocates the fund’s assets to reap the best return. Mutual funds allow investors to diversify their portfolios by making a wide range of investments. Diversification reduces the risk of losing a large amount of money at one time. Like individual securities investments, mutual funds are not guaranteed by the Federal Deposit Insurance Corp. the way bank accounts are, and may lose money.
Kinds of Mutual Funds The earliest mutual funds invested almost entirely in equities, or shares of stock in publicly traded corporations. Today, mutual funds invest in the entire spectrum of money instruments. Broadly speaking, there are four different kinds of mutual funds. Within the four categories are thousands of mutual funds, each with its own goal and strategies for achieving that goal.
Stock funds, or equity funds, are by far the most common type of mutual funds, representing more than half of all funds. These mutual funds are invested entirely in stocks. The similarities among the various kinds of stock funds end here. Aggressive growth funds invest in small companies poised for growth. Growth funds invest primarily in large well-established companies. Sector funds invest only in companies in a certain segment of the economy, for example, health care. Growth and income funds invest in large companies with growth potential and a strong record of dividend payouts. Income-equity funds are even more concerned with dividend income, and are less interested in growth potential. Emerging market funds invest in companies in developing nations. Regional equity funds invest only in companies in a certain part of the world. Global equity funds invest in equity securities traded internationally, including those of U.S. companies.
Index funds are stock funds whose portfolio mirrors the performance of various stock market indexes, such as
Standard and Poor’s 500 or the Dow Jones industrial average. Because a computer, rather than a person, manages this portfolio, the management costs of index funds are usually lower than other funds.
Bond funds invest in government- and corporate-issued long-term bonds. They are generally more conservative than stock funds but promise a steadier return. This category of funds can be divided into two subcategories: taxable bond funds and tax-free or municipal bond funds.
Hybrid funds invest in a mix of stocks and bonds. Some hybrid funds have fixed percentages allotted to each type of security; other funds allow the fund manager to change the percentages depending on market conditions.
Money market funds are often called short-term funds because they invest in short-term securities (with an average maturity of 90 days or less), such as Treasury bills, CDs, and commercial paper. Within this category are both taxable funds and tax-exempt funds. Because they are free from federal taxes (and in some cases state and local taxes as well), tax-exempt funds usually provide a lower rate of return than taxable funds.
Exchange-traded funds (ETFs) first appeared in 1990 but only became popular in 2004. They are not mutual funds but act like an index fund by making a basket of assets, often in commodities but also in stockmarket indexes. Unlike mutual funds they can be bought and sold every trading day. In 2010, American ETFs had assets of $992 billion, an increase of 137 percent since 2006.
Key Terms for Mutual Funds
closed-end funds most mutual funds are considered “open-end” funds because they offer new shares to the public at all times, and will buy back shares from shareholders at any time. A closed-end fund has a fixed number of shares, which usually trade on a major stock exchange.
expense ratio cost of managing a mutual fund. The ratio is the total amount that the fund manager charges as a percentage of the fund’s total assets. The costs include the fund manager’s salary and the administrative costs for keeping records and mailing statements. The average mutual fund has an expense ratio of about 1.5 percent. Index funds have an expense ratio of about 0.25 percent. load fee or sales charge for purchasing shares of a mutual fund, similar to a commission for purchasing stocks. Mutual funds are generally divided into load funds (those that charge a fee) and no-load funds (those that don’t).
net asset value share price for a mutual fund. It is equal to the market value of all the fund’s securities (minus expenses), divided by the total number of shares.
Hedge Funds
Like mutual funds, hedge funds are investment vehicles that pool money from corporations, syndicates and individuals, and invest it on a collective basis. But hedge funds are exempt from many federal securities regulations, including registration with the Securities and Exchange Commission. They are free to use sophisticated and aggressive investment strategies, such as derivatives, short selling, swaps, currency trading, and arbitrage.
In recent years, hedge funds have grown tremendously in size and influence. Hedge Fund Research, a tracking firm, estimates that $55.5 billion flowed into hedge funds in 2010 making it the highest annual total since 2007, but almost two-third less than the 2006 total; the total assets managed by hedge funds rose to $1.9 trillion.
