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The changing structure of the stock market: The national market system
The Changing Structure of the Stock Market: The National Market Systcm Robert C. Klemkosky and David J. Wright 10 R o b e r t C. K l e m k o s k y is a p r o f e s s o r a n d David J . W r i g h t an assistant p r o f e s s o r of finance at I n d i a n a U n i v e r s i t y .
I n n o v a t i o n s in the securities markets initiated by the Securities Acts A m e n d m e n t s o f 1975 are creating a new trading environm e n t in which the costs o f investing are red u c e d and m a n y barriers to c o m p e t i t i o n are eliminated. he revolutionary new equity who freely compete for the best marketplace of the future is stock prices available anywhere in now beginning to be the U.S. The Admendments of shaped. Recently a number of fun- 1975 merely sketched out the damental changes in our securities broad characteristics and goals of markets have created a new trading the NMS, leaving the determination environment which is affecting the of operational details to the securisecurities industry, investors, and ties industry and the Securities and corporate issuers of new capital. To Exchange Commission. The final understand this developing market form of a complete NMS is still of the 1980s, it is useful to examine open-ended; thus, recent fundathe economic and political pres- mental changes in the structure of sures underlying the innovations in securities markets are part of the the security markets. evolutionary movement toward a The catalyst of the future stock fully operational NMS. market is the Securities Acts An essential question concerns Amendments of 1975. It is the how the NMS will affect market most far-reaching piece of securities participants. Investors have already legislation enacted since the 1930s. benefited by generally lower transThe purpose of the law is to en- action costs, with future developcourage nationwide competition in ments promising cost savings in securities trading by development millions of dollars. 1 The future of a national marhet system (NMS). computerized operational requireIn contrast to the traditional trad- ments in the investment area are ing methods which separately fun- bringing about economic concentraneled orders to a specific stock tion of the securities industry. 2 The exchange, the NMS is a trading 1. U.S. Securities and Exchange Commissystem which links several securities sion, Directorate of Economic and Policy Remarkets electronically, enabling in- search, Staff Report on the Securities Industry in 1979, July 1980. Exhibit III-5. vestors to execute their trading 2. The number of brokerage firms transactorders quickly at the best competi- ing business with the public declined by 200 tive prices prevailing in several mar- from 1961 to 1976. See the New York Stock Exchange 1980 Fact Book: 74. These firms kets. In effect, the NMS is a com- have either merged, liquidated or declared puterized network of stock traders bankruptcy.
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The Changing Structure of the Stock Market
11 rapid automation of equities trading presents the real possibility that stock exchanges themselves are endangered due to their operational costs. In addition, b y enhancing market liquidity the NMS promises to reduce the cost to corporations of raising rinds through new issues of equity securities. However, the extent and pace of these changes are still uncertain. Given the ramifications of the developing NMS on market participants, it is constructive to examine the recent developments and possible future forms of the equities markets. We discuss first the economic factors leading to the NMS and describe the 1975 NMS legislation. The next sections are concerned with NMS developments since 1975 and examine future trends of NMS innovations. Finally, we offer a view of h o w alternative NMS policies may be implemented. Early Economic Pressures ignificant economic pressures for changes in securities trading began ten years before the Securities Acts Amendments of 1975. To understand why Congress passed such far-reaching legislation, it is useful to examine the unsettled market environment b e t w e e n 1965 and 1975. Stock Trading Procedures. The very heart of NMS discussion is whether the process of stock trading can be automated. Traditionally, over 80 percent of the total dollar value of trading on U.S. exchanges has occurred on the New York Stock Exchange (NYSE). 3
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Hence, the question concerning the costs and benefits of trading automation can be examined by first describing the NYSE's auction trading procedure. The auction procedure requires brokers to physically meet on the exchange floor to match customers' b u y and sell orders. Investors may submit their market orders at any time during trading hours; as a result, there may not be matching public b u y and sell orders at the same m o m e n t in time. In fact, unbalanced public order flows occur frequently. When this occurs the specialist will intervene and match the public order with his own capital or with securities he owns. The specialist is a professional security dealer on the NYSE floor who is assigned to a certain set of stocks. One of the specialist's major functions is to provide continuous price quotations for immediate purchase and sale of securities. When investors need to trade immediately, they can either purchase securities at the ask price quote or sell securities at the bid price quote if there is no offsetting order. Consequently, investors can always rely on the specialists to provide a continuous and orderly market in any stock assigned to them. Specialists are willing to supply the service of continuous bid and ask quotations in return for the benefits gained b y quoting prices away from the market price. In other words, specialists will provide immediacy in trading b y purchasing 3. 1980 Fact Book: 67.
a security from public sellers at a discount below the market price and b y selling a security to public buyers at a premium above the market price. For example, suppose a stock is selling at $90 per share. Now suppose the specialist quotes an 89 bid price and a 91 ask price. On the one hand, if two public orders match, the transaction price will be at or near $90. On the other hand, if a public sell order occurs without a matching b u y order, then the investor must sell the stock at the bid price of $89. The investor has forfeited a one dollar price concession for the benefit of selling immediately. (If a public b u y order was unmatched, then the investor would pay a one dollar premium and trade at the $91 ask price.) The spread between bid and ask prices represents a transaction cost to investors. The wider the spread, the higher the transaction cost. The investor would pay a higher bid discount or ask premium if the specialists' spread were 85 bid-95 ask. One goal of the NMS is to narrow the bid-ask spread and thereby reduce transaction costs. The other source of compensation to the specialist besides trading profits is from executing limit orders. A limit order is an order to b u y or sell a stock when and if the price of the stock reaches a specified price or better; investors who are willing to wait place limit orders at prices away from the current market price to get a better price. Brokers who hold customers' limit orders typically leave their orders with the specialist. The specialist records the prices in his limit order
"Historically, the NYSE and its specialist system were designed for the individual investor who typically traded only a small n u m b e r of shares at any one time."
12 Institutional Dominance of the NYSE NYSE Block Transactions
Number of block trades Total shares (O00's) Percentage of reported volume Average per trading day
1965
1969
1972
1979
2,171 48,262 3.1% 9
15,132 402,063 14.1% 61
31~207 766,536 18.5% 124
97,509 2,164,726 26.5% 385
Source: New York Stock Exchange, 1980 Fact Book: 66. Percentage Distribution of NYSE Public Volume
Value
Shares
1960
1971
1976
1960
1971
1976
68.6 31.4
40.3 59.7
42.7 57.3
60.7 39.3
31.8 68.2
29.7 70.3
Public individuals Institutions
Source: New York Stock Exchange, 1972 Fact Book: 53 and 1980 Fact Book: 52. Estimated Holdings of NYSE-Listed Stocks By Financial Institutions (in billions of dollars)
• Institution
1949
1959
1969
1975
Insurance companies Investment companies Non-insured pension funds Nonprofit institutions Common trust funds Miscellaneous
$2.8 3.0 0.4 3.2 *
$8.6 16.8 12.9 12.8 1.4
$21.9 43.2 61.7 27.7 4.1
$33.2 40.6 105.0 38.0 6.1
0.2
0.3
1.0
7.4
Total (billions)
$9.7
$52.8
$159.6
$230.5
Market value of NYSE stocks
$76.3
$307.7
$629.5
$685.1
Percentage held by institutions
12.7%
17.2%
25.4%
33.6%
*Less than $50 million Source: New York Stock Exchange, 1973 Fact Book: 51, and 1980 Fact Book: 50.
