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Issue Analysis

    Issue Analysis 97 - Sea-Change at the Stock Exchange

    11/29/1999

    Executive Summary

    Stock markets traditionally have used dealers called "specialists" or "market makers" to match buyers with sellers and post prices that balance supply with demand. Recent changes in NASDAQ market rules introduced competition from "Electronic Communications Networks" (ECNs), which let investors bypass the market makers and make offers directly to other market participants. ECNs reduce the marketplace spread between prices offered to buy and sell stocks, saving investors money. NASDAQ spreads are 10 to 13 percent lower when set by offers on ECNs. In addition, buyers and sellers matched through an ECN avoid paying the spread altogether, Commission rules. This change would make it easier for them to trade stocks listed on the New York Stock Exchange, in competition with NYSE market makers. reducing transaction costs by as much as 95 percent. ECNs also give investors better information about others’ offers to buy or sell, which helps individuals make better investment decisions.

    Some Electronic Communication Networks have applied for recognition as independent stock exchanges under new Securities and Exchange Commission rules. This change would make it easier for them to trade stocks listed on the New York Stock Exchange, in competition with NYSE market makers.

    Established stock markets have proposed big changes to meet this competitive challenge. The two largest – the New York Stock Exchange and NASDAQ – plan to convert from member-owned organizations to shareholder-owned companies. This change would help them raise capital to upgrade their technology and establish new organizational structures that would facilitate innovation and reduce the cost of stock trading.

    In this changing environment, how can regulators best protect America’s 76 million shareholders from fraud and abuse? Ongoing technological and organizational innovations enhance investor protection by increasing competition, improving the availability of information, and creating superior incentives for effective self-regulation. Therefore, regulators can best protect investors by allowing these innovations to unfold.

    Competition at the Stock Market

    To see how financial market innovation affects investors, it is useful to understand how competition currently sets stock prices. Each stock market has one or more dealers for each stock. These dealers are called "specialists" on the NYSE and "market makers" on NASDAQ. They do three things: (1) match buyers with sellers, (2) publicly post prices that they hope will balance supply and demand for the stock, and (3) stand ready to buy and sell at the posted prices.

    Dealers make their money on the spread between the price at which they offer to buy a stock and the price at which they offer to sell. In this sense, the specialist or market maker is like a used car dealer. A used car dealer makes more money if there is a large spread between the price he pays and the price at which he sells. People choose to buy from used car dealers because they provide a valuable service: it is more convenient to shop at a dealership than to shop through the newspaper classifieds. Similarly, going to a specialist or market maker at the stock exchange is much simpler than phoning a bunch of different brokers to see who has orders to buy or sell at various prices. The spread compensates these dealers for their willingness to serve as a buyer or seller of last resort.

    The United States has three primary stock exchanges that each trade different stocks: the New York Stock Exchange (NYSE), the American Stock Exchange, and NASDAQ. Other stock exchanges, such as Philadelphia and Chicago, primarily trade stocks that are also listed on one of the big three exchanges. The New York and American Stock Exchanges have a single specialist for each stock that trades on the exchange. But even a sole dealer in a stock on an exchange faces at least three types of competition: dealers on other stock exchanges, floor traders, and limit orders. The NASDAQ market also features multiple market makers on the same exchange and competition from relatively new players called "Electronic Communications Networks."

    Competition between exchanges

    Many stocks are traded on more than one exchange, so even a single specialist on an exchange must compete with those on other exchanges. To fill an investor’s order for Procter & Gamble stock, for example, the broker can go to the NYSE, one of the regional U.S. stock exchanges, or in some cases, an overseas stock exchange.1 To get business, the NYSE specialist has to offer prices at least as good as those offered by specialists on other exchanges that trade the same stocks. This is not just a nice theory; economic studies find that dealers do improve their prices to attract business away from other dealers and exchanges.2

    Floor traders

    Traders on the floor of the stock exchange can also offer to buy or sell stock. These traders may represent other investment firms or institutional investors, or they may even be professional speculators hoping to make a profit through daily trading activity. Unlike specialists, floor traders do not have an obligation to buy and sell at posted prices.

