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Headline: Equity market structure - Back to the Buttonwood Tree
Source: Euromoney
Date: June 2000
Author: Clare Nickson, Maryana Shteyman
For years the equity markets, especially in the US, have been inefficient and run in the interests of a select few. But new technology has allowed new players, such as electronic communication networks, to challenge the established hierarchy. Is this a revolution, or is technology returning market structures to pure enablers of trades, as they were when the New York Stock Exchange was established under a Buttonwood tree in 1792? The market faces fragmentation followed by rapid consolidation. Clare Nickson reports
The issue of market structures is a growing topic of discussion. The traditional exchanges are the creation of their users - firms primarily concerned with access to centralized pools of liquidity derived from their clients and their proprietary orders. However, despite this access, problems within the exchanges have led to the development of alternative market centres, including ECNs (electronic communication networks). The combination of technology, regulation, and competition from ECNs will drive changes in the structure of the exchanges.
The search for liquidity is placing the European exchanges under increasing pressure to consolidate, (for example the London/Frankfurt merger, and the Euronext alliance between the Paris, Amsterdam, and Brussels exchanges). However, this rash of consolidation is actually leading to further fragmentation, as the remaining exchanges, presumably feeling threatened by the consolidation, seek to form their own alliances.
Fragmentation will be caused in part by regulatory confusion. For example, the planned iX exchange, (an alliance of the London/Frankfurt and Nasdaq markets), intends to have several different platforms for trading in different types of security. This means that instead of one market combining the securities of these three exchanges, there will be several, thus fragmenting liquidity.
In addition to traditional exchanges setting up competing alliances in an attempt to grow market share of liquidity, some retail brokers in Germany and the UK are seeking to set up alternative trading systems. One example of this is the planned launch of Jiway, a joint venture between Morgan Stanley Dean Witter and OM Group.
The consolidation in Europe, and the fact that the European exchanges appear to be further along the road to demutualization than their American counterparts, are providing a competitive spur to NYSE and Nasdaq to gain their footholds in Europe in a meaningful way. We discuss Nadaq's involvement in the iX exchange, and NYSE has recently announced its intention to form a Global Equity Market (GEM) with nine international exchanges, including Euronext in Europe.
The situation is definitely one of flux, and it is difficult to say at this time what the end picture will look like, but it seems clear that further global alliances will develop. It will be interesting to see how the respective alliances make their combinations work, and whether there will be true joining of systems or whether the consolidations will be more strategic than practical
Accelerating change
Adaptation is nothing new for the traditional exchanges: they have gone through many transformations since their conception. However, never before has the pace of evolution been so rapid. Among the prominent issues facing the exchanges now are competition from non-traditional sources and the challenge of developing and maintaining sufficiently advanced technology.
It is inherent problems in the existing structures of the exchanges which have provided the catalysts for change. These problems have been highlighted by several factors. The first and one of the more obvious is the advent of the internet, which lowers costs for consumers. Second is the trend toward globalization and consolidation by the buy side; and third the growth in investable assets, bolstered by the bull market.
It would appear that the retail investor wants execution that is low cost, fast, flexible and available 24 hours a day - not a two-tiered non-transparent market. For institutional investors the priorities are to pay less in commissions, have better dealing cost management, and anonymity. At the same time, consolidation has meant that relative order size has grown. The sell side wants lower exchange costs, easy exchange access, both of which are being provided by alternative trading structures, and large liquidity pools.
Evolution, not revolution
During 2000 and 2001 there ought to be a vast amount of change relating to market structure. Many would say that this is long overdue. Since the signing of the Buttonwood agreement more than 200 years ago which heralded the birth of the NYSE, brokers have given preferential treatment to each other, fixing commissions and restricting access to information about executed trades (the ticker). Throughout that time, the club of brokers has been increasingly criticized for its monopoly on access to and information about the stock market.
In the past 30 years or so, many changes have been wrought, led by increasing pressure from Congress and regulators for cheaper execution and more equal access to the markets for all investors and by the mantra of "best execution." These shifts have generally been evolutionary rather than revolutionary, built on traditional methods of trading rather than the development of a complete new market structure, as has been the case in most European markets. The evolutionary changes have combined with technological advances to give increasingly transparent execution costs and competition, leading to the formation of alternative market centres, often ECNs. This has altered the landscape and has led to the two largest market centres, the NYSE and Nasdaq, putting their structures under review. Existing market participants had developed business models to suit the current structures; now they want the structures to adapt to their interests instead. The challenge for the regulators is to balance the political pressures generated by market participants with the desire to ensure stability and to improve market structures.
The end result is unclear as yet, but it is likely that, at the very least, there will be radical improvements in technology and connectivity at the NYSE and Nasdaq. Institutional, and indeed retail, investors will conduct an increasing amount of their transactions electronically, although this could occur on the traditional exchanges if planned technological advances are effective, with difficult trades - whether illiquid or large in size - going through the more traditional routes of the specialists and market makers. This will lead to further downward pressure on spreads on trading desks.
