Speech by SEC Staff:
This was prepared for the Luncheon Address on May 6, 2005 at the Market Microstructure Meeting of the National Bureau of Economic Research in Cambridge, Massachusetts. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a real pleasure to speak at today's luncheon at the National Bureau of Economic Research's Market Microstructure Meeting, as I have been an active participant in these meetings for many years. I'd like to thank Bruce, Duane and Subra for the invitation to speak this afternoon at this excellent conference, before so many old friends and colleagues.
Today, I'd like to describe several of the broad themes and tradeoffs in market microstructure that I view as especially important, building upon my experiences over the last ten months as Chief Economist of the Securities and Exchange Commission as well as my work as an academic with a strong interest in market microstructure and the organization of trading. I want to emphasize several ideas and themes that cut across many microstructure issues: in particular, the ideas of (a) competition across platforms vs. competition for executing against an individual order, (b) the potential desirability or costs of internalization and counterparties to trade being intermediaries and (c) market transparency. Each of these is a very powerful concept. The leverage they provide in informing market design can be especially high as they are relevant across a broad range of important market design and regulatory questions. In my remarks I also plan to point to some markets whose market structures have been relatively less explored than our equity markets as I feel that the margins for further progress in these continue to be relatively large. My choices of subject matter this afternoon are motivated by trying to spur research on dimensions that I anticipate would be especially important for policy-making.
At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not necessarily those of the Commission, individual Commissioners, or my colleagues on the staff. I also wish to point out that my use of examples is intended to elucidate and make clearer the broad economic themes that I'd like to highlight to you rather than as commentary upon past or pending issues that the Commission or its staff has or may need to address in the future.
Some of the broad ideas upon which I'd like to focus include the nature of competition in securities trading and the important distinction between competition for a particular order and competition among platforms. A central tenet in the economics discipline is to emphasize the beneficial consequences of market competition and mitigating market frictions and impediments to competition. Yet in many trading contexts the core issues concern what type of competition is most significant and should be promoted. Should our market institutions focus upon enhancing competition at the "high frequency" order-by-order level or competition among platforms with alternative designs or pricing? This is at the heart of much of the debate about inter-market competition and fragmentation. An important aspect of this is the nature and definition of the relevant market-are we focusing upon the market for purchasing shares of Company XYZ or the market in which the investor trades are executed? This is a recurring theme in market microstructure. Should we be primarily interested in promoting competition among rival platforms over time or among the orders at a point in time? The importance of dynamic competition and innovation rather than a sole focus upon static competition is often stressed in microeconomic textbooks and in industrial organization economics. Related to this, I have learned a "four-letter" word in market microstructure from my experiences in Washington, D.C., it's pronounced "CLOB," i.e., consolidated limit order book. At a broad level I feel that the negative view of a CLOB reflects a healthy respect for the importance in principle of dynamic competition across platforms.
At the same time there also is recognition of the importance of competition for individual orders as emphasized in Glosten's (1994) treatment of "the inevitability of an electronic limit order book." Many of the developments in the marketplace over the years have been motivated by the desire to enhance the competition facing individual orders. The trade-through rule adopted by the Securities and Exchange Commission is only the most recent example. An excellent much earlier example of this is the "order-handling rules," adopted in the aftermath of concerns about monopolization by Nasdaq market makers, which was strikingly pointed out to policy makers by the important academic work of Christie and Schultz (1994) and Christie, Harris and Schultz (1994). The development of Electronic Communications Networks in the last several years certainly reflects reinvigorated competition among platforms and also potentially an additional approach to increase the ability of consumers to access orders directly and also enhance the competitive environment experienced by individual orders. Nasdaq's development of SuperMontage has reflected an attempt by Nasdaq to create a more consolidated environment for displaying and trading individual orders. Rather than the traditional view that competition for individual security transactions and competition among platforms are in conflict, here we have a situation in which competition among platforms, i.e., the Nasdaq and its direct ECN rivals, leads to more competition and interaction at the individual security order level.1
Traditionally, it has been argued that the goals of promoting competition across platforms and competition for individual orders have been viewed as being in conflict. One of the major objections by critics of the Securities and Exchange Commission's recently adopted "trade-through" rule has been along these lines, i.e., the rule would discourage innovation by the various trading markets. In fact, with the benefit of just a modest degree of hindsight I would argue that this is not the case. The proposed mergers between the New York Stock Exchange and Archipelago and also between Nasdaq and Instinet illustrate that this need not be the case. By matching various types of intellectual capital and trading processes, platforms are now continuing to innovate. In these instances arguably some of the spur towards innovation is regulatory action. Even the Wall Street Journal, whose editorial page has been a prominent critic of the extension of the trade-through rule to Nasdaq, recently offered at least back-handed praise of the Securities and Exchange Commission's reformulation of the trade-through rule as it applied to the New York Stock Exchange and indirect efforts to press the New York Stock Exchange to innovate and transform the operation of its trading floor.2 Analogously, some observers associated the New York Stock Exchange's proposed "Hybrid Market" last summer with the NYSE's need to be sufficiently electronic for orders at the exchange to benefit from the order protection offered under the trade-through rule, as originally proposed in February 2004. My takeaway from these events is twofold: First, (a) well-placed regulatory changes can affect innovation and more specifically that (b) enhancing competition in the market for the shares of the underlying businesses being traded need not conflict with innovation among competing platforms. Requiring markets to expose orders to the competing prices offered on alternative platforms forces platforms to address how they compete for business.