    Limit orders

    A third form of competition comes from "limit orders." A buyer who places a limit order specifies the maximum price he or she is willing to pay. Similarly, a seller’s limit order specifies the minimum price at which he or she will sell. To get business, a dealer must offer prices that are competitive with those represented by limit orders. (If an order simply states the investor will buy the stock at the prevailing market price, it is called a "market order.")

    Due to these forms of competition, dealers do not even make a majority of the stock trades in the market. A 1996 study estimated that NYSE market orders were filled through trades with the specialist only 18 percent of the time. Floor brokers received the trade a little more frequently, 22 percent of the time. A whopping 55 percent of market orders were filled through trades with publicly-displayed limit orders, 4 percent with other market orders on the NYSE’s electronic order system, and 1 percent through trades on other exchanges.3 These figures seriously understate the importance of competition from other exchanges, because they include only market orders sent to the NYSE. If orders sent directly to the other exchanges were included in the figures, the specialists’ share of trades would be even smaller.

    Multiple market makers

    NASDAQ market makers also face competition from other market makers on the same stock exchange. Unlike the NYSE, which is a physical place, NASDAQ is an electronic market that links market makers and brokers via computers and telecommunications. Each NASDAQ stock has a potentially unlimited number of market makers. The actual number of market makers varies widely, depending on the type of stock. The largest 1 percent of companies listed on NASDAQ have an average of 47 market makers each. The smallest 10 percent of companies average five market makers apiece. The average number for a NASDAQ stock is 11.4

    Electronic Communications Networks

    Electronic Communications Networks (ECNs) allow brokers and investors to bypass dealers and transact directly with others in the market who want to buy or sell. If specialists and market makers are like used car dealers, ECNs are like classified ads. Some people choose to buy or sell cars through newspaper or Internet classifieds precisely because they do not have to pay a spread to a dealer. Sellers get a somewhat higher price, and buyers pay a somewhat lower price, than they would if they used a dealer as an intermediary. In the car market, buyers and sellers using the classifieds tolerate some additional inconvenience in exchange for the better prices. In the stock market, ECNs dramatically cut the cost and improve the ease of transacting directly with another buyer or seller.

    Securities and Exchange Commission Chairman Arthur Levitt has characterized ECNs as "one of the most important developments in our markets in years – perhaps decades."5 There currently are nine ECNs. Prominent players include Instinet, Island ECN, Archipelago, and Bloomberg Tradebook. In September 1999, such networks traded approximately 22 percent of NASDAQ share volume and 30 percent of NASDAQ trades and dollar volume.6 In July 1999, a quartet of major investment firms announced plans to form yet another network.7

    ECNs are not the same thing as online stockbrokers. New, heavily advertised companies like Ameritrade and E-trade pioneered this business, and now even established brokers like Morgan Stanley Dean Witter offer online trading as an option. Online trading simply allows investors to get stock information, review their accounts, and place orders via the Internet instead of walking into a brokerage office or phoning a broker. The broker can use an ECN to execute the order regardless of whether the investor placed the order using the Internet, a telephone, or a visit to a brokerage office.

    Millions of Americans affected

    The organization of stock markets now affects a large and growing number of Americans. There are 76 million shareholders in the United States – a figure equal to 43 percent of U.S. households. As that figure suggests, stock ownership is not just for the rich. Half of all shareholders have incomes of $50,000 or less. The number of shareholders has more than doubled during the past 15 years.8

    Information is Crucial

    Stock prices emerge through the competition of a wide variety of traders – specialists or market makers, floor traders, and institutions and individuals placing limit orders. Effective competition in stock trading requires widely available information about competing offers. For this reason, dealers’ price offers for each stock are posted in all U.S. exchanges where a stock trades, via a network called the "Consolidated Quotation System." Traders located at one exchange can then offer to buy or sell at another exchange through the Intermarket Trading System. In addition, major stock exchanges publicly post most limit orders. Since 1997, NASDAQ has also publicly posted price offers made by buyers and sellers on ECNs.

