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by Ananth Madhavan, managing director of research, ITG Inc., New York City, and Charles P. Thorton Professor of Finance and Business Economics, University of Southern California, Los Angeles The Internet has had an impact on the trading environment that is nothing short of revolutionary. Madhavan argues that this revolution is far from over-indeed, that it has been accelerated by a confluence of factors in the securities industry, including globalization, regulatory reforms, and technological changes that temporarily reversed a centuries-old trend toward greater market consolidation. This paper explores the dramatic changes in the trading environment this information revolution has brought about and discusses the role of public policy in this context. In exploring the effect of the Internet on market microstructure, especially in terms of liquidity, Madhavan describes price movements as arising from two fundamental forces: new information flows that induce shifts in the consensus beliefs of traders and frictions arising from the trading process. Price volatility reflects the volatility of both of these forces and their joint interaction, factors that have been profoundly affected by the Internet. Entirely new information sources, such as chat room message traffic and whisper numbers, provide on-line traders with up-to-date information. This "democratization of information" has reduced the information gap between institutional and retail investors. Simultaneously, the growing automation of securities markets has reduced trading costs. Together with the globalization of markets, these factors have induced large numbers of retail traders to enter the market directly. The information available on the Internet serves as a coordination device for on-line traders, who tend to respond in similar ways to the same information signals. The result has been sharply higher intraday price volatility and diminished liquidity along with episodes of outright market manipulation. In the short run, these phenomena represent the dark side of the Internet revolution. But, Madhavan points out, information and automation also allow cross-border linkages that allow traders to access and link pools of liquidity in very disparate forms. Over longer horizons, network externalities provide strong incentives for markets to create both formal and informal linkages, deepening markets and improving price efficiency. Thus, over the long run, the natural forces of competition and technology will solve the same problems that they have created in the immediate present. This is not to say, however, that policy responses are not required. Regulators should not try to mandate market structure, Madhavan argues; rather, they should let the markets evolve by providing users with best execution options that are not related to price, such as speed, reliability, and anonymity. He also suggests that regulators should proactively protect investors by tightening margin requirement for on-line traders and closely monitoring Internet message boards and chat rooms in real time. At a broader level, regulators must look for explicit regulations or policy initiatives that diminish the likelihood of international liquidity crises in financial markets. Madhavan urges regulators to coordinate with policymakers across national borders to craft strategies for acting quickly to supply liquidity if crises do occur. |