Another criticism aimed at the existing market structure has been that the interests of institutional investors, and even regional exchanges, were not aligned with those of the NYSE and Nasdaq. Institutional investors were denied access to the best prices, and the various exchanges did not allow other market centres to trade in stocks listed on their exchanges. This left a hole that was filled by the ECNs.
As the exchanges themselves change to satisfy and align with their clients' interests, there is a high probability that the ECNs will morph into other entities (such as exchanges or brokers, for example); otherwise, they will likely be used as order channelers. As for the investment banks, the largest will fare well if they are willing to extend capital to facilitate their customers' trading, as they mitigate risk and are able to find pools of liquidity, whereas investment banks with smaller balance sheets, or those unwilling to use their book to facilitate client orders, may suffer. Last, the different trading structures for NYSE and Nasdaq stocks places an additional cost burden on financial intermediaries. There is no logical reason for the difference and in the medium term it ought to disappear.
Matching deals versus reality
Is liquidity or technology more important? Is there a medium in which both are available? ECNs are emerging at a rapid pace, citing technology as the key that allows them to provide anonymity, lower-cost executions, and liquidity. Is this possible when the NYSE and Nasdaq have such large market shares? A fragmented market will always exist - the question is the balance. It appears that the common ground between the exchanges and the ECNs is the call for price and time priority, meaning that the best price at that point in time gets the priority and that the first order placed is the first filled. It appears that, at the least, there must be improved technological links between market centres.
Despite the advances made by ECNs, it is more probable that the winners will be the traditional exchanges. However, both the NYSE and Nasdaq may look very different by the end of 2001 than they look now. Admittedly the vested interests of specialist and market makers, and the investment banks and retail brokers, will delay change, but change is inevitable. That holds true for the ECNs as well. It appears that the advantage of using a traditional broker and exchange lies in the following services: first, the ability to block trade without market impact; second, the use of the specialist to smooth imbalances; third, the ability to trade less liquid names; and fourth, access to the largest pool of liquidity. Therefore, it would appear that a technology-enabled traditional exchange may be the best solution for a price and time priority market - in fact, back to the Buttonwood tree.
The mantra of "best execution"
As the stock markets globalize and as we move toward decimalization and same-day settlement (T+0), ultimately execution may become more important for institutional investors than best price. In any case, best price is not always a visible market quote, but rather a balance between immediacy, speed of execution, minimal market impact, and anonymity.
It is also worthy of note that an entire industry has grown up around the idea of answering the question of what is best execution, including consultants and performance measurers. The broker is no longer the only intermediary between the ultimate client and the market. In fact, more intermediaries have formed.
The definition of best execution varies client by client, and because of this variation it is the ability to choose how a transaction is executed which will be key in the future. If, for example, the client wants fast execution through an electronic network, and is less interested in price improvement, that option must exist. If, on the other hand the client is more concerned with a better price than the speed and anonymity provided by electronic means, then the traditional model must also exist.
Today, the SEC is considering "artificially" linking together pools of liquidity via a consolidated limit order book (CLOB). The CLOB would move execution away from existing markets, requiring automatic execution based strictly upon price and time priority. Liquidity would remain among the different exchanges and competition would not be inhibited. The traditional markets - particularly if they were demutualized and operated as businesses - would then innovate and would likely see off any competitive threat. That the SEC should implement the reforms it has proposed therefore makes much sense.
In a way, we have not come far from the old world situation of having numerous satellite exchanges surrounding the primary pools of liquidity. The regional exchanges on the whole do not provide much more than an alternative centre to book trades. The ECNs' prime capability is to allow buyers and sellers to meet electronically. Although the ECNs offer many advantages including anonymity and efficiencies of trading, it appears that they are already having to morph into something else in order to survive for the end game. For example, Instinet is structured more like a broker (in terms of offering research), Archipelago is like an exchange, NexTrade also offers price matching in foreign exchange through MatchbookFX.com, and there is still the question of what Island will do to adapt. In large part, these organizations are reliant on retail trading of technology stocks.
The outcome for investment banks
The brokerage firms will have to add value in the execution equation by developing an appetite for risk and by providing access to underwriting. The survivors and the leaders will be those firms with superior risk management systems that are willing to extend their own book to suitable clients and that have access to the broadest range of underwriting product , principally IPOs as well as secondary offers, globally.
Smaller brokers or those less willing or unable to extend their own book (because of less robust risk management systems) will be in a more difficult position. The largest clients will go to the value-added execution provided by the five to seven global bulge bracket investment banks, leaving the smaller clients with perhaps second-tier risk profiles. Hedge fund clients will probably be classed with the larger traditional buy-side companies, given their active trading natures and prime brokerage ties.