    The controversy over NASDAQ pricing practices in the 1990s illustrates the importance of information to competition. A scholarly study published in the mid-1990s claimed that spreads on NASDAQ stocks were artificially high because of dealer collusion. By way of comparison, average spreads fell by one-half to two-thirds when stocks traded on NASDAQ moved to the NYSE or the American Stock Exchange.9 Spreads for comparable stocks on the NYSE were about half as large as spreads of their NASDAQ counterparts.10 The high spreads partially reflected market makers’ higher costs of holding NASDAQ stocks, but some researchers believe the spreads were excessively high even after taking this factor into account.11

    Collusion may or may not have been a big factor, but poor information certainly widened the spreads. NASDAQ, unlike the NYSE, did not publicly post limit orders. Instead, limit orders were treated as private orders sent to market makers. Market makers could also make buy and sell offers on ECNs that were better than their public offers. Since limit orders and offers on ECNs were concealed from public view, market makers did not have to compete with them, and they could maintain higher spreads.12

    Since January 1997, Securities and Exchange Commission regulations have required NASDAQ to publicly post the price, and in many cases the size, of limit orders. The requirement includes orders posted on ECNs, and market makers cannot post prices on these networks that are better than the prices they offer on NASDAQ. These changes forced NASDAQ market makers to update their price quotes more than twice as frequently to keep up with the competition – an average of 392,000 updates per day. An additional 195,000 daily updates flow into NASDAQ through ECNs, whose prices previously were not publicized.13

    When the 100 largest NASDAQ stocks became subject to the new order-handling rules, spreads fell by 30 percent virtually overnight.14 More broadly, a NASDAQ study concluded that the 1997 changes reduced average spreads on NASDAQ stocks by between 22 and 33 percent, depending on how the spread was measured.15 A National Association of Securities Dealers study that controlled more carefully for other factors found that the order-handling rules reduced spreads on NASDAQ stocks by between 6 and 29 percent, depending on the type of stock, with a reduction at the median of 20 percent.16

    These reductions benefit individual investors the most, because individual investors are more likely to pay the spreads. Institutional investors, such as mutual funds and pension funds, typically negotiate stock prices when they trade, and so they are more likely to get better prices than the publicly posted spread. Of course, to the extent that downward pressure on spreads gives institutional investors a better negotiating position, they benefit as well. For this reason, some of the benefits of the lower spreads no doubt show up as lower costs or higher returns in individuals’ mutual fund accounts and pensions.

    Electronic Communications Networks and Competition

    Due to the crucial importance of information, ECNs are a powerful competitive force in stock trading. They currently affect competition at the stock exchanges in three ways:

    They offer some investors a lower-cost alternative to trading with market makers.

    They lower spreads in the marketplace by bringing more information about prices at which investors are willing to buy or sell.

    They induce investors to make more accurate price offers by improving the quality and quantity of investors’ information.

    Lower transaction costs from matching limit orders

    ECNs match up investors who place limit orders. When an ECN matches two investors’ orders, they trade without paying a spread. On one leading ECN, for example, clients can trade stocks for one quarter of a cent per share – which means the buyer and seller together pay a half cent per share.17 Spreads on NASDAQ stocks, in contrast, averaged 15 cents per share in June 1999 – a thirty fold difference!18

    Who benefits from this type of trading? The only spread-free trades are those in which both parties have placed limit orders. About half of NASDAQ trading volume involves limit orders, split about equally between individual and institutional investors.19 Of course, just because someone places a limit order does not mean it will get executed, or that the other party will also be someone with a limit order. Since ECNs can only match up limit orders, the volume of orders they match is one good measure of the prevalence of spread-free trading. In September 1999, at least 23 percent of NASDAQ trades occurred as a result of order matching on ECNs. These trades account for about 18 percent of the NASDAQ share volume and 24 percent of dollar volume.20

    Better marketplace information lowers spreads

    ECNs also benefit investors who place market orders by making market participants aware of better price offers. NASDAQ market makers compete against prices available from ECNs. Limit orders posted on ECNs actually determine NASDAQ spreads 6 percent to 15 percent of the time, depending on the type of stock.21 A 1999 study suggests that average spreads are 10 percent to 13 percent lower when set by a quote from an ECN.22 About one-quarter of NASDAQ volume consists of market orders from individual investors, and they are the primary beneficiaries of the lower spreads.23

    Improved investor information

    In the absence of ECNs, an individual placing a stock order has relatively little current price information. Newspaper stock listings simply report the price of the last trade the previous day, sometimes accompanied by the high and low prices for the day. A broker can tell the investor the price of the latest trade, and either the broker or the Internet can furnish charts of past price movements. But the investor knows next to nothing about the prices at which other traders are currently offering to buy or sell the stock, or how many shares others want to buy or sell at various prices.

