In late February, the Securities and Exchange Commission (SEC) published Regulation NMS, a long-awaited proposal for reform of the US securities market. There is little doubt that reform is overdue. The last major restructuring of the securities markets occurred in 1975, when Congress adopted a plan for a national market system that contemplated competing securities exchanges; as then conceived, shares listed on the New York Stock Exchange (NYSE) – where most shares were then listed – could be traded on any other exchange, and all exchanges were floor-based auction markets.
Since then, there has been a virtual revolution in the securities markets. An informal dealer market that traded non-listed securities over the counter in 1975 became a formalized dealer market known as Nasdaq and attracted listings from a large number of companies; entirely new computerized order-matching venues (known as electronic communications networks, or ECNs), arose to challenge the Nasdaq dealer market; and in response, Nasdaq itself became a fully electronic market. So fierce is the competition among trading venues in the Nasdaq market, that Nasdaq itself now trades less than 20 percent of Nasdaq-listed shares; most of the rest are traded on the ECNs. Meanwhile, the NYSE became the dominant trading venue for NYSE-listed securities, and has no significant competition. About 80 percent of all trading in NYSE-listed stocks takes place on the NYSE. The competing markets Congress envisioned never developed.
There are complex reasons for this, but SEC regulatory decisions are probably an important factor. Since 1975, the SEC has approved rules – such as the so-called trade-through rule – that have tended to support the dominant position of the NYSE in trading NYSE-listed securities. The trade-through rule requires that orders to buy or sell securities listed on any registered stock exchange be sent for execution to the market where the best price is posted. Because the NYSE is the largest and most liquid market for these securities, its prices tend to be the best, and most orders flow there first. Thus, the trade-through rule has reduced the likelihood that any serious competition for the NYSE would arise.
As originally formed, Nasdaq was a dealer market; it consisted entirely of dealers who made markets in securities that were not listed on any exchange by offering to buy or sell shares as principals. Since Nasdaq was a dealer market, it was not subject to the trade-through rule and was thus vulnerable to competition from a source that offered superior services or other advantages.
Such a competitor appeared in the late 1990s, when ECNs began to offer computerized matching of offers to buy or sell Nasdaq-listed securities. Over time, as institutional investors found that they could effect trades at lower cost with better pricing on the ECNs, these competitive trading venues began to drain market share away from the dealers who made up the Nasdaq market. In a bid to remain a viable market, Nasdaq sought approval from the Securities and Exchange Commission to become a privately owned electronic market, competing with the electronic communications networks, or ECNs, for market share in Nasdaq securities.
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