b o o k and executes them whenever market prices converge to the specified prices. When the limit orders are executed, the b ro k e r must pay a fee to the specialist for his agency services. A not her goal o f the NMS is to reduce or eliminate this fee b y automating limit order execution. Other members o f the NYSE who will be directly affected b y the NMS are the commission brokers e m p l o y e d by the member brokerage firms to represent their customers' orders on the trading floor, and the floor brokers, primarily individual entrepreneurs, who act as independent commission brokers. An aut om at ed stock execution system would pose an economic threat to these m em ber types, especially the latter. Institutionalization of Equity Markets. Historically, the NYSE and its specialist system was designed for the individual investor who typically traded only a small n u m b e r of shares at any one time. The system came u n d e r stress when large financial institutions (such as banks, investment companies, insurance companies, and pension funds) began to dominate trading. The trading needs of institutional investors differ substantially from those of individual investors, primarily because the size of an average institutional trading position is much larger than that of the individual investor. The rapid growth o f the institutionalization of investing is apparent when NYSE trading statistics over recent years are examined in the accompanying Table. One indication of institutional activity is the
The Changing Structure of the Stock Market
13 number of block trades (defined as transactions of 10,000 shares or more) because block trades are primarily executed b y institutions ra~Lher than b y individual investors. Block trading has grown dramatically since 1965. The average number of blocks traded per day in 1979 (3;85 blocks per day) was forty-two times greater than the number of blocks traded in 1965 (9 blocks per day). In addition, block trading as a percent of reported volume increased from 3.1 percent in 1965 to 14.1 percent in 1969, and to 26.5 percent in 1979. Thus, more than one out of every four shares traded on the NYSE is part of a block transaction. Another indication of institutional growth is the distribution of public trading on the NYSE between individuals and institutions. In 1960 individuals dominated NYSE public trading, accounting for over 68 percent of the total share volume and 60 percent of the dollar value. By 1976, individuals' trading had dropped to 40 percent of the share volume and only 30 percent of the dollar volume. Although this trend appears to have leveled off in recent years, insitutions account for a dominant share of NYSE public trading. Institutional dominance has not been confined solely to trading volume. The major financial institutions have consistently increased their relative holdings of NYSElisted stocks, from 12.7 percent in 1949 to 33.6 percent in 1975. It has been estimated that inclusion of all institutional holdings of NYSElisted stocks would increase their relative holdings to 50 percent. 4
There are at least three reasons for the institutional dominance of the NYSE. First, individuals systematically withdrew from the stock market as direct investors to become indirect investors through the financial institutions, s The institutions can offer individuals diversification, lower transaction costs, and professional management. Second, there was a dramatic growth in the size of institutions that can own equities, especially the private pension funds. 6 And third, the institutions increased their relative trading activity (that is, higher portfolio turnover rates). 7 Thus, the growth in institutional ownership and trading put tremendous pressure on the existing market structure. Problems concerning commissions, perceived liquidity, and market fragmentation exposed the need for fundamental changes in the existing system. The biggest stress on traditional practices was caused b y the fixed brokerage commission fee system. Members of the NYSE were required to charge fixed minimum commission rates which prevented competitive pricing between brokerage firms. Charging fixed com4. 1980 Fact Book: 50. 5. For example, odd-lot (transactions of less than 100 shares) sales have exceeded odd-lot purchases in every year since 1966. See the NYSE, 1980 Fact Book: 64. In addition, the NYSE shareowner surveys found that almost one out of 5 (18.1 percent) shareowners had left the stock market between 1970 and 1975. (See the 1980 Fact Book: 49). 6. It is estimated that private pension fund assets are n o w approaching $400 billion. Furthermore, these assets are projected to be in the range of $2 trillion by the end of the century. These projections were made for the U.S. Labor D e p a r t m e n t b y ICF Inc. 7. See NYSE, 1980 Fact Book: 22.
missions was a firmly embedded practice that dated back from the original brokers' agreement in 1792. The commission fee schedule caused problems because it was inequitable from an economic standpoint. The commission fee per share charged by brokers did n o t decline for larger orders, even though the brokers' execution costs per share were substantially lower on bigger trades. As a result, the institutions were burdened b y unrealistically high brokerage commissions on their block trades. The institutions reacted to the fixed brokerage rates by increasing their trading through non-NYSE brokers. The non-NYSE brokers could trade NYSE listed stocks on regional exchanges or on the OverThe-Counter Market (OTC). Since they were not b o u n d b y the NYSE fixed commission rates, they would substantially reduce their commission fees on block trades. In the late 1960s, the volume w a s diverted away from the NYSE to the regional exchanges and the OTC market, thus seriously fragmenting the equity market. 8 The fragmented market was detrimental to the investing public because trades in NYSE listed stocks executed on the regional exchanges and on the OTC market were n o t disclosed on the NYSE stock record tape. In addition, public limit orders on the NYSE were bypassed by trades occurring off the NYSE floor. Therefore, fixed commissions not only created costly inequities, but also encouraged market fragmentation. 8. NYSE, 1973 Fact Book: 15.
14 The institutional block trading also highlighted problems with the specialist system. The specialists did not have sufficient capital or the necessary institutional contacts to match block trades. As a result, the large, well capitalized brokerage firms began facilitating block trades for institutions by becoming block positioners. Hence, the large brokerage firms began to compete indirectly with the specialists' market-making services. As the traditional market structure cracked under the weight of heavy institutional trading, Congress recognized the need for fundamental changes in the stock market. Congress authorized the SEC to conduct the Institutional Investor Study to examine the possible alternatives. Three important findings of this study laid the groundwork for the 1975 NMS legislation. First, the study suggested that fixed minim u m brokerage commissions be abolished to promote rate competition and reduce market fragmentation. Second, the study pointed to new computer-based communications and data-processing technology which could electronically link all markets. Third, increased competition for the NYSE specialist would narrow bid-ask spreads. In other words, the study advocated formation of a single, central market system that eliminates all barriers to competition. The findings of the Institutional Investor Study were supported by several independent academic studies. One of the variables examined was trading volume. The research indicated that stocks with higher
trading volume had narrower spreads? An active security provides a greater opportunity to buy or sell; consequently, the security dealer incurs lower holding period costs on his security inventory. The other variable examined by the studies was dealer competition. Although the empirical results regarding this variable were not unanimous, most studies showed that dealer competition narrowed the bid-ask spread. 10 In total, the studies suggest that all competing dealers should be allowed to participate equally in all the trading volume within one central market system.
tion in all aspects of the market by electronically combining all market centers. Specifically, the law states that: The linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to best execution of such orders. 11 The SEC suggested the following four fundamental NMS components would achieve the goals of the 1975 legislation: 1. Abolition of minimum fixed Framework of the NMS brokerage commissions; he strong evidence provided 2. Central reporting of stock by both the Institutional price quotations and transactions; Investor Study and by the 3. Central order routing system; academic studies led to the passage 4. National protection of limit of the Securities Acts Amendments orders. of 1975. The legislation directed Elimination of fixed commisthe SEC to establish a NMS that sions. The elimination of minimum met certain goals outlined in the fixed commissions was part of the law. However, the legislation did Securities Acts Amendments; hownot mandate any specific design for ever, this was already accomplished the NMS, nor did it set a timetable before the law was enacted on June for implementation of the NMS. 6, 1976. The SEC abolished miniResolution of the explicit mechan- m u m fixed commissions on "Mayics of the NMS was left to the SEC. day," May 1, 1975. Central reporting of price quoThe 1975 legislation expressed the need for nationwide competi- tations and transactions. The system would collect and disseminate 9. See Harold Demsetz, "The Cost of bid and ask prices from all competTransactions," Quarterly Journal of Economics 82 (February 1968): 33-55 and Seha M. Tinic, ing dealers which would include "The Economics of Liquidity Services," Quar- quotes from the NYSE specialist, terly Journal of Economics 86 (February the regional exchanges, mad the 1972): 79-93. 10. See Seha Tirdc and Richard R. West, OTC market. In addition to quota"Competition and the Pricing of Dealer Services tions, all stock transaction data
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in the Over-the-Counter StockMarket," Journal of Financial and Quantitative Analysis, 7 (June 1972): 1707-27.
11. U.S. Public Law, 94-29 (June 4, 1975): 112.
The Changing Structure of the Stock Market
"The 1975 legislation expressed the need for nationwide competition in all aspects of the market by electronically combining all market centers."
15 would be aggregated. For example, if General Electric is traded on the NYSE, on the Midwest Stock Exchange, and on the OTC market, then, trades in General Electric sl:ock from all three markets would be reported on the same ticker tape. Central reporting would reduce fragmentation of information by providing the public with the broadest, most complete trading data available. The composite quotation system and transaction tapes are already operational. Central order routing system. This c o m p o n e n t of the NMS is designed to assure prompt execution of orders in markets which offer the best price for a stock. For example, suppose an investor wants to b u y 100 shares of IBM. A computerized network would automatically route his order to the seller, located on a market anywhere in the country, who is offering the lowest selling price on IBM. The advantage of the central order routing system is that it encourages dealer competition. Competition is strengthened considering that dealers quoting the best prices (that is, the narrowest spread) would automatically receive the public orders. One major obstacle to a central order routing system is the NYSE rule 390 (previously rule 394). Rule 390 compels NYSE members to execute all dealer orders for NYSE listed stocks on the NYSE. In effect, NYSE members could not send their trading orders away from exchange floors. Therefore, Rule 39.0 would have to be removed to allow NYSE members to execute
public orders in competition with the specialists on the floor of the exchange. National protection of limit orders. In a strict sense, the SEC proposed that limit orders from all markets be stored together on an equal basis. The execution of limit orders would be based entirely upon their price and time priority, regardless of which broker entered the limit order. This feature would assure the following: Suppose an investor places a limit order to sell 100 shares of GM at $70 on the NYSE. If the market price on GM first reaches $70 on the Pacific Stock Exchange, then the investor's GM stock would be promptly sold on the Pacific Stock Exchange. In absence of nationwide limit orders protection, GM could be sold for $71 on other exchanges or the OTC market w i t h o u t executing the $70 limit order on the NYSE. This problem occurred frequently when institutions traded blocks off the NYSE floor. Recent Market Innovations ecause of the 1975 Congressional mandate for a NMS, the last six years have witnessed a number of significant changes in the securities markets. Various degrees of progress have been accomplished on each of the four fundamental NMS components described in the previous section. Although a fully operational NMS is not yet fully in place, the transformation on Wall Street has already profoundly affected market participants. The recent NMS inno-
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vations are discussed with respect to their fulfillment of the four fundamental NMS goals. Benefits of negotiable brokerage commissions. The 1975 Mayday abolition of fixed minimum commission rates has clearly been a success. Competitive pricing of commission rates has resulted in significant cost savings for b o t h institutional and individual investors. A SEC study found that from April 1975 to December 1979, brokerage commissions fell by 55 percent for institutional investors while individual investors' commission fell 18 percent. 1 Two reasons were offered for the institutional commission rates declining more sharply than the rates for individual investors. First, institutional investors primarily trade in block transactions which have a much lower commission fee per share than the charge per share on smaller trades. For institutional investors in December 1979, the commission fee per share on small trades of less than 200 shares (42 cents per share) was over five times greater than the fee on blocks (only 8 cents per share). Hence, institutional investors benefit from commission cost economies on large scale transactions. Even if the effects of order size are controlled, a second reason for lower institutional rates is their bargaining power. Institutions generally have much larger accounts than individuals; therefore, brokers are more willing 12. U.S. Securities and Exchange Commission, Directorate of Economic and Policy Research, Staff Report on the Securities Industry in 1979, July 1980, Exhibit 1II-5.