    ECNs allow individual investors to see others’ limit orders. As a result, the investor understands how many shares are currently available at what prices, and how many shares others want to buy at various prices. An investor armed with this information is in a much better position to decide whether and how to place an order.24

    Consider, for example, the decision of whether to place a market or a limit order. A market order guarantees that the investor will get the stock, but the investor runs the risk of paying a price much higher than expected if the market price suddenly rises before the order is executed. A limit order controls this risk but introduces new risk. If the market price is well above the investor’s limit, there may be no seller. If the market price is well below the investor’s limit, the investor might not get the best possible price.

    This investor can better understand the tradeoffs involved by consulting an ECN. If there are many sell orders at close to the same price, then the odds are good that the investor can get a pretty predictable price with a market order. If prices vary more widely, then the investor might want to place a limit order to prevent a nasty surprise due to a sudden price run-up. Viewing others’ limit orders also helps the investor decide what price to put on his or her own limit order.

    The used car market again provides a useful analogy. An investor who places a market order after looking at yesterday’s prices in the paper is like a car buyer who agrees to buy at some unknown "market" price after looking up a car’s Blue Book value. An investor using an ECN is like a car buyer who consults the classifieds to find out what models and prices are currently available in the market.

    A Lower Cost Stock Market?

    Although ECNs have delivered significant benefits, their impact has also been limited by the fact that they trade mostly NASDAQ stocks. As a result, trading on the networks does not affect spreads on the large-company stocks listed on the NYSE or the growth company stocks listed on the American Stock Exchange.

    That could soon change. Two ECNs – Archipelago and Island ECN – have applied to be recognized as independent stock exchanges, under new rules adopted by the Securities and Exchange Commission in December 1998.

    Transforming an ECN into a stock exchange would be the first step in allowing it to compete effectively trading stocks listed on the New York and American Stock Exchanges.25 As an independent stock exchange, an ECN would be eligible to have its prices posted on the Consolidated Quotation System, forcing specialists and floor traders at the exchanges to compete with those available through the ECN.

    Since stock exchanges already compete with each other, and some even allow multiple market makers, one might question whether the recognition of ECNs would increase competition in any meaningful way. Adding more of the same type of competitors in a highly competitive market may not benefit customers very much. But ECNs do more than that. They offer a lower-cost way of transacting that also produces more and better information for investors. Therefore, the most important effect of ECNs is not that they represent more competition, but that they provide better competition.

    In addition to lower cost, ECNs can also execute trades faster than more conventional stock exchanges. An order delivered to the NYSE through its electronic SuperDot system takes 22 seconds to execute, while an ECN can execute the order in 2 to 3 seconds.26 In today’s fast-paced financial markets, a ten-fold difference in execution time lets investors capture fleeting market opportunities that would otherwise vanish.

    ECNs will not necessarily make specialists and market makers extinct, any more than newspaper and Internet classifieds have eliminated car dealers. However, they do pose a significant competitive challenge. To retain customers, dealers will either have to reduce spreads by cutting costs or find new ways of creating value for investors and brokers.

    Dealers Respond to Competition

    And that is precisely what dealers are trying to do. NASDAQ wants to create a single, centralized, public "book" of all limit orders that would effectively make NASDAQ more like a giant ECN.27 Both NASDAQ and the NYSE have announced later trading sessions. More importantly, both have floated plans to radically alter their organizational structures so they can compete more promptly and effectively.

    The NYSE is currently owned and controlled by member firms who buy seats on the exchange – specialists, investment banks, securities dealers, individual speculators, and other parties. NASDAQ does not have seats, but it too is owned and controlled by the dealers who do the trading. If the NYSE and NASDAQ transfer ownership to shareholders through a public stock offering, their management would then be responsible to a diverse group of shareholders rather than committees of traders. Current traders could own stock, or they could simply use the organized market as a trading venue.

    A force for market efficiency

    The managers of the NYSE and NASDAQ likely proposed stock offerings because shareholder-owned firms are generally more flexible and responsive to change than user-owned firms.