Hedge funds have traditionally been limited to wealthy investors, though more recently pensions and foundations have also begun to invest heavily in them. Some types of hedge funds are restricted by law to a maximum of 100 investors. The minimum investment is extremely high, ranging from $250,000 to more than $1 million.
The speculative investments favored by many hedge funds can generate enormous profits, but they also entail huge risks. In 1998, the Federal Reserve averted a panic in world markets by engineering a bailout for Long-Term Capital Management; the fund had borrowed heavily and lost billions on a huge position in currency and Treasury markets. The crisis was averted, and Long-Term Capital eventually folded in 2000, but the episode illustrated the risks that accompany this huge and unregulated field. In late 2006, the Amaranth Advisors fund imploded after losing some $6.5 billion in a month’s time by betting incorrectly on the demand for natural gas, but its losses did not have implications for the broader market.
Hedge funds charge a management fee while also collecting a percentage of the profits (typically 20 percent). This fee structure has lead to enormous paydays for fund managers. According to AR Magazine, each of the top 25 earners took home an average of $880 million in 2010 (down 13 percent in one year.) John Paulson, the most highly-compensated manager, made $4.9 billion in 2010.
“Funds of hedge funds” have emerged as a popular variation on this investment vehicle, allowing investors to
diversify their holdings by buying shares in a basket of hedge funds. Many of these funds have lower minimum investment requirements.
Derivatives
The sudden popularity of hedge funds has also drastically increased the use of derivatives as a means of reducing risk. Derivatives are contracts between two parties that allow investors to minimize or shift risk. The value of a derivative is based on (i.e. derived from) an underlying asset such as a commodity, a security, a stock index, or a currency. For example, a derivative could be based on the future price of copper (i.e. a future), or whether it will be cold enough in Colorado to make artificial snow. Investors use derivatives to hedge their bets against loss. Broadly speaking, there are two kinds of derivatives.
Exchange-traded derivatives are publicly traded, standardized transactions that are regulated either by the Securities and Exchange Commission or the Commodity Futures Trading Commission. The two major kinds of exchange-traded derivatives are: options, which are the right to buy or sell something for a predetermined price at some point in the future, and futures, which are the obligation to buy something at that price. The total number of futures and options traded around the world has skyrocketed from 113 million in 1980 to 22.3 billion in 2010, according to the Futures Industry Association. For the first time Asia-Pacific had the largest share of global volume traded (8.86 billion contracts), an increase of 42.8 percent from the previous year.
Over-the-counter derivatives, or swaps, are privately negotiated arrangements, and are not regulated. Their terms are not standardized. The most popular are credit-default swaps used to protect investors in corporate bonds from the possibility that a company will not honor its debt and but will “default.” According to the International Swaps and Derivatives Association, more than $466.8 trillion of derivatives were traded through June of 2010. That’s double the number from 2005, and 20 times the amount from 1995. By comparison, the gross domestic product of the United States, the European Union, Canada, Japan and China combined is about $45 trillion.
The seeds of globalization were planted at the end of World War II. In 1944, at a summit in Bretton Woods, N.H., a dollar-dominated global economic system was designed. The agreement created the International Monetary Fund to mitigate international currency crises by making short-term loans to countries facing a credit or liquidity crunch. It also created the International Bank for Reconstruction and Development, commonly called the World Bank, to provide long-term credit to poor and underdeveloped countries. The International Monetary Fund and the World Bank provided a measure of global financial stability that made it easier for companies to do business internationally.
By the late 1980’s, advances in communications were opening up seemingly endless new opportunities for businesses. The current interaction among rich and poor economies—aided greatly by the technological revolution—has set in motion an unprecedented global movement of capital from the wealthiest nations to developing ones. Because holders of capital always seek greater returns on their investments, they will put their money in economies that show potential growth; if they own or run corporations, they will look for ways to reduce the costs of manufacturing, especially labor costs, so that they realize a greater profit. When they invest in foreign companies or establish their businesses in foreign nations, the power of capital can rapidly transform the economies of poorer nations while rearranging the patterns of daily life for millions. In 1950 there were stock markets in 49 countries. Today 116 countries are home to 215 stock and commodity exchanges.