16 to negotiate for the institutions' sizeable brokerage business. Commission rates have generally declined since May 1975 because the old commission rate schedule overestimated the actual variable cost c o m p o n e n t of trading and underestimated the fixed cost component. Actual trading costs per share decline on larger trades as fixed costs are spread over a higher number of shares. The key benefit of competitive rates is that investors n o w pay for brokerage services at prices that more closely reflect the brokers' actual costs of providing these services. A favorable by-product of negotiable commissions is the emergence of so-called discount brokers. Discount brokers offer transaction services at rates as much as 80 percent below those of full-service firms. 13 Unlike the large full-service firms, discount brokers cut their costs b y not providing investors advice or personal attention on their investments. The discount firms aim mass media advertising (such as The Wall Street Journal) at the type of investor who makes his own investment decisions without relying on a broker's advice. After a slow start, the discount brokerage industry n o w consists of over 100 firms which have captured almost 10 percent of the total commission business. These typically small, specialized firms are now one of the most profitable and rapidly growing segments of the securities industry. Solid foundation for the central 13. Tim Garrington, "Bigger Brokers Reluctantly Provide Discounts for Individual Investors," Wall Street Journal, July 30, 1980: 19.
reporting system. The start of central reporting systems for b o t h stock transactions and stock quotations was an important step toward creation of the NMS. This allows investors to make their investment decisions based upon complete, aggregate market data collected nationwide. The first system to concentrate market data was the composite tape. On J u n e 16, 1975, the composite tape began reporting all sales of securities as they occurred on the principal exchanges. For example, all transactions in AT & T stock on the Midwest or Pacific stock exchanges will appear on the tape along with AT & T trades on the NYSE. Investors can now receive a prompt, full disclosure of all transactions executed nationally before making their investment decisions. The second major technological advance in data reporting systems was the composite quotation system. The system electronically displays to brokers on an exchange floor the best bid and ask price quotations in the different markets. Suppose a broker on an exchange floor wants to purchase 100 shares of IBM stock. He can now check the composite quotation system display screen to determine whether a lower bid-ask price is available on another exchange. Under an SEC requirement, the broker is assured that quotes on the display screen are firm and binding commitments to trade. However, the composite quotation system b y itself does not allow the broker to send orders to other markets.
Slower progress on a central order routing system. In contrast to the rapid-paced developments on brokerage commissions and on composite reporting, the growth of a central order routing system is proceeding at a slow, deliberate pace. Although the composite quotation system provides quotes from alternative markets, the system does not have an execution capability. Consequently, the SEC's goal is an arrangement that will enable brokers to send customers' orders from their offices to whatever market has the best price. To achieve its goal, the SEC is currently experimenting with two possible prototypes of the eventual central order routing system. One p r o t o t y p e of the NMS that allows orders to be routed between the primary exchanges is the Intermarket Trading System (ITS). ITS began operating in April 1978 b y providing a n e t w o r k of electronic communications terminals located in the various exchanges. The system enables a broker on the floor of one exchange to switch his order to another exchange if a better price is available on that exchange. ITS works in conjunction with the composite quotation system in the following manner. A broker on the NYSE may compare the NYSE prices with the quotes from the other exchanges displayed on the composite quotation system. If he discovers a better price on, say, the Midwest Stock Exchange, he enters a commitment for the bid or offer through an ITS terminal located on the NYSE floor, When the deal is completed on the Midwest Stock
The Changing Structure of the Stock Market
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° ' S u p p o r t e r s of Cm c i n n a u "5 s
electronic exchange believe that elimination of exchange floors and manual trading methods can provide substantial savings to investors."
17 Exchange, a confirmation is then sent back through ITS to notify the NYSE broker. The second possible form of future equities markets is an electronic system similiar to the Cincinnati Stock Exchange. Unlike the traditional face-to-face trading on other exchanges, in the Cincinnati Stock Exchange all buying and selling is done through the computer. Brokers simply enter their orders through terminals located in their offices, and then, trades are automatically confirmed. In place of the specialist system, the Cincinnati computer automatically logs limit orders and executes them when prices hit the predetermined level. 14 The two competing NMS prototypes are creating a considerable controversy in the Congress, the SEC, and the securities industry. The dispute is focused on the advantages and disadvantages of the two trading mechanisms. The strongest advocate of the ITS is the NYSE which maintains that the linkage of exchange floors provides effective competition. Yet, critics of the ITS have debated the NYSE's contention by noting several problems with the ITS. First, the system does n o t guarantee that orders are routed to the market wil'h the best price. Many times 14. The Cincinnati Stock Exchange was recently linked to the ITS, although only three securities were initially involved in the linkage. Because the other exchanges felt that an electronic market might have a competitive edge, the exchanges agreed that orders routed to the Cindnnati Exchange must be first received by a clerk and then entered into the computerized system manually for automatic execution. See the Wall Street Journal, February 2, 1981: 3.
NYSE brokers ignore, as they have Lynch, who accounts for more than the right to do, better quotes else- half of Cincinnati's trading, many where. Second, time delays occur brokers are reluctant to trade on with the ITS which are due to its the Cincinnati system due to its low separation from the composite quo- volume. However, a proposed linktation system. Consequently, dur- age of the Cincinnati Exchange to ing times of heavy trading, brokers the ITS could dramatically improve avoid using ITS. As a result, in the the acceptance of the Cincinnati period from February 1979 Exchange. In addition to the ITSthrough February 1980, the ITS trading experiments, accounted for less than 4 percent of Cincinnati the overall trading in the stocks it NYSE Rule 390 is also drawing the carries. IS One major hope for attention of the securities industry. strengthening the ITS is a proposed On J u l y 18, 1980, the SEC waived linkage between the ITS and the Rule 390 for 130 NYSE-listed dealers on the over-the-counter stocks. The SEC always believed (OTC) market. Brokers already that Rule 390 was a barrier to have desk-top terminals for OTC competition since it prohibited offquotes, so the ITS-OTC tie-in board trading by NYSE members. would allow brokers to send orders Notably, the real competition for anywhere directly from their of- the NYSE specialists are the large rices. 16 brokerage firms instead of their Supporters of the Cincinnati's nominal competition, the regional electronic exchange believe that exchanges. The large brokerage elimination of exchange floors and firms are well-capitalized with exmanual trading methods can pro- tensive communications networks; vide substantial savings to investors. hence, they can aggressively comFurthermore, the Cincinnati system pete with the specialist. For examautomatically executes limit orders ple, the removal of Rule 390 allows which would save brokers the fees Merrill Lynch to act as a dealer by now paid to specialists. Neverthe- quoting bid and ask prices. If Merless, only forty-six securities now rill Lynch can match or improve trade on the Cincinnati system. 17 upon the specialist's quotes, then With the exception of Merrill Merrill Lynch itself can execute its customers' orders w i t h o u t going to 15. "SEC Hit by House Unit for Slow the exchange floor. Merrill Lynch Progress in Creation of National Securities Markets," Wall Street Journal, September 12, would then simply report the trans1980: 3. action directly to the composite 16. The National Association of Security Dealer's Computer Automated Execution tape. System is emerging as the foundation of the The elimination of Rule 390 has OTC link with the ITS. This system will provide the potential to reduce investors' routing and trading execution capabilities and will be operation in 1981. The SEC has proposed a September 1981 deadline for installation of a link between the ITS and the OTC systems. See the Wall Street Journal, February 6, 1981: 7.