In addition to narrower spreads, the Order Handling Rules led to the proliferation of ECNs because if a market maker did not include customer limit orders in his spread, the order had to be sent for display on an ECN. The Quote Rule was designed to address the issue of ECNs being used as an inside market to which investors did not have access. In addition, the broker-dealer community was no longer permitted to communicate with each other about market conditions, as this was deemed to give them preferential access to information. This last point made price discovery more difficult, particularly at the open.
The number of electronic communication networks rose from one in 1969 to around nine today, although there are many variations, such as internal electronic communication networks within sell-side firms. ECNs are passive electronic networks that facilitate the internal matching of bids and offers (using price/time priority) without the necessity of having to send the trade to an exchange or other market centre for execution. Effectively, an ECN is an order-driven stock exchange that is regulated as a broker rather than a stock exchange. ECNs do not have specialists or market makers that help to ensure a continuous market, nor do they extend capital.
Some ECNs are used by both the buy side and sell side directly and are generally thought of as beneficial, as they can lower the cost of execution. Examples of ECNs include Instinet and Island (mainly for retail investors through its relationship with Datek). They were established by their main shareholders to cross-match their order flow and to benefit from their order flow without having to pay dealers.
ECNs developed in response to changes in regulation and inefficiencies in the existing structure. ECNs can add efficiency to the market place by centrally crossing bids and offers. ECNs predominantly operate in Nasdaq-listed stocks at present in part because of the restrictions that have existed on trading NYSE listed stocks, and in part because of the order book nature of NYSE trading. We estimate that ECNs have 30% market share of trading in Nasdaq stocks, at present, and less than 5% of NYSE-listed stocks.
Outside the United States, ECNs are not as much in evidence because European exchanges generally already operate a CLOB, eliminating the economic value added by an ECN. In these countries, ECNs operate more as routing networks to give clients access to an exchange. This last point will have implications for the United States. If either of the two main stock markets develops a CLOB, the role of the ECN would likely diminish.
The development of wholesale intermediaries such as Knight Trimark that provide incentives to retail brokers to trade through them, and Schwab and Merrill Lynch's purchases of specialists follows exactly the same drive. That is to allow retail brokers to gain additional benefits from retail order flow to offset competition driving down explicit commissions while market structures prevent low-cost execution.
Both the NYSE and Nasdaq have announced their intentions to become public companies primarily in order to compete with the new market centres, in terms of investing in technology. At the same time, several ECNs, such as Archipelago and the Island, have stated their intentions to become fully-fledged and regulated exchanges.
The future for ECNs
ECNs are applying to become exchanges in order to gain access to the Intermarket Trading System (ITS) at the NYSE, which would give them direct access to trading formerly elusive NYSE-listed stocks.
Currently, we estimate that less than 5% of NYSE volumes are traded by ECNs. Previously, Rule 390 had prevented NYSE firms from trading securities listed before April 26, 1979, outside of a traditional exchange. However, this protectionist rule has recently been overturned. NYSE chairman Richard Grasso has stated that this rule covered 23% of listed stocks, which accounted for approximately 46% of volume on NYSE.
On December 8, 1999, the SEC proposed that all firms have access to trade all NYSE-listed securities through the extension the Intermarket Trading System (ITS), a network linking the NYSE with the regional exchanges and with Nasdaq, ensuring that the best price is made available. However, because ITS was only introduced in 1978, stocks listed before that time were not included. More recently, the board of the NYSE has stated that the ITS is outdated and that a new system will have to be introduced. Nevertheless, one thing remains certain, the board and the SEC believe that access to this should only be extended to self-regulating organizations (SROs), such as exchanges.
The second reason that ECNs want to become exchanges is that as for-profit exchanges, they may be more efficient than the traditional mutual exchanges, and therefore provide better value for participants. The third reason is that, at present, they are regulated by Nasdaq, which could be viewed as their competitor. Fourth, as an exchange, the ECNs may be able to charge money for market data services. Fifth, they are concerned that their advantage will disappear if Nasdaq and NYSE develop more efficient market structures.
However, it is as yet unknown whether the ECNs plan to go as far as to list companies: this is unlikely as it would involve a significant increase in their costs. And the question over regulation remains unanswered at this point. It is fair to say that we will see consolidation of ECNs in the near future, and maybe not only intra-ECN. We may see more pairings with traditional exchanges or brokers. In the short term there will be more sharing of books by the ECNs.
ECNs are not yet competing with Nasdaq head-on. Rather, they are part of Nasdaq in that they are making it more efficient and therefore enabling higher trading volumes. The ECNs are competing with the market makers, however. This has two important implications for the ECNs: first it raises the question whether Nasdaq will create a CLOB of its own in which orders are automatically matched in price-time priority - which is another way of saying that Nasdaq becomes an ECN itself; and second it is evidence that the market makers and floor brokers are still in the most privileged position regarding information flow.