With the rapid development of the Internet, financial transactions could be made around the world in a matter of seconds. The flow of money among nations increased enormously in the form of foreign direct investment in another nation’s businesses and portfolio investment i.e. investing in stocks and bonds of foreign businesses or government debt. In 2006, foreign direct investment totaled $1.5 trillion but by 2007 it had reached $2.3 trillion. Most of these investments were in fully developed economies such as the United States, France, Germany, and Great Britain. But ever-increasing amounts were being targeted to developing nations, especially China, and also Russia, India, Brazil, Chile, and Mexico. The total investments rose from $165 billion in 2000 to $583 billion in 2008, which was actually a decrease, as all foreign investment rapidly declined during 2008–09 due to the world financial crisis.
Sovereign Wealth Funds In recent years national governments as well as several state governments in the United States have started investment funds from revenues from their cash reserves. Known as sovereign wealth funds, their purpose is to increase the income from their sources of wealth—usually natural resources, natural gas, minerals and oil. Many of the largest funds are run by oil-producing states including the U.A.E., Saudi Arabia, Kuwait, Libya, and Norway. There are approximately 40 nations with sovereign wealth funds today with a total estimated value of over $4 trillion in 2011. China and the U.A.E have four or more funds.
Exchange Rates Because countries have their own currencies, trade between them also involves exchanging or trading currencies. The exchange rate between currencies represents the ratio at which they can be exchanged or the price of one currency in terms of the other. For example, if the exchange rate between the British pound and the U.S. dollar is $1.50, then one British pound can be purchased at that price.
Before World War I, exchange rates for world currencies were artificially fixed by tying them to a certain amount of gold. Central banks would then buy and sell gold in order to equalize supply and demand for the currencies and maintain the fixed exchange rates. For this reason, the central banks maintained enormous gold stockpiles, like the one the United States had at Fort Knox. Long-term changes in trading relationships and in the demand for various currencies eventually made the fixed exchange rates of the gold standard impossible to support; in 1944 the Bretton Woods agreement established the U.S. dollar as the world standard.
Today, the exchange rate of a currency rises or appreciates when the demand for it rises or the supply falls, or both. This may happen because foreign buyers want to buy more of a nation’s goods or because consumers within the country decide to buy fewer imports. It may also happen because the country reduces its money supply. In addition, the central banks of countries can manipulate their exchange rates slightly by buying and selling their own and other currencies.
Insurance is the pooling of assets by a group of individuals to protect each member against loss. Each contributor to the pool pays a relatively small sum so as to receive a much larger sum in the event of a catastrophe. The notion of insurance can be traced all the way back to Babylonian times. But the modern insurance business has its roots in maritime commerce, where protection against fire, shipwreck, piracy, and other disasters was vital. As early as 1688, merchants, shipowners, and underwriters transacted business at Lloyd’s Coffee House in London. Today, the global insurance industry is a $4 trillion business; nearly one-third of that business is generated in the United States. The U.S. insurance industry includes more than 184,000 companies, employing nearly 2.4 million people, with a payroll of $153 billion in 2007, according to the U.S. Census Bureau.
There are two major categories of insurance: life and nonlife. In the U.S. (and only in the U.S.,) these designations are more commonly referred to as life/health and property/casualty. (Because health insurance has become so complex, it is often regarded as its own segment of the industry).According to the Insurance Information Institute, premiums for all major forms of insurance totaled $582 billion in 2010.
These huge sums make the U.S. insurance industry a major player in the world’s financial markets. Good, safe investments have given them enormous total assets. The great majority of the property/casualty insurance industry’s assets ($886 billion, or 68 percent) were invested in credit market investments in 2009. Another $369 billion (or 28 percent of the total) were invested in municipal securities and loans. Similarly, of the life insurance industry’s $3 trillion in assets in 2009, $2.2 trillion, or 74 percent, was invested in bonds (mostly corporate bonds), while $72 billion (2.4 percent) was in stocks (primarily common stocks).
Life Insurance
Life insurance is a contract between an individual and an underwriter based on the statistical likelihood of when the individual will die. The individual pays an annual premium, and the underwriter pays a death benefit in the unlikely event of the individual’s death. There are two basic kinds of life insurance: term life and permanent life.