17. Tim Carrington, "Pace-Setting Cincinnati Stock Exchange, Two Years Later, is J u s t Barely Getting By," Wall Street Journal, September 3, 1980: 25.
18 transaction costs by increasing dealer competition, by increasing the amount of capital committed to dealer trading, and by reducing exchange floor trading costs. Yet, specialists charge that elimination of Rule 390 will fragment total trading among the large brokerage firms, thereby reducing NYSE order flow and widening spreads. Results of the current experimental suspension of Rule 390 will determine whether the rules should be eliminated for a broader set of stocks. Apart from the ITS-Cincinnati and Rule 390 experiments, the securities industry has introduced three automated trading innovations. First, the NYSE now executes orders of less than 100 shares directly by computer. Second, the Securities Industry Association has r e c o m m e n d e d an automated execution system that can handle orders of 500 shares or less. Such a system would automatically execute more than half the orders on the floor of the NYSE. The NYSE has proposed that orders of 100 shares and less be executed automatically. 1s Third, many orders of up to 299 shares are electronically routed directly from the brokers' offices to the exchange floor where they are executed without a fee. The system, called Direct Order Turnover, now routes as much as a half of NYSE's orders. All of these automated systems are a major reason why the NYSE has successfully handled its currently high volume, 18. Tim Carrington, "Securities Industry Group Is Urging Plan to Increase Automation," Wall Street Journal, December 4, 1980: 4.
which has more than doubled over the past four years. Fourth, Merrill Lynch in 1980 introduced their "Best Price Selector" which is an electronic system that finds the best market for a customer's trade and sends the trade to that securities market in a fraction of a second. Merrill Lynch's innovation is regarded as a competitive tool; nevertheless, it potentially is an important part of the envisioned national market system. Resistance to national limit order protection. With respect to the four fundamental NMS goals, national limit order protection has encountered the least amount of progress. The SEC originally proposed a system that would electronically pool and display limit orders from all markets. This central file would provide nationwide limit order protection by treating all limit orders on a simple time and price priority basis, regardless of where the limit orders were placed. An example of such a system, known as a central fimit order book (CLOB), is the Cincinnati Stock Exchange. However, a nationwide CLOB does not exist. There now is no assurance that a customer's limit order on one exchange will be executed when the specified price is reached on another exchange. The composite quotation system only provides the highest bid and the lowest ask prices from each of the exchanges. Furthermore, the existing ITS system does not store or execute limit orders. There are several advantages to the CLOB. First, the system could easily and automatically impose ex-
ecution priorities according to price and time. The computer would provide a clear record for regulating the participating dealers. Second, the CLOB encourages effective competition by allowing any qualified dealer to submit price quotes. Third, investors' transaction costs would be reduced by eliminating fees and physical inefficiencies associated with manually operating the book on exchange floors. The NYSE believes a CLOB would end the independence of exchanges by becoming one central exchange in its own right. Moreover, the NYSE is concerned about CLOB's economic impact on the specialists who depend on limit orders for a substantial portion of their income. For example, in 1978 these fees represented 40 percent of the specialists' income. 19 Specialists fear that a CLOB would sharply reduce or eliminate fees charged for executing limit orders. Thus, the NYSE has recently proposed a system designed to protect limit orders and preserve the specialists' conventional fee schedule. Instead of a CLOB, the NYSE suggested a set-up called the Limit Order Information System. In the NYSE scheme, each stock market maintains its own electronic file and makes it available throughout the ITS system. Any broker or dealer who executes a price-triggering trade on one exchange would be required to protect limit orders on other exchanges. Unlike the CLOB, 19. U.S. Securities and Exchange Commission, Directorate of Economic and Policy Research, Staff Report on the Securities Industry in 1978, July 26, 1979: Table A-6A.
The Changing Structure of the Stock Market
"Near-term progress on the central routing and limit order goals depends primarily on the SEC's desire to act in the face of certain industry opposition."
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the NYSE still requires limit orders to be processed through the specialist in the usual manner. Nevertheless, advocates of CLOB argue that the specialist fee system is indirectly costing investors millions of dollars each week. Furthermore, with Rule 390 in place, the NYSE system does not allow competitive brokers and dealers to quote prices for their own accounts. Future Developments ear-term progress on the central routing and limit order goals depends primarily on the SEC's desire to act in the face of certain industry opposition. Increasing SEC pressure has resulted from recent Congressional subcommittee hearings which have blamed the SEC for not providing a more active leadership role. In response to Congressional pressure, outgoing SEC chairman Harold M. Williams stated that the NMS could essentially be in place b y 1982. In the longer run, the exact shape of the future market remains far from certain. Nevertheless, the trend of recent developments has outlined the general shape of the market during the 1980s and beyond-the financial marketplace that will finance the U.S. e c o n o m y into the twenty-first century. Although there is no clear time schedule for the market evolution, the following future developments are possible. ,J The 1980s will be the decade when the individual investor returns. Although institutional investors will still dominate trading, the
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individual investors will increase their relative participation. ~° The new political climate in Washington will initiate new laws that encourage higher levels of investment. Moreover, the NMS will bring the individual investor closer to the center of the market, because the information he gets will be the same as that on the floors of any or all stock exchanges. Also, automation of trading promises to reduce brokers' actual fixed cost per trade, thereby reducing brokerage commissions for individual investors. • The institutional investor created a new market environment in the late 1960s and 1970s, b u t ironically, it will be the return of the individual investors in the 1980s that will create new pressures for market automation. In contrast to volume created b y institutional block trading which is relatively easy to process, individual trading requires more paperwork. A surge in smaller trades would overwhelm the conventional system. The growing trading volume of the 1980s will simply demand more automation. The mythical 100 million share day will soon become a reality. In fact, the NYSE is now adding computer capacity to handle a daily volume of 150 million shares. The current system, which is 20. The N Y S £ recently released results from its eight shareowner survey, conducted during the s u m m e r of 1980. It showed that the n u m b e r of shareholders in the U.S. increased b y 18 percent to 29,840,000 since 1975. The Chairman of the NYSE, William Batten, attributes the increased interest in stocks to two factors: the market's performance over the past two years and the more liberal t r e a t m e n t of capital gains. See Lawrence Armor, " T h e Trader,"Barrons, December 12, 1980: 71.
largely tied to the physical handling of order slips, creates tremendous paperwork problems. As more trades are executed b y computer, many of the current paperwork snarls will disappear. • As part of the trend to reduce the costs or paperwork, stock certificates will be eliminated. An electronic funds transfer system will automate the settlement mechanism. Investors, broker-dealers, and banks will be integrated into a system that will electronically transfer credit to the appropriate books. • A majority of the brokerage business will be concentrated among a few large, full-service firms. Mergers of brokerage firms have signalled a more capitalintensive industry. Capital is needed for the new dealer opportunities in a NMS environment. In addition, capital is required as the industry becomes more machine intensive. Despite the capital requirements of the full-service firms, many medium and small brokerage firms will survive b y choosing a specific area of expertise. For example, the discount brokers are an example of small profitable brokerage firms. • The new conditions created b y the NMS will benefit corporations. By including both listed and unlisted firms in the NMS, small firms will gain broader exposure. In addition, the NMS will encourage individual investors to commit capital on new issues b y providing stronger secondary markets. More liquid markets for corporations will reduce their costs of raising new equity capital.
"The growing trading volume of the 1980s will simply demand more automation. The mythical 100 million share day will soon become a reality."
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• Prices will be quoted in pennies instead of eighths of a dollar. In addition, fractional shares may be easily traded via the computer. • Eventually, there will be a twenty-four-hour global market. The large, multi-national firms such as IBM, Sperry Rand, and General Motors are each listed on more than ten exchanges around the world. Greater investor interest in the growing number of multi-national companies will result in an electronic linkage of stock markets worldwide, providing twenty-fourhour trading capabilities for those companies. • Ultimately, there might be a single universal financial marketplace that trades stocks, options,
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bonds, futures, and commodities.
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more questions concerning the detailed design of the NMS must be he NMS is no longer the resolved. Given the conflict of invague, abstract concept de- terests among different market parscribed in the Securities ticipants, the optimal rate of Acts Amendments of 1975. Key change is debatable. But, above all NMS elements have already been the discussion of the ultimate tradestablished, producing extraordi- ing mechanism, the essential characnary benefits to investors. The re- teristic of the NMS is a system cord of solid progress includes low- based on equitable principles of er brokerage commission rates; in- trade that will reduce costs o f creasing automation of trading transacting for investors. [ZZ] which provides the ability to handle more trading volume; intense cost21. The Chairman of the NYSE, William consciousness and cost-effectiveness Batten, stated recently that the ITS saved individual and institutional investors about $20 among brokerage firms; and new million during the first nine months of 1980. technologies that eliminate many Approximately 5 7 8 , 0 0 0 trades were executed on the ITS in the nine month period, versus barriers to competition. 21 only 235,000 trades on the system during the As the securities markets move first nine months of 1979. See Securities Week, forward to a fully developed NMS, November 17, 1980: 2.
