Full text of Uchimoto article:
Trading Securities in the Next Millennium
By William W. Uchimoto
Executive Vice President and General Counsel, Ashton Technology Group
Flash forward sometime early into the next millennium. On Wall Street, tourists anxiously wait to take pictures with the shouting but mute bronze floor trader standing amidst the litter of recreated cancelled order tickets on the Exchange Museum floor. Rubbing the shiny belly of the trader for good luck, a teacher says to her field trip students, ?this was how they used to trade stocks in the last century.?
The days when throngs of traders scurried around in a great hall called a stock exchange may be as numbered as trading outdoors under the shade of a Buttonwood tree. What will America?s stock markets look like in the 21st Century and what forces are shaping their change?
Stock exchanges serve the vital role of creating a common place and time where buyers and sellers can meet to secure for themselves the most favorable and fair prices whenever the impulse to buy or sell stock strikes them. Exchanges must serve all paying customers including Uncle Bob who wants to buy 100 shares of ASTN (Ashton Technology Group) and ABC State Pension Fund that wants to sell 500,000 shares of AOL. Having made their investment decisions, both investors want to execute immediately at prices they believe are available in the market. How markets will accommodate both ?retail? and ?institutional? customers will reveal the look of next century?s exchanges.
The forces that are shaping change today take impetus from visions of Congress and the SEC almost a quarter a century ago. In 1975, Congress mandated the SEC to facilitate the establishment of a National Market System (?NMS?) for securities with the objectives of assuring economically efficient securities transactions; fair competition between brokers and dealers, and between exchanges and other markets; the universal availability of securities information; the execution of investors? orders in the best market; and an opportunity to execute orders without dealer participation. Congress also commented that the linking of all markets through communication and data processing facilities will foster achievement of these objectives.
Soon thereafter, the SEC called for a ?Central Limit Order File.? The File also was described in terms of ?nation-wide price protection for public limit orders.? The SEC cited the File as ?a mechanism in which public limit orders can be entered and queued for execution in accordance with auction trading principles of price and time priority and by means of which such orders can be assured of receiving an execution prior to the execution of any other order by a broker or dealer in any market at the same or an inferior price.? The File initiative was enormously controversial to vested interests in the status quo and deemed to be the ?Black Box? that would ultimately replace the specialist and market making systems and possibly the exchanges that sponsored them. By 1980, the File notion was shelved.
In the late 1990?s, the Internet has made up-to-the-minute stock pricing information, once accessible only to traders and investment professionals, now universally available to millions of ordinary investors. Additionally, web technology has made millions of home computers powerful trading terminals that have ignited the precipitous decline in retail commission rates and the explosive emergence of the on-line trading industry. On another front, SEC ?Order Handling? regulations have squeezed spreads and market making profits by forcing limit orders as well as the market maker?s own proprietary trading interest into public quotes and prohibiting Nasdaq market makers from trading ahead of customer orders. In the wake of increasing volumes, volatility and trading risk, market making commitments are declining and business is increasing through ECNs and other alternative trading systems (?ATSs?) operated on an agency basis by brokers.
ECNs operate on a strict price-time priority, and automatically match buy and sell orders. The best bid and offer of each ECN is available for reflection in public quotes, however, only the subscribers of a particular ECN see all subscriber orders. The automation, transparency and simplicity features of ECNs have spurred the explosive growth of the nine current ECNs which account for approximately 30 percent of Nasdaq volume. In fact, each ECN resembles some of the functionality and structure of the Central Limit Order File envisioned by the SEC so long ago. The problem is that there is not a single ECN that consolidates all of the order flow on one central electronic book and the short term proliferation of ECNs causes marketplace balkanization or fragmentation that is inimical to NMS goals. At this stage, every ECN is scrambling for liquidity and looking to do deals for increased order flow so that it can be the ultimate Super ECN.
While ECNs do their thing, the nation?s largest traditional marketplaces ? the NYSE and Nasdaq ? are not lounging about. The NYSE is exploring direct business relationships with a number of ECNs and last year Nasdaq proposed to build a ?Limit Order File? but was derailed over vociferous objections by market makers and ECNs. One leading ECN asserted that Nasdaq?s initiative would put all ECNs out of business overnight. Nevertheless, Nasdaq threatens to float a new central order book initiative shortly. Once an ECN, traditional exchange or consortium of ECNs and/or traditional exchanges becomes the clear liquidity winner, it has ostensibly become the totally automated, screen-based Central Limit Order File.
While the Central File will technically achieve all the NMS objectives cited earlier, the very openness of the File offering transparency to the world as to order prices and sizes could harm some investors. Uncle Bob will have no problem in placing his 100 share buy order into the File; on the other hand the ABC State Pension Fund manager would need his head examined if he chose to sell all at once the Fund?s 500,000 shares in the File. In this regard, institutions and other large traders are extremely sensitive to market impact costs.
Economics 101 taught us that stock prices are based on supply and demand. In conventional markets, the more shares available for sale at any given time, the lower prices buyers will pay. Accordingly, institutions which place large orders drive up the supply, and drive down the share?s price ? to their own detriment. The bigger the order, the greater the market impact. Moreover, the more disclosure and manual handling of the order before the trade, the more risk that the order can be ?front-run? generating additional adverse market impact. Market impact costs can be 10 times higher than commission costs.
Recognizing threats to America?s capital market supremacy by the increasing number of for-profit, technologically savvy foreign exchanges, the SEC has encouraged U.S. exchanges and brokers to innovate leading edge trading systems. In what amounts to a major deregulatory move, the SEC has recently adopted new rules that reduce the time and cost of bringing new trading systems into the market. The SEC also endorsed the concept of non-member owned, for-profit exchanges to increase competitive opportunities for U.S. exchanges that heretofore have been structured in just the opposite fashion. These sweeping regulatory changes should promote an increasing array of investor products and services, available during expanded hours, and at dramatically lower costs.
Desiring to back the ultimate new exchange paradigm, Wall Street firms are spreading their bets around various ECNs, ATSs and Tradepoint, a London-based electronic exchange. Should the NYSE , Nasdaq and regional exchanges convert to a for-profit status and go public, bets will surely be placed on them as well. The bottom line is that there are now structural changes afoot and spirited competition, alas, to create the Central Limit Order File and specialized, institutional electronic trading systems for both stocks and options, all that are guaranteed to reduce traders? dependency on throat lozenges and comfortable shoes in the next millennium. |
