The term algorithm refers to a set of rules for performing arithmetic, though there’s no generally accepted definition. It commonly refers to any set of procedures used for solving problems or performing tasks. The most common component of an algorithm is the “if-then” statement: “IF” the kitchen is floor is dirty, “THEN” you should mop it. Most algorithms are infinitely more complex.
By the 1990s, stock traders realized they could harness the speed of computers and began experimenting with algorithms for executing trades. As the size of institutional investors’ orders grew and electronic stock trading exploded, so, too, did the use of algorithmic trading. But it all goes back to the one firm that pioneered the algorithmic trading bandwagon: Knight Capital Group.
Founded in 1995 by Kenneth Pasternak and Walter Raquet, Knight was not headquartered on fabled Wall Street, but across the river in Jersey City. It owed both its inception and rapid growth to the NASDAQ stock market, a growth that was spurred by the technological advancements of the 1990s.
Raquet had the technological insight to see that the old exchange model was outdated and it would inevitably be replaced by computerized trading. It was a revolutionary way to think at the time. Raquet and Pasternak took the idea and ran with it.
By 1997, Knight had grown to become the single largest market-maker of NASDAQ stocks, benefitting directly from individuals executing their own trades online without having to call their broker. And just as the founders hoped, Knight was the innovator in low-cost stock market execution, positioned right at the epicenter of the Internet explosion.
In July of 1998, Knight used those three little words that investors love to hear – Initial Public Offering – and raised an immediate $145 million more in capital. Within six months its market capitalization soared from $725 million to $2 billion; by the end of 1999 that value ballooned to a staggering $8 billion.
Anytime money is involved there’s almost always someone who finds a way to exploit the loopholes. There were more than a few scandals that rocked Knight over the years. John Hewitt, an executive brought in from Goldman Sachs to become president of Knight, caught wind of front-running rumors and discovered the firm had problems. It was too late to avoid major fines from the National Association of Securities Dealers for failure to supervise trading activities.
In the end, the practice of front-running by individual traders was not eradicated by new rules or new regulations. Instead, it was done by taking the human trader out of the equation. Technology had eliminated much of the ability of the human trader to front-run investor orders as the era of electronic matching has arrived.