The issue of market fragmentation
Although the changes wrought by the Order Handling Rules led to a narrowing of spreads, it is not clear whether costs of execution have really fallen for institutional investors. Some market participants believe that the proliferation of market centres through the growth in the number of ECNs, as well as through practices such as internalization of order flow, has increased market fragmentation, which has, in turn, led to an increase in costs of execution.
The regional exchanges lack liquidity and are mainly used as a place to book trades. Similarly, although we have seen the proliferation of alternative trading systems, the bulk of liquidity remains on the principal exchanges, despite the benefits of anonymity and increased speed of execution that alternative trading systems provide. We estimate that more than 80% of trading in NYSE-listed stocks takes place on the NYSE and 70% of Nasdaq trading takes place on Nasdaq. Liquidity remains the key, and although the new alternatives may have higher market shares of trading volumes than do the regional exchanges, the bulk of liquidity is still focused on the NYSE and Nasdaq. The number of market centres is likely to fall again, especially if the NYSE and Nasdaq make the necessary improvements to technology, and if the NYSE, in particular, implements its proposed plan to create the "New NYSE."
The low cost of sending trades to an ECN is illustrated by the fact that the second largest ECN, the Island (which has filed for exchange status), charges around $0.001 per share for limit orders and $0.0035 per share for market orders, compared with approximately $0.06 per share for institutional orders executed through a traditional broker, or even $0.03 per share on the oldest ECN, Instinet. (See table for a more complete list of fees charged by different market centres.) These lower costs are made possible through the lower overhead associated with ECNs, which are not human-labor intensive.
However, there are hidden costs associated with trading using an ECN, including the costs of the technology, getting on the traders' desks, educating users, fragmentation of liquidity, and the opportunity cost associated with scanning market centres for the best price.
Although overhead costs are low for ECNs, their lifeblood is volume. Volumes traded over the ECNs have risen dramatically. However, the data are not clear cut, as some ECNs report volumes that use their system but that are actually executed either on another ECN or on a traditional exchange. Thus far, there has been no creation of an industry standard. That will change, and there will be a convergence or standardization, preceded by consolidation.
There are three methods of paying for order flow: first, the Knight Trimark model of paying retail brokers on a per share basis; second, rewarding liquidity providers; and finally payment in the form of warrants, whereby providers of liquidity are rewarded by an equity stake. We think that the motivation behind the investment in certain ECNs by the broker community is driven by the benefits of payment for order flow, and we expect more debate on this subject. A fragmented market place with internalization and payment for order flow may not necessarily encourage broker-dealers to offer a better price. The NYSE board has called for the ending of the practice of internalization for this very reason. The fundamental disagreement over the issue of internalization on the part of two groups of member firms led in part to the death of the call for a CLOB at the NYSE.
The potential for ECNs
According to Nasdaq, about 30% of Nasdaq trades are routed through an ECN at present, indicating a potential for 70% increase in market share to be gained. However, we estimate that approximately 22% of Nasdaq volume is block trading, which implies execution through traditional exchanges (although some of this block trading is probably aggregated retail volume). About 26% of volume is in illiquid names, and market orders represent an additional 10% of volume. Therefore there is approximately 12% potential increase in market share available to the ECNs. We believe ECNs will never have 100% market share. ECNs currently do not execute a high level of block trading and market orders, nor do they open trading in IPOs.
The ability to trade a large number of shares without impacting the market has long been the proud boast of the traditional brokers and is one of their remaining differentiating strengths. Block trading takes time in part because traders have to react to the market conditions and news regarding the stocks. The question arises whether institutional investors will break up sizeable trades and programme them to be executed automatically over a period of time. This is possible but there is still value in the traditional broker, although a chinese menu approach with regard to products and pricing may well emerge, as on the retail side. Research, IPOs, and risk could all be priced separately in the future but the skills of the traditional broker will likely still be required and technology will be a tool to enable the broker to provide best execution.
Many market watchers believe that the increase in the number of market centres, and hence in market fragmentation, has increased price volatility because having several diverse market centres makes price discovery more difficult as investors have to scan several market centres to ensure best execution. In addition, as the number of trading centres increases, the amount of capital that market makers can commit to each centre becomes smaller, thereby reducing the number of shares that a market maker is able to bid on in each venue. It is unclear whether the benefit of anonymous trading is worth the negative aspects of fragmented market places.
Proponents of fragmentation believe it ensures competition and therefore makes best execution the more likely outcome. But that is more than likely just a short-term phenomenon and the number of competing market centres will shrink and the issue of market fragmentation will become less pertinent over time.
Clare Nickson and Maryana Shteyman are securities industry analysts at UBS Warburg in New York
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