Some prominent policy-makers in Washington, D.C. find that reference to particular time series offers much salient information.3 In reflecting upon changes and anticipated changes in the design of equity markets I think that an interesting summary example of data is the recent trend in New York Stock Exchange (NYSE) seat prices (see Figure 1).4 Among the events spurring the decline in seat prices in 2003 were reports alleging improper specialist inter-positioning and the spillover from the controversy about the NYSE CEO's executive compensation package. Perhaps more interesting from the perspective of this presentation is the substantial decline in seat prices during 2004 as Regulation NMS and especially the trade-through rule were proposed and moved towards ultimate adoption by the SEC in April 2005 and in response the NYSE developed its hybrid model, which was widely viewed as the NYSE's encouraging electronic competition against the specialist and decreasing the potential economic rents that might be enjoyed by the specialist. Much of the decline in seat values in 2004 is arguably related to perceptions of decreasing rents that specialists and floor traders would be able to earn.
At least as striking is the run-up in seat values in 2005, which had bottomed out at about $1 million and reached approximately $1.6 million at the time that the SEC adopted Regulation NMS. Even at the higher level the purchase of a seat appears to have been an attractive investment, as emphasized by the 60% increase in seat prices in the two weeks since the announcements of the merger between the New York Stock Exchange and Archipelago and the related decision of the NYSE to go public! Of course, the movement earlier in the year may have reflected anticipations that the NYSE would need to innovate and/or go public and therefore, ultimately raise the market value of its seats. There is an interesting ambiguity in the recent increase in the market value of the seats. Does this reflect larger rents that could be earned by the intermediaries or does it reflect an improved market structure that adds significant value and is able to compete more effectively with other platforms? Of course, the implications of these alternatives are quite distinct.
In reacting favorably upon the merger in (the current issue of) Business Week, Terry Hendershott commented, "Would we be better off if we had 10 equally size auction or better off because buying and selling is concentrated on eBay?" and answering his own question said that "As long as eBay's [fees] don't get too high, we are better off that way."5 This speaks in an interesting way to some of the key trade-offs involving consolidation vs. fragmentation and frankly, one of the central concerns associated with too much consolidation. Indeed, since the announcement of the merger between Archipelago and the New York Stock Exchange as well as that between Nasdaq and Instinet, some commentators have expressed concern about the viability of the regional exchanges and more specifically, whether the dominant trading platform will face sufficient market competition.
Of course, there is an extensive academic literature on the subject of inter-market competition and fragmentation. There is a very interesting literature on some of the recent trade-offs-important aspects of this work are summarized in my survey with Bruno Biais and Larry Glosten (Biais, Glosten and Spatt (2005)). My purpose today was not to review this work or the broader academic literature, but to show how the issue of consolidation vs. fragmentation theme is at the core of an array of central policy issues in market structure.
To what extent is internalization desirable and when it should be encouraged or allowed? In the trading process intermediaries, such as market makers and specialists, play an important role, especially when there are not coincident arrivals of potential buyers and sellers of a security. Of course, when there are matched arrivals of buyers and sellers the investors find it useful to trade directly with one another and indeed, under such conditions market intermediaries should not undercut the trading dynamics. However, in various contexts intermediaries are able to match the prevailing quote and obtained a desired execution. Of course, this limits the ability of customer orders to directly interact with each other, which may widen market spreads. In my survey with Biais and Glosten (Biais, Glosten and Spatt (2005)) we suggest that this is analogous to "price matching" in industrial organization economics and that price matching can be anti-competitive in market equilibrium. For example, firms do not need to quote aggressively if they have the opportunity to match the market price only when necessary to attract the marginal sales. Consequently, in the market microstructure context that means spreads are artificially high. Yet, the empirical consequences of internalization are much more nuanced.6
Many policy innovations have been designed to reduce the extent of internalization of orders and increase the interaction of customers in the marketplace. Benefits to the investing public can arise from both tighter spreads and a reduced need to trade against intermediaries.7 Measuring the extent to which a customer order interacts with customer orders as compared to when the customer order is executed by an intermediary and assessing the resulting size of the spreads is important to the evaluation of many policy interventions. Among the range of issues for which attention to internalization is relevant have been the order-handling rules, payment for order flow, inter-positioning by the specialist, auto-quoting and the ability of the specialist to stop the market, market fragmentation, market data revenues, dealerization of the bond market, price improvement programs such as the innovative structure currently being used on the Boston Options Exchange8 and the definition of an "exchange." As you can see, many of the same concepts and principles apply to an important range of market structure questions. For example, the SEC currently has a Concept Release seeking feedback concerning the allocation and determination of market data revenues. In the past these revenues have influenced the degree of fragmentation of the marketplace.