    Such flexibility is especially important in an era of sweeping technological change. Stock markets currently have opportunities to utilize ECNs and other information technologies to cut the cost of trading and give investors better prices. A market owned by traders, however, potentially faces a conflict between traders who benefit from the new technology and traders who profit from the current way of doing things. Converting a stock market to a publicly held, investor-owned enterprise gives its managers a single, clear goal: make their market as efficient as possible to attract the most trading business. The stock offering also generates funds to "buy out" dealers who would otherwise oppose change – much as two business partners might buy out a third who disagreed with their expansion plans.

    Investors should welcome shareholder-owned stock markets. Research on other financial organizations reveals that shareholder-owned firms generally have lower costs and lower probability of failure than user-owned firms.28 The principal reason is that ownership by shareholders makes the organization’s management more accountable for good performance. Since shareholders receive the profits, shareholders owning a large number of shares have strong incentives to monitor managerial performance. Since shares can be sold, owners have strong incentives to maximize the long-term value of the enterprise, rather than grabbing a quick profit. In addition, shareholder-owned companies can offer their employees stock and stock options as an incentive for good performance. Managers of shareholder-owned firms also face the threat of takeovers if they do not do a good job. For these reasons, investors can expect shareholder-owned stock markets to reduce the cost of trading and promote long-term survival of the market.

    New regulatory challenges?

    Stock markets currently practice extensive self-regulation under Securities and Exchange Commission supervision. SEC Chairman Arthur Levitt has raised questions about mixing a self-regulatory organization (SRO) with a for-profit ownership structure: "The potential for conflicts of interest that may arise if the SRO is enmeshed within a for-profit corporation must be defused. At the very least, I believe that strict corporate separation of the self-regulatory role from the marketplace it regulates is a minimum for the protection of investors in a for-profit structure."29 At the very most, others have proposed that stock markets’ self-regulatory responsibilities be merged into a single "super-regulator" overseeing all markets.30

    Stock markets currently enforce an assortment of rules whose intent is to protect investors by constraining certain activities of traders. Some rules are federally mandated, and others are developed by the markets themselves. The SEC chairman and some market observers argue that a market’s management might be reluctant to investigate or discipline a trading firm that also had a large ownership stake in the market.31

    However, it is not at all clear why this kind of undue influence is any more likely in a shareholder-owned market than in a member-owned market. NASDAQ, for example, was censured by the SEC in 1996 because its dealer-dominated oversight committees declined to investigate allegations of questionable dealer activities, such as collusion, failure to honor quoted prices, sharing customer information without informing the customers, and failure to indicate when trades were reported out-of-sequence.32 NASDAQ responded to the SEC’s criticism by making its regulatory operations independent of its market operations and appointing a lot more outside representatives to key committees. These steps might not have been necessary if NASDAQ had been owned by a more diverse group of shareholders.

    A shareholder-owned market likely has stronger incentives than a trader-owned market to promote honest dealing and transparency of price information. A trader-owned market faces a potential conflict between the long-run interest of the institution and the short-run interests of some it its members. The market as an institution benefits by developing a reputation for honest dealing and low transaction costs. A subset of members, however, may find it profitable to oppose moves that improve transparency and lower costs. Such moves could involve anything from technological innovations to enforcement of the market’s own regulations that are supposed to promote investor confidence. It is easier for shady traders to rig the game if only traders own the market. It is harder if shareholders whose profits depend on attracting trading business from other markets own the market.

    Even if some traders owned large blocks of stock in a for-profit stock market, the board and management of the institution would be responsible to all who own shares. Manipulating the market to benefit a subset of owners would invite a lawsuit from the remaining shareholders. For this reason, ownership by shareholders gives a stock market strong incentives to accomplish precisely what regulators want: an honest, low-cost marketplace that retains the confidence of investors.

    It is even possible that the most profitable strategy for a particular market that wants to retain investor confidence is to separate its self-regulatory function from the actual operation of the market, as NASDAQ did under SEC prodding. Unfortunately, we have no way of knowing if this is in fact the best solution unless competing markets are free to adopt or reject it. Imposing it as a regulatory requirement prevents markets from trying other, possibly better, solutions.