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I n n o v a t i o n s in the securities markets initiated by the Securities Acts A m e n d m e n t s o f 1975 are creating a new trading environm e n t in which the costs o f investing are red u c e d and m a n y barriers to c o m p e t i t i o n are eliminated. he revolutionary new equity who freely compete for the best marketplace of the future is stock prices available anywhere in now beginning to be the U.S. The Admendments of shaped. Recently a number of fun- 1975 merely sketched out the damental changes in our securities broad characteristics and goals of markets have created a new trading the NMS, leaving the determination environment which is affecting the of operational details to the securisecurities industry, investors, and ties industry and the Securities and corporate issuers of new capital. To Exchange Commission. The final understand this developing market form of a complete NMS is still of the 1980s, it is useful to examine open-ended; thus, recent fundathe economic and political pres- mental changes in the structure of sures underlying the innovations in securities markets are part of the the security markets. evolutionary movement toward a The catalyst of the future stock fully operational NMS. market is the Securities Acts An essential question concerns Amendments of 1975. It is the how the NMS will affect market most far-reaching piece of securities participants. Investors have already legislation enacted since the 1930s. benefited by generally lower transThe purpose of the law is to en- action costs, with future developcourage nationwide competition in ments promising cost savings in securities trading by development millions of dollars. 1 The future of a national marhet system (NMS). computerized operational requireIn contrast to the traditional trad- ments in the investment area are ing methods which separately fun- bringing about economic concentraneled orders to a specific stock tion of the securities industry. 2 The exchange, the NMS is a trading 1. U.S. Securities and Exchange Commissystem which links several securities sion, Directorate of Economic and Policy Remarkets electronically, enabling in- search, Staff Report on the Securities Industry in 1979, July 1980. Exhibit III-5. vestors to execute their trading 2. The number of brokerage firms transactorders quickly at the best competi- ing business with the public declined by 200 tive prices prevailing in several mar- from 1961 to 1976. See the New York Stock Exchange 1980 Fact Book: 74. These firms kets. In effect, the NMS is a com- have either merged, liquidated or declared puterized network of stock traders bankruptcy.
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The Changing Structure of the Stock Market
11 rapid automation of equities trading presents the real possibility that stock exchanges themselves are endangered due to their operational costs. In addition, b y enhancing market liquidity the NMS promises to reduce the cost to corporations of raising rinds through new issues of equity securities. However, the extent and pace of these changes are still uncertain. Given the ramifications of the developing NMS on market participants, it is constructive to examine the recent developments and possible future forms of the equities markets. We discuss first the economic factors leading to the NMS and describe the 1975 NMS legislation. The next sections are concerned with NMS developments since 1975 and examine future trends of NMS innovations. Finally, we offer a view of h o w alternative NMS policies may be implemented. Early Economic Pressures ignificant economic pressures for changes in securities trading began ten years before the Securities Acts Amendments of 1975. To understand why Congress passed such far-reaching legislation, it is useful to examine the unsettled market environment b e t w e e n 1965 and 1975. Stock Trading Procedures. The very heart of NMS discussion is whether the process of stock trading can be automated. Traditionally, over 80 percent of the total dollar value of trading on U.S. exchanges has occurred on the New York Stock Exchange (NYSE). 3
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Hence, the question concerning the costs and benefits of trading automation can be examined by first describing the NYSE's auction trading procedure. The auction procedure requires brokers to physically meet on the exchange floor to match customers' b u y and sell orders. Investors may submit their market orders at any time during trading hours; as a result, there may not be matching public b u y and sell orders at the same m o m e n t in time. In fact, unbalanced public order flows occur frequently. When this occurs the specialist will intervene and match the public order with his own capital or with securities he owns. The specialist is a professional security dealer on the NYSE floor who is assigned to a certain set of stocks. One of the specialist's major functions is to provide continuous price quotations for immediate purchase and sale of securities. When investors need to trade immediately, they can either purchase securities at the ask price quote or sell securities at the bid price quote if there is no offsetting order. Consequently, investors can always rely on the specialists to provide a continuous and orderly market in any stock assigned to them. Specialists are willing to supply the service of continuous bid and ask quotations in return for the benefits gained b y quoting prices away from the market price. In other words, specialists will provide immediacy in trading b y purchasing 3. 1980 Fact Book: 67.
a security from public sellers at a discount below the market price and b y selling a security to public buyers at a premium above the market price. For example, suppose a stock is selling at $90 per share. Now suppose the specialist quotes an 89 bid price and a 91 ask price. On the one hand, if two public orders match, the transaction price will be at or near $90. On the other hand, if a public sell order occurs without a matching b u y order, then the investor must sell the stock at the bid price of $89. The investor has forfeited a one dollar price concession for the benefit of selling immediately. (If a public b u y order was unmatched, then the investor would pay a one dollar premium and trade at the $91 ask price.) The spread between bid and ask prices represents a transaction cost to investors. The wider the spread, the higher the transaction cost. The investor would pay a higher bid discount or ask premium if the specialists' spread were 85 bid-95 ask. One goal of the NMS is to narrow the bid-ask spread and thereby reduce transaction costs. The other source of compensation to the specialist besides trading profits is from executing limit orders. A limit order is an order to b u y or sell a stock when and if the price of the stock reaches a specified price or better; investors who are willing to wait place limit orders at prices away from the current market price to get a better price. Brokers who hold customers' limit orders typically leave their orders with the specialist. The specialist records the prices in his limit order
"Historically, the NYSE and its specialist system were designed for the individual investor who typically traded only a small n u m b e r of shares at any one time."
12 Institutional Dominance of the NYSE NYSE Block Transactions
Number of block trades Total shares (O00's) Percentage of reported volume Average per trading day
1965
1969
1972
1979
2,171 48,262 3.1% 9
15,132 402,063 14.1% 61
31~207 766,536 18.5% 124
97,509 2,164,726 26.5% 385
Source: New York Stock Exchange, 1980 Fact Book: 66. Percentage Distribution of NYSE Public Volume
Value
Shares
1960
1971
1976
1960
1971
1976
68.6 31.4
40.3 59.7
42.7 57.3
60.7 39.3
31.8 68.2
29.7 70.3
Public individuals Institutions
Source: New York Stock Exchange, 1972 Fact Book: 53 and 1980 Fact Book: 52. Estimated Holdings of NYSE-Listed Stocks By Financial Institutions (in billions of dollars)
• Institution
1949
1959
1969
1975
Insurance companies Investment companies Non-insured pension funds Nonprofit institutions Common trust funds Miscellaneous
$2.8 3.0 0.4 3.2 *
$8.6 16.8 12.9 12.8 1.4
$21.9 43.2 61.7 27.7 4.1
$33.2 40.6 105.0 38.0 6.1
0.2
0.3
1.0
7.4
Total (billions)
$9.7
$52.8
$159.6
$230.5
Market value of NYSE stocks
$76.3
$307.7
$629.5
$685.1
Percentage held by institutions
12.7%
17.2%
25.4%
33.6%
*Less than $50 million Source: New York Stock Exchange, 1973 Fact Book: 51, and 1980 Fact Book: 50.