Term life and permanent life Term life insurance is the simplest and least expensive form of life insurance. Coverage ends the minute the individual stops paying the premiums. Term life insurance grows more expensive as individuals age and become, statistically speaking, more likely to die. Permanent life insurance is often called cash
value insurance because the policy has a cash value even if the individual stops paying the premiums. Permanent life insurance is much more expensive than term life insurance, but after the individual pays premiums for a certain number of years, the death benefit is guaranteed. Whole life, universal life, and variable universal life are all forms of permanent life insurance.
Annuities are the opposite of life insurance. They are a contract based on the statistical likelihood that an individual will live. In an annuity, the individual invests an amount of money and the underwriter returns an agreed-upon portion of that money (plus interest) every year until the individual’s death. As Americans have begun living longer, there has been a dramatic increase in the amount of money invested in annuities. In 2010, annuities ($221 billion) accounted for slightly more than twice as much income as life insurance premiums ($101 billion), according to the Insurance Information Institute.
Property and Casualty Insurance
Property and casualty insurance protects individuals against loss of property or against liability. Private automobile insurance is the most popular form of property and casualty insurance, constituting more than one–third of all premiums written, according to the Insurance Information Institute. Homeowner’s insurance, is the second-most common form, accounting for more than 12 percent of premiums in 2005. Other forms of property and casualty insurance include commercial auto (6.3 percent of premiums), workers’ compensation (to protect against loss due to an employee’s injury; 9.3 percent of premiums), and medical malpractice (to protect doctors against liability; 2.3 percent of premiums).
Health Insurance
Like other forms of insurance, health insurance allows individuals to defray the cost of expensive medical procedures by paying a fixed amount of money each month. Healthy individuals subsidize sick people. Approximately 253.6 million Americans are covered by some form of health insurance; another 50.7 million lacked health coverage of any kind in 2009.
Most health insurance plans are administered through groups, usually an employer, a union, or the federal government (See “Government health insurance”). The larger the group, the more healthy people there are to offset medical costs of any one person. In some cases, individuals may purchase private health insurance, but the price is usually very high. There are numerous kinds of health insurance, but most fall into one of the following categories:
Fee-for-service Individuals choose any doctor and insurance covers a portion of the cost. This is the most expensive type of health insurance.
Managed care Patients receive health care services at a lower cost as long as they stay within a network of participating doctors, hospitals, and other medical providers. There are several kinds of managed care.
Preferred Provider Organizations (PPOs) are similar to fee-for-service plans. Costs are lower (usually requiring just a $15 or $20 co-payment for an office visit to a participating provider), but also offer the flexibility to see doctors outside the network (though coverage is lower).
Health Maintenance Organizations (HMOs) are much less expensive but require patients to stay within the network except in case of emergency. Most HMOs require a co-payment for office visits, but have much lower out-of-pocket costs than other plans.
Point of Service (POS) plans are a hybrid of PPO and HMO plans. Primary care physicians in the network (sometimes called gatekeepers) make referrals to specialists and other providers. Members can go outside of the plan, but insurance will only cover a portion of the cost.
Government health insurance The Federal government funds health insurance programs for the needy (Medicaid) and for people over 65 (Medicare). Medicare also covers certain people under 65 with long-term disabilities. The State Children’s Health Insurance Program (SCHIP) is a separate government health insurance plan funded at the state level for low-income children whose parents do not qualify for Medicaid.
American Stock Exchange (ASE) one of the major American stock exchanges; emphasizes lower-priced stocks and younger, growing companies; see New York Stock Exchange.
auction market sale in which an item is offered to bidders by an auctioneer who sells the item to the highest bidder.
barter exchange of goods or services of one kind for another without the use of money.
bear market stock market in which traders expect prices to fall; traders sell stocks, driving down prices and fulfilling their expectations; see bull market.
