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by Erik R. Sirri, associate professor of finance, Babson College, Wellesley, Massachusetts The last decade has witnessed marked change in the way equity securities are traded, especially in the United States. Trades are no longer consummated only on a formal stock exchange but also on a continuum of functionally equivalent trading venues with radically different organizational forms. This paper discusses how equity markets are evolving and the underlying economic reasons for these changes. Sirri argues that two factors, technological progress and the process of regulatory arbitrage, have enabled newer, more efficient organizational forms for stock trading. The first of these factors—new communications technology, including the Internet—has lowered the cost of gathering order flow from remote points and made it much more profitable for brokers to handle the small orders of retail investors. Also, this technology has made the cost of creating a new trading platform quite small. Computerized markets use the Internet for connectivity, obviating the need for dedicated networks. The second factor behind changes in equity markets relates to regulatory arbitrage between traditional exchanges and broker-dealers. New entrants into the trading platform business—electronic communication networks (ECNs) and alternative trading systems (ATSs)—offer quasi exchanges that, for regulatory purposes, are organized not as exchanges but as broker-dealers. The reason for this organization is an issue of cost. Not only do traditional exchanges bear the costs associated with a physical infrastructure, but such exchanges are subject to more stringent SEC regulations and must perform a host of regulatory functions. Being organized as broker-dealers allows the new ECNs to escape the regulatory tax associated with being an exchange. However, the proliferation of trading venues has brought attendant problems. Markets have fragmented as new entrants unbundle the standard package of services offered by traditional exchanges and compete for only the most profitable portions of the business. This development has posed challenges for federal regulators such as the SEC, which would like to foster competition and encourage innovation. It has also altered the competitive positions of brokers that are customers of the exchanges. Sirri argues that changes in market structure have had a profound impact on the discovery and dissemination of prices. He discusses four pricing issues raised by these changes: (1) determining the criteria for broker-dealers’ best execution of orders for their customers; (2) the segmentation of markets into different exchanges, creating various prices even in well-functioning markets; (3) price validity in markets fragmented by time and location; and (4) the price of the price—the fees associated with the sale and delivery of market data. Policy toward pricing issues is only part of the larger question of what to do with the structure of markets and exchanges. Policymakers have several choices: to sit on the sidelines and watch the various contestants, new and old, battle for market share; to step in and attempt to guide the evolution of the marketplace; or to keep to a middle ground, intervening only to ensure fair competition and transparency. |
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