An important theme with applicability to a variety of market design issues is the potential importance of transparency of the underlying markets in which the instruments trade. As with my earlier topics, transparency relates to how orders are exposed to the market and indirectly, the role of rents captured by the various players in these markets. Economists tend to feel that both pre-trade and post-trade transparency are relevant to the competitiveness of a trading platform. Pre-trade transparency relates to whether quotes and potentially even the order book are available to investors at the time of the trade, while post-trade reporting refers to the rapidity of reporting of the trade after the fact. By increasing the investor's knowledge about market conditions, the competitiveness of the underlying trading market can ultimately be enhanced by post- and even pre-trade transparency. For example, economic intuition suggests that the absence of trade reporting gives dealers considerable market power because it limits the investor's understanding of the size of the spread and the state of the market. In fact, Green, Hollifield and Schurhoff (2004) use a structural model to econometrically identify the market power parameter and show that much of the spread in the municipal bond market is due to market power. The usual argument against transparency is that dealers need time to work large orders; if this argument were correct it would suggest that the spreads and price impact of large orders would be substantially greater than for small orders. The contention that the results reflect market power rather than the costs of working large orders seems greatly enhanced by empirical evidence in various market contexts that the size of the spread in both the municipal and corporate bond markets is much greater for retail executions than for institutionally--sized trades.9 From this perspective, the evidence presented this morning in the paper by Bessembinder, Maxwell and Venkataraman (2005), that transparency dramatically reduces even institutional bond trading costs, is quite striking.
The evidence of larger spreads for smaller orders is in sharp contrast to equity markets, where large orders have much larger price impact than smaller orders. Of course, in equity markets the context in which transparency is often evaluated is not whether there is ex-post dissemination of trade reports (which there always is), but rather the extent to which order information is transparent on an ex-ante basis. A very nice example of this benefit to greater transparency on the NYSE is the analysis from the opening of the limit order book on the NYSE undertaken by Boehmer, Saar and Yu (2004). Frankly, I find it surprising that there has been so little attention to pre-trade transparency in the design of the U.S. bond markets. While some might argue that this is a consequence of the degree of fragmentation in the bond market, I would point to options markets and European bond markets-which are similarly fragmented, but much more transparent on a pre-trade basis.10
While we lack direct evidence about the optimal transparency regime, competition and transparency have proved important in other market microstructure contexts and I anticipate that this will prove to be the case for our bond markets. As pointed out in my survey with Bruno Biais and Larry Glosten, Naik, Neuberger and Viswanathan (1999) offer an interesting argument as to why transparency may be optimal by enhancing risk sharing. While the conventional argument is that trade disclosure can make it harder to supply liquidity to large traders because the market maker is in a difficult position in trying unwind his inventory after a large and difficult order, Naik, Neuberger and Viswanathan (1999) argue that in a transparent system the market maker would not need to scale back the size of the trade (the informational content of the trade would already be reflected in the marketplace), thereby enhancing risk sharing. A similar effect also arises in Vayanos (1999). The empirical evidence in Gemmill (1996) for the London Stock Exchange is consistent with the view that transparency does not reduce liquidity, in contrast to the views of critics of bond transparency.
Of course, one of the fundamental frictions with respect to the bond markets is the spreading of liquidity across many instruments, i.e., market fragmentation. In fact, in a recent keynote address I pointed to how the mortgage-backed securities market has relatively successfully resolved the issue by trading many issues on a generic basis but especially valuable ones on a specific basis, recognizing the inherent potential for adverse selection in a delivery process where various instruments are viewed as substitutes. Also some futures contracts allow settlement based on a range of underlying assets. While a full commitment to trade reporting would strengthen the bond markets in my view, there also are a range of open questions with respect to transparency and optimal market design. As my examples above suggest, a variety of solutions to the liquidity fragmentation problem are conceivable.