Black Tuesday October 29, 1929, the day the stock market produced a record volume of more than 16 million shares—most of them sales—and the Dow Jones industrial average dropped 11 percent in one day; began a prolonged decline in the stock market that was a contributor to the Great Depression.
bond security issued by government or public company promising to repay borrowed money at a set interest rate in a specified period of time; see junk bond.
bubble market in which the price of an asset continues to rise because speculators believe it will continue to rise even further, until prices reach a level that is not sustainable; panic selling begins and the price falls precipitously.
bull market stock market in which traders expect prices to rise; traders buy stocks, driving up prices and fulfilling their expectations; see bear market.
business cycle tendency for the economy to expand and contract; different theories attribute the cause to government policies, economic shocks (e.g., the rate of technological progress), lags in timing of economic decisionmaking, or a combination of these and other factors.
call see option.
central bank A bank that controls the money supply and monetary policy in a country; see Bank of England and Federal Reserve System.
closed-end fund A mutual fund that has a fixed number of shares which usually trade on a major stock exchange; see open-end fund.
collateralized mortgage obligation (CMO) a security, backed by a pool of mortgages, structured so that there are several classes of bondholders with varying maturities called tranches. The principal payments from the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in the prospectus. Also known as mortgage pass-through security.
commercial bank bank that deals with the general public; it accepts interest-paying deposits and lends to a wide variety of households and small businesses; see investment bank.
commercial paper short-term unsecured promissory notes issued by a corporation. The maturity of commercial paper is typically less than nine months; the most common maturity range is 30 to 50 days or less.
credit default swaps a form of insurance that protects lenders in case of loan defaults. The buyer receives credit protection while the seller guarantees the credit worthiness of the product.
decimal trading trading in securities priced in hundredths of a unit of money; in the United States decimal trading began at the New York Stock Exchange in 2000; see fractional trading.
debenture any debt obligation backed strictly by the borrower’s integrity, e.g., an unsecured bond.
debt money borrowed.
debt service interest payments plus repayments of principal to creditors. Investors pay close attention to whether or not a company is making enough money to service its debt.
derivative financial contract whose value is based on, or “derived” from, a traditional security such as a stock or bond, commodity, or market index.
discount rate interest rate charged by the U.S. Federal Reserve for short-term borrowing by member banks.
diversification in investing, holding a variety of assets in order to minimize the risk of losses in any single asset.
dividend portion of a company’s profit paid to holders of its common and preferred stocks. A stock selling for $20 with an annual dividend of $1 a share yields the investor a 5 percent dividend.
Dow Jones industrial average An index based on the prices of 30 widely traded United States industrial stocks; often considered a gauge of overall stock market performance.
earnings before interest, taxes, depreciation, and amortization (EBITDA) financial measure defined as revenues less cost of goods sold and selling, general, and administrative expenses. In other words, a company’s profit before the deduction of interest, income taxes, depreciation, and amortization expenses. EBITDA became popular
in the 1980’s when corporate raiders tried to assess what a company’s operation generated, not counting interest, taxes, or noncash expenses such as depreciation and amortization that reflect diminished values of a company’s assets.
equity ownership interest in a firm or asset. In real estate, dollar difference between what a property could be sold for and debts claimed against it, such as a mortgage. In a brokerage account, equity equals the value of the account’s securities minus any money borrowed from a brokerage firm in a margin account. “Equities” is another name for stocks or company shares.
euro (€) unit of currency of the European Union; adopted in 1999, it replaced the currencies of all of the E.U. countries except the United Kingdom.
Federal Deposit Insurance Corporation (F.D.I.C.) U.S. regulatory body formed by the Banking Act of 1933, it charters banks and insures the deposits (up to a maximum of $100,000 per depositor) in member banks; financed by charges paid by member banks.
federal funds rate interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. The fed-funds rate, as it is called, often points to the direction of U.S. interest rates because it is set daily by the market, unlike the prime rate and the discount rate. The Federal Reserve does not have a target for the fed-funds rate, which it moves periodically.
Federal Reserve System created in 1913 by the Federal Reserve Act, it is the U.S. central bank system. It consists of a board of governors and 12 district reserve banks; they fix bank reserve and margin requirements, the discount rate, and manage the federal funds rate; the board manages monetary policy with the intention of minimizing the fluctuations of business cycles.
fiat money money that circulates by command of the state; originally money was coined of valuable metals that corresponded to their face value; but when money was coined of base metals, and paper currency came into use, its value had to be established by the power of the state; modern money is fiat money.
fiduciary money money that is backed by real assets and owes it acceptability to pubic trust and confidence.
fractional trading trading in securities priced in halves, quarters, and eighths of a dollar; in 2000 the New York Stock Exchange converted to decimal trading.
futures market market in which contracts commit two parties to buy and sell commodities, securities, or currencies on a date in the future at a price fixed when the contact is made; if the market price at the time the contract matures is higher than the contract price, the buyer profits; if the market price is lower, the seller profits.
gold standard system of fixing exchange rates to the price of gold in order to facilitate trade between nations.