b o o k and executes them whenever market prices converge to the specified prices. When the limit orders are executed, the b ro k e r must pay a fee to the specialist for his agency services. A not her goal o f the NMS is to reduce or eliminate this fee b y automating limit order execution. Other members o f the NYSE who will be directly affected b y the NMS are the commission brokers e m p l o y e d by the member brokerage firms to represent their customers' orders on the trading floor, and the floor brokers, primarily individual entrepreneurs, who act as independent commission brokers. An aut om at ed stock execution system would pose an economic threat to these m em ber types, especially the latter. Institutionalization of Equity Markets. Historically, the NYSE and its specialist system was designed for the individual investor who typically traded only a small n u m b e r of shares at any one time. The system came u n d e r stress when large financial institutions (such as banks, investment companies, insurance companies, and pension funds) began to dominate trading. The trading needs of institutional investors differ substantially from those of individual investors, primarily because the size of an average institutional trading position is much larger than that of the individual investor. The rapid growth o f the institutionalization of investing is apparent when NYSE trading statistics over recent years are examined in the accompanying Table. One indication of institutional activity is the
The Changing Structure of the Stock Market
13 number of block trades (defined as transactions of 10,000 shares or more) because block trades are primarily executed b y institutions ra~Lher than b y individual investors. Block trading has grown dramatically since 1965. The average number of blocks traded per day in 1979 (3;85 blocks per day) was forty-two times greater than the number of blocks traded in 1965 (9 blocks per day). In addition, block trading as a percent of reported volume increased from 3.1 percent in 1965 to 14.1 percent in 1969, and to 26.5 percent in 1979. Thus, more than one out of every four shares traded on the NYSE is part of a block transaction. Another indication of institutional growth is the distribution of public trading on the NYSE between individuals and institutions. In 1960 individuals dominated NYSE public trading, accounting for over 68 percent of the total share volume and 60 percent of the dollar value. By 1976, individuals' trading had dropped to 40 percent of the share volume and only 30 percent of the dollar volume. Although this trend appears to have leveled off in recent years, insitutions account for a dominant share of NYSE public trading. Institutional dominance has not been confined solely to trading volume. The major financial institutions have consistently increased their relative holdings of NYSElisted stocks, from 12.7 percent in 1949 to 33.6 percent in 1975. It has been estimated that inclusion of all institutional holdings of NYSElisted stocks would increase their relative holdings to 50 percent. 4
There are at least three reasons for the institutional dominance of the NYSE. First, individuals systematically withdrew from the stock market as direct investors to become indirect investors through the financial institutions, s The institutions can offer individuals diversification, lower transaction costs, and professional management. Second, there was a dramatic growth in the size of institutions that can own equities, especially the private pension funds. 6 And third, the institutions increased their relative trading activity (that is, higher portfolio turnover rates). 7 Thus, the growth in institutional ownership and trading put tremendous pressure on the existing market structure. Problems concerning commissions, perceived liquidity, and market fragmentation exposed the need for fundamental changes in the existing system. The biggest stress on traditional practices was caused b y the fixed brokerage commission fee system. Members of the NYSE were required to charge fixed minimum commission rates which prevented competitive pricing between brokerage firms. Charging fixed com4. 1980 Fact Book: 50. 5. For example, odd-lot (transactions of less than 100 shares) sales have exceeded odd-lot purchases in every year since 1966. See the NYSE, 1980 Fact Book: 64. In addition, the NYSE shareowner surveys found that almost one out of 5 (18.1 percent) shareowners had left the stock market between 1970 and 1975. (See the 1980 Fact Book: 49). 6. It is estimated that private pension fund assets are n o w approaching $400 billion. Furthermore, these assets are projected to be in the range of $2 trillion by the end of the century. These projections were made for the U.S. Labor D e p a r t m e n t b y ICF Inc. 7. See NYSE, 1980 Fact Book: 22.
missions was a firmly embedded practice that dated back from the original brokers' agreement in 1792. The commission fee schedule caused problems because it was inequitable from an economic standpoint. The commission fee per share charged by brokers did n o t decline for larger orders, even though the brokers' execution costs per share were substantially lower on bigger trades. As a result, the institutions were burdened b y unrealistically high brokerage commissions on their block trades. The institutions reacted to the fixed brokerage rates by increasing their trading through non-NYSE brokers. The non-NYSE brokers could trade NYSE listed stocks on regional exchanges or on the OverThe-Counter Market (OTC). Since they were not b o u n d b y the NYSE fixed commission rates, they would substantially reduce their commission fees on block trades. In the late 1960s, the volume w a s diverted away from the NYSE to the regional exchanges and the OTC market, thus seriously fragmenting the equity market. 8 The fragmented market was detrimental to the investing public because trades in NYSE listed stocks executed on the regional exchanges and on the OTC market were n o t disclosed on the NYSE stock record tape. In addition, public limit orders on the NYSE were bypassed by trades occurring off the NYSE floor. Therefore, fixed commissions not only created costly inequities, but also encouraged market fragmentation. 8. NYSE, 1973 Fact Book: 15.
14 The institutional block trading also highlighted problems with the specialist system. The specialists did not have sufficient capital or the necessary institutional contacts to match block trades. As a result, the large, well capitalized brokerage firms began facilitating block trades for institutions by becoming block positioners. Hence, the large brokerage firms began to compete indirectly with the specialists' market-making services. As the traditional market structure cracked under the weight of heavy institutional trading, Congress recognized the need for fundamental changes in the stock market. Congress authorized the SEC to conduct the Institutional Investor Study to examine the possible alternatives. Three important findings of this study laid the groundwork for the 1975 NMS legislation. First, the study suggested that fixed minim u m brokerage commissions be abolished to promote rate competition and reduce market fragmentation. Second, the study pointed to new computer-based communications and data-processing technology which could electronically link all markets. Third, increased competition for the NYSE specialist would narrow bid-ask spreads. In other words, the study advocated formation of a single, central market system that eliminates all barriers to competition. The findings of the Institutional Investor Study were supported by several independent academic studies. One of the variables examined was trading volume. The research indicated that stocks with higher
trading volume had narrower spreads? An active security provides a greater opportunity to buy or sell; consequently, the security dealer incurs lower holding period costs on his security inventory. The other variable examined by the studies was dealer competition. Although the empirical results regarding this variable were not unanimous, most studies showed that dealer competition narrowed the bid-ask spread. 10 In total, the studies suggest that all competing dealers should be allowed to participate equally in all the trading volume within one central market system.
tion in all aspects of the market by electronically combining all market centers. Specifically, the law states that: The linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to best execution of such orders. 11 The SEC suggested the following four fundamental NMS components would achieve the goals of the 1975 legislation: 1. Abolition of minimum fixed Framework of the NMS brokerage commissions; he strong evidence provided 2. Central reporting of stock by both the Institutional price quotations and transactions; Investor Study and by the 3. Central order routing system; academic studies led to the passage 4. National protection of limit of the Securities Acts Amendments orders. of 1975. The legislation directed Elimination of fixed commisthe SEC to establish a NMS that sions. The elimination of minimum met certain goals outlined in the fixed commissions was part of the law. However, the legislation did Securities Acts Amendments; hownot mandate any specific design for ever, this was already accomplished the NMS, nor did it set a timetable before the law was enacted on June for implementation of the NMS. 6, 1976. The SEC abolished miniResolution of the explicit mechan- m u m fixed commissions on "Mayics of the NMS was left to the SEC. day," May 1, 1975. Central reporting of price quoThe 1975 legislation expressed the need for nationwide competi- tations and transactions. The system would collect and disseminate 9. See Harold Demsetz, "The Cost of bid and ask prices from all competTransactions," Quarterly Journal of Economics 82 (February 1968): 33-55 and Seha M. Tinic, ing dealers which would include "The Economics of Liquidity Services," Quar- quotes from the NYSE specialist, terly Journal of Economics 86 (February the regional exchanges, mad the 1972): 79-93. 10. See Seha Tirdc and Richard R. West, OTC market. In addition to quota"Competition and the Pricing of Dealer Services tions, all stock transaction data
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in the Over-the-Counter StockMarket," Journal of Financial and Quantitative Analysis, 7 (June 1972): 1707-27.
11. U.S. Public Law, 94-29 (June 4, 1975): 112.
The Changing Structure of the Stock Market
"The 1975 legislation expressed the need for nationwide competition in all aspects of the market by electronically combining all market centers."
15 would be aggregated. For example, if General Electric is traded on the NYSE, on the Midwest Stock Exchange, and on the OTC market, then, trades in General Electric sl:ock from all three markets would be reported on the same ticker tape. Central reporting would reduce fragmentation of information by providing the public with the broadest, most complete trading data available. The composite quotation system and transaction tapes are already operational. Central order routing system. This c o m p o n e n t of the NMS is designed to assure prompt execution of orders in markets which offer the best price for a stock. For example, suppose an investor wants to b u y 100 shares of IBM. A computerized network would automatically route his order to the seller, located on a market anywhere in the country, who is offering the lowest selling price on IBM. The advantage of the central order routing system is that it encourages dealer competition. Competition is strengthened considering that dealers quoting the best prices (that is, the narrowest spread) would automatically receive the public orders. One major obstacle to a central order routing system is the NYSE rule 390 (previously rule 394). Rule 390 compels NYSE members to execute all dealer orders for NYSE listed stocks on the NYSE. In effect, NYSE members could not send their trading orders away from exchange floors. Therefore, Rule 39.0 would have to be removed to allow NYSE members to execute
public orders in competition with the specialists on the floor of the exchange. National protection of limit orders. In a strict sense, the SEC proposed that limit orders from all markets be stored together on an equal basis. The execution of limit orders would be based entirely upon their price and time priority, regardless of which broker entered the limit order. This feature would assure the following: Suppose an investor places a limit order to sell 100 shares of GM at $70 on the NYSE. If the market price on GM first reaches $70 on the Pacific Stock Exchange, then the investor's GM stock would be promptly sold on the Pacific Stock Exchange. In absence of nationwide limit orders protection, GM could be sold for $71 on other exchanges or the OTC market w i t h o u t executing the $70 limit order on the NYSE. This problem occurred frequently when institutions traded blocks off the NYSE floor. Recent Market Innovations ecause of the 1975 Congressional mandate for a NMS, the last six years have witnessed a number of significant changes in the securities markets. Various degrees of progress have been accomplished on each of the four fundamental NMS components described in the previous section. Although a fully operational NMS is not yet fully in place, the transformation on Wall Street has already profoundly affected market participants. The recent NMS inno-
B
vations are discussed with respect to their fulfillment of the four fundamental NMS goals. Benefits of negotiable brokerage commissions. The 1975 Mayday abolition of fixed minimum commission rates has clearly been a success. Competitive pricing of commission rates has resulted in significant cost savings for b o t h institutional and individual investors. A SEC study found that from April 1975 to December 1979, brokerage commissions fell by 55 percent for institutional investors while individual investors' commission fell 18 percent. 1 Two reasons were offered for the institutional commission rates declining more sharply than the rates for individual investors. First, institutional investors primarily trade in block transactions which have a much lower commission fee per share than the charge per share on smaller trades. For institutional investors in December 1979, the commission fee per share on small trades of less than 200 shares (42 cents per share) was over five times greater than the fee on blocks (only 8 cents per share). Hence, institutional investors benefit from commission cost economies on large scale transactions. Even if the effects of order size are controlled, a second reason for lower institutional rates is their bargaining power. Institutions generally have much larger accounts than individuals; therefore, brokers are more willing 12. U.S. Securities and Exchange Commission, Directorate of Economic and Policy Research, Staff Report on the Securities Industry in 1979, July 1980, Exhibit 1II-5.