Finally, I should also note that the first line of regulation with regard to the degree of transparency is the relevant Self Regulatory Organization (in the case of corporate bonds traded over-the-counter, the National Association of Security Dealers (NASD), and in the case of municipal bonds, the Municipal Securities Rulemaking Board (MSRB)). An interesting facet of this SRO structure in the NASD example is the role of the dealers as members of the committee in defining the market handling of transparency. Dealers have considerable influence and interest in the governance of the bond markets through the SRO structure. How delegation should work in defining the regulatory mechanism does not seem completely clear, especially in light of conflicts of interest by market participants. This raises some fascinating questions of potential interest to academics. In fact, the governance of SROs is the subject of a current SEC Concept Release (2004). Of course, the ultimate success of transparency will reflect market forces as well as regulation. The value perceived by customers helps determine whether the transparent prices are published in the financial press and whether brokers offer these prices to retail investors as a competitive service.
To summarize, I think that the key elements of many of the core market design issues in recent years can be viewed through a lens that emphasizes the extent of inter-market competition, internalization and dealer participation, and market transparency. The skills and sophistication of market microstructure economists with respect to frictions in the trading process are important for evaluating key policy issues.
As I conclude, I also should emphasize explicitly to you the importance of the microstructure of the options and bond markets. As a consequence of both inherent fragmentation and design issues, frictions in these markets are much larger than in the equity markets. Relative to our equity markets, the bond and options markets have been far less analyzed-the marginal value of attention to these markets by researchers is especially high for both academic and policy reasons.
I welcome your questions, both about my remarks and experiences.
Bessembinder, H., W. Maxwell, and K. Venkataraman, 2005, "Market Transparency and Institutional Trading Costs," unpublished manuscript.
Biais, B., L. Glosten, and C. Spatt, 2005, "Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications," Journal of Financial Markets, forthcoming.
Biais, B. and R. Green, 2005, "A Historical Investigation of the Microstructure of the Bond Market," unpublished manuscript.
Battalio, R., 1997, "Third Market Broker-Dealers: Cost Competitors or Cream Skimmers?" Journal of Finance 52, 341-352.
Battalio, R., J. Greene, and R. Jennings, 1997, "Do Competing Specialists and Preferencing Dealers Affect Market Quality?" Review of Financial Studies 10, 969-993.
Boehmer, E., G. Saar, and L. Yu, 2004, "Lifting the Veil: An Analysis of Pre-trade Transparency at the NYSE," Journal of Finance, forthcoming.
Business Week, "The Tremors from Two Trading Titans," May 9, 2005, page 82-83.
Christie, W., J. Harris, and P. Schultz, 1994, "Why did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?" Journal of Finance 49, 1841-1860.
Christie, W. and P. Schultz, 1994, "Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?" Journal of Finance 49, 1813-1840.
Edwards, A., L. Harris, and M. Piwowar, Sept. 2004, "Corporate Bond Market: Transparency and Transaction Costs," unpublished manuscript.
Gemmill, G., 1996, "Transparency and Liquidity: A Study of Block Trades on the London Stock Exchange Under Different Publication Rules," Journal of Finance 51, 1765-1790.
Glosten, L., 1994, "Is the Electronic Open Limit Order Book Inevitable?" Journal of Finance 49, 1127-1161.
Green, R., B. Hollifield, and N. Schurhoff, Feb. 2004, "Financial Intermediation and the Costs of Trading in an Opaque Market," unpublished manuscript.
Harris, L. and M. Piwowar, 2005, "Secondary Trading Costs in the Municipal Bond Market," Journal of Finance, forthcoming.
Keim, D. and A. Madhavan, 2000, "The Relation Between Stock Price Movements and NYSE Seat Prices," Journal of Finance 55, 2817-2840.
Naik, N., A. Neuberger, and S. Viswanathan, 1999, "Trade Disclosure Regulation in Markets with Negotiated Trades," Review of Financial Studies 12, 873-900.
Spatt, C., "Frictions in the Bond Market," keynote address presented at the Second MTS Conference on "Financial Markets: The Organization and Performance of Fixed-Income Markets" in Vienna, Dec. 16, 2004. http://www.sec.gov/news/speech/spch121604cs.htm
U.S. Securities and Exchange Commission, 2004, "Concept Release Concerning Self-Regulation," Washington, D.C.
Vayanos, D., 1999, "Strategic Trading and Welfare in a Dynamic Model," Review of Economic Studies 66, 219-254.
Wall Street Journal editorial, "Really Big Board," April 22, 2005.
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