Gresham’s law tendency for people to spend money of low intrinsic value (coins of base metal and paper currency) and hoard money of higher intrinsic value (coins of precious metals) when these forms of money circulate concurrently; often stated as “bad money drives out good”; first articulated by Sir Thomas Gresham (ca. 1519–79), an adviser to Queen Elizabeth I.
hard money money which can be converted into other money or whose price compared with other money is expected to remain stable or to rise; see soft money.
hedge fund investment strategy that employs a variety of techniques to enhance returns, such as both buying and shorting stocks.
inflation condition in which prices and wages increase as measured by changes in an appropriate price index such as the Consumer Price Index.
initial public offering (IPO) stock issued for the first time by a public company.
investment bank bank dealing with other firms rather than the general public; see commercial bank.
investor buyer and seller of securities who considers their inherent value; see speculator.
joint-stock company company in which investors pool their money and receive profits or dividends in proportion to their investments; often are limited liability companies in that investors are liable only for any debts in the amount of their original investments.
junk bond bond issued by companies with low credit ratings that compensate for high risk by paying high interest rates; also called a “high yield bond.”
legal tender form of money that a creditor is legally obligated to accept in payment of a debt.
letter of credit letter issued by a bank authorizing the bearer to withdraw a stated amount of money from the issuing bank or its branches and agencies.
leveraged buyout purchase of the equity of a company financed mostly by borrowing against the stock of the target company; during the heyday of leveraged buyouts in the 1980’s corporate raiders also raised large sums with unsecured
junk bonds.
limited liability company (LLC) company in which investors’ potential loss is limited to the amount of their investments in the event that the business fails.
liquid assets assets that can be converted into money rapidly and at a reasonably predictable rate.
liquidity property of assets that allows them to be converted into money rapidly and at a reasonably predictable rate; in a company, having assets that are liquid.
margin the difference between the market value of a stock and the loan a broker makes; allows investors to buy securities by borrowing money from a broker.
money medium of exchange in goods and services and a means of storing value over time.
money market fund pooled fund that invests in short-term loans.
NASDAQ (National Association of Securities Dealers and Automated Quotation system) opened in 1971, NASDAQ was the first stock exchange to rely on sophisticated computer and telecommunications systems to trade and monitor millions of securities on a daily basis. Trading was no longer limited to a single location; millions of dealers across the globe were connected by an electronic network to execute trades and deliver data in real time.
New York Stock Exchange (NYSE) largest U.S. market for trading stocks and bonds based on the specialist system.
price-to-earnings ratio (P/E) ratio obtained by dividing the current market price of a stock by the most recently published earnings for equity per share.
put see option.
pyramid scheme illegal, fraudulent scheme in which a con artist persuades victims to invest by promising an extraordinary return; he or she embezzles the funds while using the minimum necessary to pay off any investors who insist on terminating their investment.
ROI (return on investment) generally, income as a proportion of a company’s net book value. Also known as profitability ratio.
savings and loan institution (S&L) financial institution that accepts deposits from the public and lends its funds primarily as home mortgages.
Securities and Exchange Commission (SEC) created by the Securities Exchange Act of 1934, it monitors and regulates the sale of corporate securities in the U.S.
seigniorage originally the profit made by a ruler who issues money with a face value exceeding the cost of production; today it refers to the ability of governments to issue new money to pay for goods and services.
selling short (short selling) sale of a stock that is not actually owned. If an investor thinks the price of a stock is going down, the investor borrows the stock from a broker and sells it.
soft money money which cannot be converted into other money or whose price compared with other money is expected to fall; see hard money.
speculator buyer and seller of securities betting that they will rise or decline in value; see investor.
specialist individual on the floor of a stock exchange who is employed by a specialist firm to match buyers and sellers of stocks of specific companies; obligated to “make a market” in a stock by buying shares when there are no other buyers and to sell shares from the firm’s inventory when there are no other sellers.
specie money in the form of coins, not paper currency.
stock capital that a company raises by selling shares that entitle the owner to dividends and other rights of ownership.
stock exchange place where stocks, bonds, and other financial instruments are bought and sold.
stock market stock exchange; also can refer to the overall performance of the prices of stocks and bonds, as in, “The stock market rose today.”
tight money money that is difficult to borrow because of high interest rates or limited availability.
traders individuals who take positions in securities and their derivatives with the objective of making profits.
trading buying and selling securities.