16 to negotiate for the institutions' sizeable brokerage business. Commission rates have generally declined since May 1975 because the old commission rate schedule overestimated the actual variable cost c o m p o n e n t of trading and underestimated the fixed cost component. Actual trading costs per share decline on larger trades as fixed costs are spread over a higher number of shares. The key benefit of competitive rates is that investors n o w pay for brokerage services at prices that more closely reflect the brokers' actual costs of providing these services. A favorable by-product of negotiable commissions is the emergence of so-called discount brokers. Discount brokers offer transaction services at rates as much as 80 percent below those of full-service firms. 13 Unlike the large full-service firms, discount brokers cut their costs b y not providing investors advice or personal attention on their investments. The discount firms aim mass media advertising (such as The Wall Street Journal) at the type of investor who makes his own investment decisions without relying on a broker's advice. After a slow start, the discount brokerage industry n o w consists of over 100 firms which have captured almost 10 percent of the total commission business. These typically small, specialized firms are now one of the most profitable and rapidly growing segments of the securities industry. Solid foundation for the central 13. Tim Garrington, "Bigger Brokers Reluctantly Provide Discounts for Individual Investors," Wall Street Journal, July 30, 1980: 19.
reporting system. The start of central reporting systems for b o t h stock transactions and stock quotations was an important step toward creation of the NMS. This allows investors to make their investment decisions based upon complete, aggregate market data collected nationwide. The first system to concentrate market data was the composite tape. On J u n e 16, 1975, the composite tape began reporting all sales of securities as they occurred on the principal exchanges. For example, all transactions in AT & T stock on the Midwest or Pacific stock exchanges will appear on the tape along with AT & T trades on the NYSE. Investors can now receive a prompt, full disclosure of all transactions executed nationally before making their investment decisions. The second major technological advance in data reporting systems was the composite quotation system. The system electronically displays to brokers on an exchange floor the best bid and ask price quotations in the different markets. Suppose a broker on an exchange floor wants to purchase 100 shares of IBM stock. He can now check the composite quotation system display screen to determine whether a lower bid-ask price is available on another exchange. Under an SEC requirement, the broker is assured that quotes on the display screen are firm and binding commitments to trade. However, the composite quotation system b y itself does not allow the broker to send orders to other markets.
Slower progress on a central order routing system. In contrast to the rapid-paced developments on brokerage commissions and on composite reporting, the growth of a central order routing system is proceeding at a slow, deliberate pace. Although the composite quotation system provides quotes from alternative markets, the system does not have an execution capability. Consequently, the SEC's goal is an arrangement that will enable brokers to send customers' orders from their offices to whatever market has the best price. To achieve its goal, the SEC is currently experimenting with two possible prototypes of the eventual central order routing system. One p r o t o t y p e of the NMS that allows orders to be routed between the primary exchanges is the Intermarket Trading System (ITS). ITS began operating in April 1978 b y providing a n e t w o r k of electronic communications terminals located in the various exchanges. The system enables a broker on the floor of one exchange to switch his order to another exchange if a better price is available on that exchange. ITS works in conjunction with the composite quotation system in the following manner. A broker on the NYSE may compare the NYSE prices with the quotes from the other exchanges displayed on the composite quotation system. If he discovers a better price on, say, the Midwest Stock Exchange, he enters a commitment for the bid or offer through an ITS terminal located on the NYSE floor, When the deal is completed on the Midwest Stock
The Changing Structure of the Stock Market
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° ' S u p p o r t e r s of Cm c i n n a u "5 s
electronic exchange believe that elimination of exchange floors and manual trading methods can provide substantial savings to investors."
17 Exchange, a confirmation is then sent back through ITS to notify the NYSE broker. The second possible form of future equities markets is an electronic system similiar to the Cincinnati Stock Exchange. Unlike the traditional face-to-face trading on other exchanges, in the Cincinnati Stock Exchange all buying and selling is done through the computer. Brokers simply enter their orders through terminals located in their offices, and then, trades are automatically confirmed. In place of the specialist system, the Cincinnati computer automatically logs limit orders and executes them when prices hit the predetermined level. 14 The two competing NMS prototypes are creating a considerable controversy in the Congress, the SEC, and the securities industry. The dispute is focused on the advantages and disadvantages of the two trading mechanisms. The strongest advocate of the ITS is the NYSE which maintains that the linkage of exchange floors provides effective competition. Yet, critics of the ITS have debated the NYSE's contention by noting several problems with the ITS. First, the system does n o t guarantee that orders are routed to the market wil'h the best price. Many times 14. The Cincinnati Stock Exchange was recently linked to the ITS, although only three securities were initially involved in the linkage. Because the other exchanges felt that an electronic market might have a competitive edge, the exchanges agreed that orders routed to the Cindnnati Exchange must be first received by a clerk and then entered into the computerized system manually for automatic execution. See the Wall Street Journal, February 2, 1981: 3.
NYSE brokers ignore, as they have Lynch, who accounts for more than the right to do, better quotes else- half of Cincinnati's trading, many where. Second, time delays occur brokers are reluctant to trade on with the ITS which are due to its the Cincinnati system due to its low separation from the composite quo- volume. However, a proposed linktation system. Consequently, dur- age of the Cincinnati Exchange to ing times of heavy trading, brokers the ITS could dramatically improve avoid using ITS. As a result, in the the acceptance of the Cincinnati period from February 1979 Exchange. In addition to the ITSthrough February 1980, the ITS trading experiments, accounted for less than 4 percent of Cincinnati the overall trading in the stocks it NYSE Rule 390 is also drawing the carries. IS One major hope for attention of the securities industry. strengthening the ITS is a proposed On J u l y 18, 1980, the SEC waived linkage between the ITS and the Rule 390 for 130 NYSE-listed dealers on the over-the-counter stocks. The SEC always believed (OTC) market. Brokers already that Rule 390 was a barrier to have desk-top terminals for OTC competition since it prohibited offquotes, so the ITS-OTC tie-in board trading by NYSE members. would allow brokers to send orders Notably, the real competition for anywhere directly from their of- the NYSE specialists are the large rices. 16 brokerage firms instead of their Supporters of the Cincinnati's nominal competition, the regional electronic exchange believe that exchanges. The large brokerage elimination of exchange floors and firms are well-capitalized with exmanual trading methods can pro- tensive communications networks; vide substantial savings to investors. hence, they can aggressively comFurthermore, the Cincinnati system pete with the specialist. For examautomatically executes limit orders ple, the removal of Rule 390 allows which would save brokers the fees Merrill Lynch to act as a dealer by now paid to specialists. Neverthe- quoting bid and ask prices. If Merless, only forty-six securities now rill Lynch can match or improve trade on the Cincinnati system. 17 upon the specialist's quotes, then With the exception of Merrill Merrill Lynch itself can execute its customers' orders w i t h o u t going to 15. "SEC Hit by House Unit for Slow the exchange floor. Merrill Lynch Progress in Creation of National Securities Markets," Wall Street Journal, September 12, would then simply report the trans1980: 3. action directly to the composite 16. The National Association of Security Dealer's Computer Automated Execution tape. System is emerging as the foundation of the The elimination of Rule 390 has OTC link with the ITS. This system will provide the potential to reduce investors' routing and trading execution capabilities and will be operation in 1981. The SEC has proposed a September 1981 deadline for installation of a link between the ITS and the OTC systems. See the Wall Street Journal, February 6, 1981: 7.
17. Tim Carrington, "Pace-Setting Cincinnati Stock Exchange, Two Years Later, is J u s t Barely Getting By," Wall Street Journal, September 3, 1980: 25.