    Conclusion

    "This is not a revolution; it’s an earthquake." That’s how Robert Schwartz, a finance professor at Baruch College, summarized ongoing changes in stock trading technology and market organization.33 Frank Zarb, chairman of the National Association of Securities Dealers, apparently agrees, noting, "You will not recognize these markets in five years."34

    While Internet stock brokerage and day trading have garnered most of the headlines, the most important changes in stock trading are happening elsewhere. Aided by information technology, the U.S. stock systems are continuing their gradual evolution toward a single, national system in which everyone from limit order investors to the dealers and speculators must compete to offer the best prices. Even the exchanges themselves will have to compete to offer better prices and services. Electronic Communications Networks have facilitated this trend, and they could deliver even larger benefits to investors if they are recognized as independent stock exchanges. The NYSE and NASDAQ have responded to this competitive challenge by proposing historic changes in their organizational structure via public stock offerings.

    Regulators and legislators can best serve investors by allowing these changes to occur. ECNs save investors money by lowering or eliminating spreads, and they have the potential to give investors more and better information about current market activity. For-profit stock markets will likely reduce transaction costs further as they jockey to attract trading business. For-profit ownership also gives the market’s managers strong incentives to practice effective self-regulation. For this reason, proposals to replace each market’s self-regulation with a "super-regulator" are unwarranted.

    1The five regional U.S. stock exchanges are Boston, Chicago, Cincinnati, Philadelphia, and Pacific. Not all regional exchanges trade all NYSE stocks.

    2Marshall E. Blume and Michael A. Goldstein, "Quotes, Order Flow, and Price Discovery," Journal of Finance 52:1 (March 1997), pp. 237-39; Mark Klock and D. Timothy McCormick, "The Impact of Market Maker Competition on NASDAQ Spreads," NASD Working Paper No. 98-04, pp. 11-12.

    3Katharine D. Ross, James E. Shapiro, and Katherine A. Smith, "Price Improvement of Super Dot Market Orders on the NYSE," NYSE Working Paper 96-02 (March 11, 1996).

    4See September 1999 market maker statistics at (http://www.marketdata.NASDAQ.com).

    5Arthur Levitt, "Dynamic Markets, Timeless Principles," speech at Columbia Law School, Sept. 23, 1999.

    6See September 1999 ATS figures at (http://www.marketdata.NASDAQ.com).

    7The four are Fidelity, Charles Schwab, Donaldson, Lufkin, Jenrette, and Spear, Leeds & Kellogg LLP. See Wall Street Journal (July 22, 1999), p. C1.

    8Richard Nadler, "The Rise of Worker Capitalism," Cato Institute Policy Analysis No. 359 (November 1, 1999).

    9Most of the difference in spreads was accounted for by stocks for which NASDAQ dealers avoided quoting prices in "odd eighths" of a dollar, which was believed to be the rounding method used to widen the spreads. See William G. Christie and Paul H. Schultz," Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?," Journal of Finance 49:5 (Dec. 1994), pp. 1813-40; Michael J. Barclay, "Bid-Ask Spreads and the Avoidance of Odd-Eighth Quotes on NASDAQ: An Examination of Exchange Listings," Journal of Financial Economics 45 (1997), pp. 35-60; Paul Clyde, Paul Schultz, and Mir Zaman, "Trading Costs and Exchange Delisting: The Case of Firms that Voluntarily Move from the American Stock Exchange to the NASDAQ," Journal of Finance 52:5 (Dec. 1997), pp. 2103-12.

    10Roger D. Huang and Hans R. Stoll, "Dealer Versus Auction Markets: A Paired Comparison of Execution Costs on NASDAQ and the NYSE," Journal of Financial Economics 41 (1996), pp. 313-57.

    11Hendrik Bessembinder, "The Degree of Price Resolution and Equity Trading Costs," Journal of Financial Economics 45 (1997), pp. 9-34.

    12Harold Demsetz, "Limit Orders and the Alleged NASDAQ Collusion," Journal of Financial Economics 45 (1997), pp. 91-95. Huang and Stoll, "Dealer Versus Auction Markets," observed, "It is not so much that market makers implicitly collude as that the system provides no incentive for competition, at least in quotes."

    13http://www.NASDAQ.com.

    14Michael J. Barclay, William G. Christie, Jeffrey H. Harris, Eugene Kandel, and Paul H. Schultz, "Effect of Market Reform on the Trading Costs and Depths of NASDAQ Stocks," Journal of Finance 54:1 (Feb. 1999), pp. 1-34.

    15http://www.marketdata.NASDAQ.com/mr_archive_6.html.