Treasury bill (T-bill) debt obligation of the U.S. Treasury that has maturity of one year or less. Maturities for T-bills are usually 91 days, 182 days, or 52 weeks.
Treasury bond debt obligation of the U.S. Treasury that has maturity of two years or more.
venture capital capital invested in new or small businesses, with comparatively high risk, in the hope of making a substantial profit if the businesses prosper.
yield percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note.
Times focus
The New Speed of Money, Reshaping Markets
By GRAHAM BOWLEY
A substantial part of all stock trading in the United States takes place in a warehouse in a nondescript business park just off the New Jersey Turnpike. Few humans are present in this vast technological sanctum, known as New York Four. Instead, the building, nearly the size of three football fields, is filled with long avenues of computer servers illuminated by energy-efficient blue phosphorescent light. Countless metal cages contain racks of computers that perform all kinds of trades for Wall Street banks, hedge funds, brokerage firms and other institutions. And within just one of these cages—a tight space measuring 40 feet by 45 feet and festooned with blue and white wires—is an array of servers that together form the mechanized heart of one of the top four stock exchanges in the United States. The exchange is called Direct Edge, hardly a household name. But as the lights pulse on its servers, you can almost see the holdings in your 401(k) zip by.
In many of the world’s markets, nearly all stock trading is now conducted by computers talking to other computers at high speeds. As the machines have taken over, trading has been migrating from raucous, populated trading floors like those of the New York Stock Exchange to dozens of separate, rival electronic exchanges. They rely on data centers like this one, many in the suburbs of northern New Jersey.
While this “Tron” landscape is dominated by the titans of Wall Street, it affects nearly everyone who owns shares of stock or mutual funds, or who has a stake in a pension fund or works for a public company. For better or for worse, part of your wealth, your livelihood, is throbbing through these wires. The advantages of this new technological order are clear. Trading costs have plummeted, and anyone can buy stocks from anywhere in seconds with the simple click of a mouse or a tap on a smartphone’s screen.
But some experts wonder whether the technology is getting dangerously out of control. Even apart from the huge amounts of energy the megacomputers consume, and the dangers of putting so much of the economy’s plumbing in one place, they wonder whether the new world is a fairer one—and whether traders with access to the fastest machines win at the expense of ordinary investors.
It also seems to be a much more hair-trigger market. The so-called flash crash in the market May 2010—when stock prices plunged hundreds of points before recovering—showed how unpredictable the new systems could be. No one knows whether this is a better world, and that includes the regulators, who are struggling to keep up with the pace of innovation in the great technological arms race that the stock market has become.
Direct Edge’s office demonstrates that it doesn’t take many people to become a major outfit in today’s electronic market. The firm, whose motto is “Everybody needs some edge,” has only 90 employees, most of them on this building’s sixth floor. There are lines of cubicles for programmers and a small operations room where two men watch a wall of screens, checking that market-order traffic moves smoothly and, of course, quickly. Direct Edge receives up to 10,000 orders a second.
Computer-driven trading began in earnest when the S.E.C. forced the New York Stock Exchange and Nasdaq to post orders electronically and execute them immediately, at the best price available in the United States—suddenly giving an advantage to start-up operations that were faster and cheaper. The N.Y.S.E. and Nasdaq fought back, buying up smaller rivals. And to give itself greater firepower, the N.Y.S.E., which had been member-owned, became a public, for-profit company.
Brokerage firms and traders came to fear that a Nasdaq-N.Y.S.E. duopoly was asserting itself, one that would charge them heavily for the right to trade, so they created their own exchanges. One was Direct Edge, which formally became an exchange in late 2010. Another, the BATS Exchange, is located in another unlikely capital of stock market trading: Kansas City, Mo.
