continued from p. B1
Thus, by 2004 the US securities market was characterized by two entirely different trading structures. For NYSElisted securities (as well as those listed on the smaller American Stock Exchange, or Amex), there is a centralized exchange that accounts for the vast majority of the trading. For Nasdaq securities, there is a market that consists of competitive trading venues, each vying to gain and hold market share. Although some portion of trading in NYSE securities takes place on Nasdaq or the ECNs under various exemptions, by and large the two different markets do not compete to offer better services or prices to investors. What competition between them occurs is limited to vying for listings by companies that want their shares to be traded on an organized market.
Each of the structures has its strong proponents. Supporters of the centralized NYSE structure and the trade- through rule argue that concentrating most trading in a single market reduces bid-ask spreads and thus offers investors the best prices. They contend that opening this centralized market to competition would cause it to fragment, reducing liquidity and price discovery – especially for the shares of medium and small companies.
However, many institutional investors – mutual funds, pension funds, and other large traders – have complaints about trading in the centralized NYSE market.
Among their concerns is the view that their trading interest – either buying or selling-has a greater "market impact" on the NYSE than when it takes place electronically on the ECNs. What institutional traders mean by market impact is that share prices on the NYSE tend to move away from them when the existence of a large potential buy or sell order becomes known in the market; in this case, others anticipate the effect of the order and profit from trading ahead of it, adversely affecting the average price that institutional investors receive in completing a large trade. For this reason, many institutional investors believe that they can generally get better pricing on ECNs, where they can trade anonymously and without revealing the size of their trading interest to others in the market.
However, as long as the trade-through rule exists, it will be difficult for institutional investors to trade NYSE-listed securities on ECNs. This is because ECNs match buy and sell orders virtually instantaneously.
If, as required by the trade-through rule, these orders must be sent first to the floor of the NYSE (because a better price, even for a small number of shares, may be posted there), the delay before execution in that slower market might mean that the original match can no longer be effected. An example will make this clear. Assume that an institutional buyer wants to purchase 5,000 shares of Company A, an NYSE-listed security, that has been posted for sale on an ECN at $30. At the same time, an offer to sell 100 shares of Company A at $29.50 is posted on the floor of the NYSE. Under the trade-through rule, the order must first be sent to the NYSE to clear the 100- share offer before it can be executed for the full 5,000 shares on the ECN. Some surveys indicate that it takes an average of twelve seconds for the NYSE specialist to respond to an order, if it is executed at all. By that time, for several reasons, the original offer at $30 may be gone. Thus, the trade- through rule seriously impairs the ability of ECNs to compete with the NYSE in trading NYSE- listed securities, and correspondingly deprives institutional investors of the benefits of using ECNs for trading NYSE-listed securities.
It is hard to see how government support for the existence of two entirely different securities market structures can have any rational policy basis. One of these trading formats must, on the whole, be better than the other. It would be one thing if the two structures were competing – if, for example, NYSE-listed securities could be traded on Nasdaq and vice versa. Then competition would resolve the issue: the best overall system would win. Competition decides, or the systems become so specialized that they serve important submarkets. But it is unusual in the heavily regulated securities market that government regulation seems to prevent competition by perpetuating support for two different structures so that competition between them cannot resolve the question of which is best for investors and public companies.
So what we have here is a complex policy debate, revolving around questions such as these: Will a centralized market like the NYSE deliver better services to investors over time than a competitive market like Nasdaq? If the trade-through rule were eliminated, would the ECNs out-compete the NYSE as they out- competed Nasdaq? Would that be a bad thing or a good thing for investors or for companies of varying sizes that list their shares for sale? There is little doubt that ECNs are a benefit to institutional investors; the benefits they offer to individual investors are less clear. Should the securities market be structured so as to provide benefits to institutional investors over individual investors, or the other way around? Should this question be answered through a regulatory decision or through competition?
Into this policy debate stepped the SEC with its market structure reform proposal. Among other things, the SEC proposed in Regulation NMS to allow investors – probably institutional investors – to opt out of the trade-through rule on a trade-by-trade basis. This suggested that the SEC favored competition among trading venues; but then it also proposed to apply the trade-through rule to the Nasdaq market, where it had not been applicable before.
Regulation NMS thus seems completely ad hoc and has many of the earmarks of a political compromise: giving institutional investors and the ECNs a limited opportunity to trade NYSE securities in the electronic markets, while telling those who favor a centralized market and the trade-through rule that all the benefits of the rule will now be available to investors in Nasdaq securities.
This may work as regulatory politics, but it does not work as policy. If institutional investors take advantage of the opt-out provision, it could substantially reduce the role of the NYSE as a central market and thus the benefits a central market is supposed to confer. And if applying the trade-through rule to Nasdaq securities has any effect, it will destroy the benefits that many see in the competitive Nasdaq marketplace. Regulation NMS, then, may be a way of compromising differences among contending groups, but it is not good regulatory policy and it is certainly not real market structure reform.
Peter J. Wallison is a resident fellow at the American Enterprise Institute in Washington, DC. This article is adapted from a version published by AEI in July 2004