    16Numbers calculated by the author based on results reported in NASD working paper 98-02, which examines the effect of the limit order rules and NASDAQ’s 1997 switch from quoting stocks in eighths of a dollar to sixteenths of a dollar. The combined effect was to reduce spreads by 7-34 percent. At the median, the limit order rules accounted for 85 percent of the spread reduction, so they were responsible for a spread reduction of about 6-29 percent. The term "at the median" refers to the spread reduction for a stock that has the median number of trades, price, float, and volatility. In some sense this could be thought of as a "typical" NASDAQ stock, though all four factors vary quite widely. See Jeffrey W. Smith, "The Effects of Order Handling Rules and 16ths on NASDAQ: a Cross-Sectional Analysis," NASD Working Paper 98-02 (Oct. 29, 1998).

    17Hal Lux and Jack Willoughby, "May Day," Institutional Investor (Feb. 1999), p. 45.

    18See "Market Quality Statistics" at (http://www.nasd.com).

    19Conversation with Jeffrey W. Smith, NASD economist, October 1999.

    20Figures for ECN market shares are from "Market Quality Statistics," at (http://www.marketdata/NASDAQ.com). Some ECNs report trades they execute with dealers as part of their volume. However, volume figures for the two ECNs that account for 85 percent of this business – Island and Instinet – include only trades that occurred as a result of customer orders matching on their systems. These two ECNs handled 18 percent of NASDAQ share volume, 22.7 percent of trades, and 24.3 percent of dollar volume in September 1999.

    21Smith, "The Effects of Order Handling Rules," p. 26.

    22Figure calculated from research results in Barclay et. al., p. 16. Examining the first 100 NASDAQ stocks subject to the SEC’s new order-handling rules, this study found that average spreads fell from 23-26 cents/share to 17.9-19 cents/share in cases where ECNs were not involved in setting the spread. When an ECN’s quote set the spread, average spreads fell to 16-16.5 cents/share. Therefore, spreads set by an ECN’s quote were 1.9-2.5 cents/share lower, or 10.6-13 percent.

    23Proportion of market volume accounted for by individual investors placing market orders is from fn. 18.

    24One of the largest networks, Island ECN, even posts its limit orders on the Internet and updates them continuously. To see how this works, go to (http://www.island.com).

    25To get its quotes posted on the Consolidated Quotation System, an ECN must first be recognized as a stock exchange, then receive unanimous approval from its competitors – the other exchanges.

    26Randall Smith, Greg Ip and Charles Gasparino, "Bitter Rivals Jointly Seek Major Changes in the Markets," Wall Street Journal (Oct. 1, 1999), p. C2.

    27Susan Barreto, "ECNs Run Risk of Being DOA," Pensions & Investments (Sept. 6, 1999), p. 10.

    28Benjamin E. Hermalin and Nancy E. Wallace, "The Determinants of Efficiency and Solvency in Savings and Loans," Rand Journal of Economics 25:3 (Autumn 1994), pp. 361-381; James A. Verbrugge and John S. Jahera, Jr., "Expense-Preference Behavior in the Savings and Loan Industry," Journal of Money, Credit, and Banking 13:4 (Nov 1981), pp. 465-76, and the references cited therein. Some studies show that mutual savings and loans have lower costs than savings and loans owned by shareholders; this is most likely because for very small institutions, the efficiency incentives are outweighed by the costs associated with issuing stock. (See Mike Carhill and Iftekhar Hasan, "Mutual to Stock Conversion, Information Cost, and Thrift Performance," Financial Review 32:3 (Aug. 1997), 545-68.) Since stock exchanges are very large organizations, the efficiency incentives will most likely outweigh the costs of issuing stock.

    29Levitt, "Dynamic Markets."

    30Jeffrey E. Garten, "How to Keep the NYSE’s Stock High," Wall Street Journal (Sept.13, 1999), p. A44; Michael Schroeder, "Levitt Studies Plan for Single Market Regulator," Wall Street Journal (Sept.21, 1999), p. C1.

    31"Levitt Has Doubts About NYSE Plan," Washington Post (Aug. 31, 1999).

    32Securities and Exchange Commission, Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the NASDAQ Market.

    33Diana B. Henriques, "Testing an Emerging Market," New York Times (May 12, 1999).

    34Lux and Willoughby, "May Day," p. 48.