Direct Edge now trails the N.Y.S.E. and Nasdaq in size; it vies with BATS for third place. Direct Edge is backed by a powerful roster of financial players: Goldman Sachs, Knight Capital, Citadel Securities and the International Securities Exchange, its largest shareholder. JPMorgan also holds a stake.
The exchange now accounts for about 10 percent of stock market trading in the United States, according to
the exchange and the TABB Group, a specialist on the markets. Of the 8.5 billion shares traded daily in the United States, about 833 million are bought and sold on the Direct Edge platforms.
As it has grown, Direct Edge and other new venues have sucked volumes away from the Big Board and Nasdaq. The N.Y.S.E. accounted for more than 70 percent of trading in N.Y.S.E.-listed stocks in 2006. Now, the Big Board handles only 36 percent of those trades itself. The remaining market share is divided among about 12 other public exchanges, several electronic trading platforms and vast so-called unlit markets, including those known as dark pools.
The Big Board is embracing the new warp-speed world. Although it maintains a Wall Street trading floor, even that is mostly electronic. The exchange also has its own, separate electronic arm, Arca, and opened a new data center in 2010 for its computers in Mahwah, N.J.
In this high-tech stock market, Direct Edge and the other exchanges are sprinting for advantage. All the exchanges have pushed down their latencies—the fancy word for the less-than-a-blink-of-an-eye that it takes them to complete a trade. Almost each week, it seems, one exchange or another claims a new record: Nasdaq, for example, says its time for an average order “round trip” is 98 microseconds—a mind-numbing speed equal to 98 millionths of a second. The exchanges have gone warp speed because traders have demanded it. Even mainstream banks and old-fashioned mutual funds have embraced the change.
Even the savings of many long-term mutual fund investors are swept up in this maelstrom, when fund managers make changes in their holdings. But the exchanges are catering mostly to a different market breed—to high-frequency traders who have turned speed into a new art form. They use algorithms to zip in and out of markets, often changing orders and strategies within seconds. They make a living by being the first to react to events, dashing past slower investors—a category that includes most investors—to take advantage of mispricing between stocks, for example, or differences in prices quoted across exchanges.
One new strategy is to use powerful computers to speed-read news reports—even Twitter messages—automatically, then to let their machines interpret and trade on them. By using such techniques, traders may make only the tiniest fraction of a cent on each trade. But multiplied many times a second over an entire day, those fractions add up to real money. According to the TABB Group, high-frequency traders now account for 56 percent of total stock market trading. A measure of their importance is that rather than charging them commissions, some exchanges now even pay high-frequency traders to bring orders to their machines.
The exchange is making its investment because derivatives as well as stocks are being swept up in the high-frequency revolution. The Commodity Futures Trading Commission estimates that high-frequency traders now account for about one-third of all volume on domestic futures exchanges.
The “flash crash,” the harrowing plunge in share prices that shook the stock market during the afternoon of May 6, 2010, crystallized the fears of some in the industry that technology was getting ahead of the regulators. In their investigation into the plunge, the S.E.C. and Commodity Futures Trading Commission found that the drop was precipitated not by a rogue high-frequency firm, but by the sale of a single $4.1 billion block of E-Mini Standard & Poor’s 500 futures contracts on the Chicago Mercantile Exchange by a mutual fund company.
Since the flash crash, the S.E.C. and the exchanges have introduced marketwide circuit breakers on individual stocks to halt trading if a price falls 10 percent within a five-minute period. But some analysts fear that some aspects of the flash crash may portend dangers greater than mere mechanical failure. They say some wild swings in prices may suggest that a small group of high-frequency traders could manipulate the market. Since May 2010, there have been regular mini-flash crashes in individual stocks for which, some say, there are still no satisfactory explanations. Some experts say these drops in individual stocks could herald a future cataclysm.
Some analysts question whether everyone benefits from this technological upending. “It is a technological arms race in financial markets and the regulators are a bit caught unaware of how quickly the technology has evolved,” says Andrew Lo, director of the Laboratory for Financial Engineering at M.I.T. “Sometimes, too much technology without the ability to manage it effectively can yield some unintended consequences. We need to ask the hard questions about how much of this do we really need. It is the Wild, Wild West in trading.”