18 transaction costs by increasing dealer competition, by increasing the amount of capital committed to dealer trading, and by reducing exchange floor trading costs. Yet, specialists charge that elimination of Rule 390 will fragment total trading among the large brokerage firms, thereby reducing NYSE order flow and widening spreads. Results of the current experimental suspension of Rule 390 will determine whether the rules should be eliminated for a broader set of stocks. Apart from the ITS-Cincinnati and Rule 390 experiments, the securities industry has introduced three automated trading innovations. First, the NYSE now executes orders of less than 100 shares directly by computer. Second, the Securities Industry Association has r e c o m m e n d e d an automated execution system that can handle orders of 500 shares or less. Such a system would automatically execute more than half the orders on the floor of the NYSE. The NYSE has proposed that orders of 100 shares and less be executed automatically. 1s Third, many orders of up to 299 shares are electronically routed directly from the brokers' offices to the exchange floor where they are executed without a fee. The system, called Direct Order Turnover, now routes as much as a half of NYSE's orders. All of these automated systems are a major reason why the NYSE has successfully handled its currently high volume, 18. Tim Carrington, "Securities Industry Group Is Urging Plan to Increase Automation," Wall Street Journal, December 4, 1980: 4.
which has more than doubled over the past four years. Fourth, Merrill Lynch in 1980 introduced their "Best Price Selector" which is an electronic system that finds the best market for a customer's trade and sends the trade to that securities market in a fraction of a second. Merrill Lynch's innovation is regarded as a competitive tool; nevertheless, it potentially is an important part of the envisioned national market system. Resistance to national limit order protection. With respect to the four fundamental NMS goals, national limit order protection has encountered the least amount of progress. The SEC originally proposed a system that would electronically pool and display limit orders from all markets. This central file would provide nationwide limit order protection by treating all limit orders on a simple time and price priority basis, regardless of where the limit orders were placed. An example of such a system, known as a central fimit order book (CLOB), is the Cincinnati Stock Exchange. However, a nationwide CLOB does not exist. There now is no assurance that a customer's limit order on one exchange will be executed when the specified price is reached on another exchange. The composite quotation system only provides the highest bid and the lowest ask prices from each of the exchanges. Furthermore, the existing ITS system does not store or execute limit orders. There are several advantages to the CLOB. First, the system could easily and automatically impose ex-
ecution priorities according to price and time. The computer would provide a clear record for regulating the participating dealers. Second, the CLOB encourages effective competition by allowing any qualified dealer to submit price quotes. Third, investors' transaction costs would be reduced by eliminating fees and physical inefficiencies associated with manually operating the book on exchange floors. The NYSE believes a CLOB would end the independence of exchanges by becoming one central exchange in its own right. Moreover, the NYSE is concerned about CLOB's economic impact on the specialists who depend on limit orders for a substantial portion of their income. For example, in 1978 these fees represented 40 percent of the specialists' income. 19 Specialists fear that a CLOB would sharply reduce or eliminate fees charged for executing limit orders. Thus, the NYSE has recently proposed a system designed to protect limit orders and preserve the specialists' conventional fee schedule. Instead of a CLOB, the NYSE suggested a set-up called the Limit Order Information System. In the NYSE scheme, each stock market maintains its own electronic file and makes it available throughout the ITS system. Any broker or dealer who executes a price-triggering trade on one exchange would be required to protect limit orders on other exchanges. Unlike the CLOB, 19. U.S. Securities and Exchange Commission, Directorate of Economic and Policy Research, Staff Report on the Securities Industry in 1978, July 26, 1979: Table A-6A.
The Changing Structure of the Stock Market
"Near-term progress on the central routing and limit order goals depends primarily on the SEC's desire to act in the face of certain industry opposition."
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the NYSE still requires limit orders to be processed through the specialist in the usual manner. Nevertheless, advocates of CLOB argue that the specialist fee system is indirectly costing investors millions of dollars each week. Furthermore, with Rule 390 in place, the NYSE system does not allow competitive brokers and dealers to quote prices for their own accounts. Future Developments ear-term progress on the central routing and limit order goals depends primarily on the SEC's desire to act in the face of certain industry opposition. Increasing SEC pressure has resulted from recent Congressional subcommittee hearings which have blamed the SEC for not providing a more active leadership role. In response to Congressional pressure, outgoing SEC chairman Harold M. Williams stated that the NMS could essentially be in place b y 1982. In the longer run, the exact shape of the future market remains far from certain. Nevertheless, the trend of recent developments has outlined the general shape of the market during the 1980s and beyond-the financial marketplace that will finance the U.S. e c o n o m y into the twenty-first century. Although there is no clear time schedule for the market evolution, the following future developments are possible. ,J The 1980s will be the decade when the individual investor returns. Although institutional investors will still dominate trading, the
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individual investors will increase their relative participation. ~° The new political climate in Washington will initiate new laws that encourage higher levels of investment. Moreover, the NMS will bring the individual investor closer to the center of the market, because the information he gets will be the same as that on the floors of any or all stock exchanges. Also, automation of trading promises to reduce brokers' actual fixed cost per trade, thereby reducing brokerage commissions for individual investors. • The institutional investor created a new market environment in the late 1960s and 1970s, b u t ironically, it will be the return of the individual investors in the 1980s that will create new pressures for market automation. In contrast to volume created b y institutional block trading which is relatively easy to process, individual trading requires more paperwork. A surge in smaller trades would overwhelm the conventional system. The growing trading volume of the 1980s will simply demand more automation. The mythical 100 million share day will soon become a reality. In fact, the NYSE is now adding computer capacity to handle a daily volume of 150 million shares. The current system, which is 20. The N Y S £ recently released results from its eight shareowner survey, conducted during the s u m m e r of 1980. It showed that the n u m b e r of shareholders in the U.S. increased b y 18 percent to 29,840,000 since 1975. The Chairman of the NYSE, William Batten, attributes the increased interest in stocks to two factors: the market's performance over the past two years and the more liberal t r e a t m e n t of capital gains. See Lawrence Armor, " T h e Trader,"Barrons, December 12, 1980: 71.
largely tied to the physical handling of order slips, creates tremendous paperwork problems. As more trades are executed b y computer, many of the current paperwork snarls will disappear. • As part of the trend to reduce the costs or paperwork, stock certificates will be eliminated. An electronic funds transfer system will automate the settlement mechanism. Investors, broker-dealers, and banks will be integrated into a system that will electronically transfer credit to the appropriate books. • A majority of the brokerage business will be concentrated among a few large, full-service firms. Mergers of brokerage firms have signalled a more capitalintensive industry. Capital is needed for the new dealer opportunities in a NMS environment. In addition, capital is required as the industry becomes more machine intensive. Despite the capital requirements of the full-service firms, many medium and small brokerage firms will survive b y choosing a specific area of expertise. For example, the discount brokers are an example of small profitable brokerage firms. • The new conditions created b y the NMS will benefit corporations. By including both listed and unlisted firms in the NMS, small firms will gain broader exposure. In addition, the NMS will encourage individual investors to commit capital on new issues b y providing stronger secondary markets. More liquid markets for corporations will reduce their costs of raising new equity capital.
"The growing trading volume of the 1980s will simply demand more automation. The mythical 100 million share day will soon become a reality."
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• Prices will be quoted in pennies instead of eighths of a dollar. In addition, fractional shares may be easily traded via the computer. • Eventually, there will be a twenty-four-hour global market. The large, multi-national firms such as IBM, Sperry Rand, and General Motors are each listed on more than ten exchanges around the world. Greater investor interest in the growing number of multi-national companies will result in an electronic linkage of stock markets worldwide, providing twenty-fourhour trading capabilities for those companies. • Ultimately, there might be a single universal financial marketplace that trades stocks, options,
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more questions concerning the detailed design of the NMS must be he NMS is no longer the resolved. Given the conflict of invague, abstract concept de- terests among different market parscribed in the Securities ticipants, the optimal rate of Acts Amendments of 1975. Key change is debatable. But, above all NMS elements have already been the discussion of the ultimate tradestablished, producing extraordi- ing mechanism, the essential characnary benefits to investors. The re- teristic of the NMS is a system cord of solid progress includes low- based on equitable principles of er brokerage commission rates; in- trade that will reduce costs o f creasing automation of trading transacting for investors. [ZZ] which provides the ability to handle more trading volume; intense cost21. The Chairman of the NYSE, William consciousness and cost-effectiveness Batten, stated recently that the ITS saved individual and institutional investors about $20 among brokerage firms; and new million during the first nine months of 1980. technologies that eliminate many Approximately 5 7 8 , 0 0 0 trades were executed on the ITS in the nine month period, versus barriers to competition. 21 only 235,000 trades on the system during the As the securities markets move first nine months of 1979. See Securities Week, forward to a fully developed NMS, November 17, 1980: 2.
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