The National Market System

The Securities Act Amendments of 1975 directed the Securities and Exchange Commission to implement a national competitive securities market. Such a market would entail centralized reporting of transactions and a centralized quotation system, and would result in enhanced competition among market makers. In 1975 a "Consolidated Tape" began reporting trades on the NYSE, the Amex, and the major regional exchanges, as well as on Nasdaq-listed stocks. In 1977 the Consolidated Quotations Service began providing online bid and asked quotes for NYSE securities also traded on various other exchanges. This enhances competition by allowing market participants such as brokers or dealers who are at different

CHAPTER 3 How Securities Are Traded 75

locations to interact, and it allows orders to be directed to the market in which the best price can be obtained. In 1978 the Intermarket Trading System was implemented. It currently links 10 exchanges by computer (NYSE, Amex, Boston, Cincinnati, Midwest, Pacific, Philadelphia, Chicago, Nasdaq, and Chicago Board Options Exchange). Nearly 5,000 issues are eligible for trading on the ITS; these account for most of the stocks that are traded on more than one exchange. The system allows brokers and market makers to display and view quotes for all markets and to execute cross-market trades when the Consolidated Quotations Service shows better prices in other markets. For example, suppose a specialist firm on the Boston Exchange is currently offering to buy a security for $20, but a broker in Boston who is attempting to sell shares for a client observes a superior bid price on the NYSE, say $20.12. The broker should route the order to the specialist's post on the NYSE where it can be executed at the higher price. The transaction is then reported on the Consolidated Tape. Moreover, a specialist who observes a better price on another exchange is also expected either to match that price or route the trade to that market.

While the ITS does much to unify markets, it has some important shortcomings. First, it does not provide for automatic execution in the market with the best price. The trade must be directed there by a market participant, who might find it inconvenient (or unprofitable) to do so. Moreover, some feel that the ITS is too slow to integrate prices off the NYSE.

A logical extension of the ITS as a means to integrate securities markets would be the establishment of a central limit order book. Such an electronic "book" would contain all orders conditional on both prices and dates. All markets would be linked and all traders could compete for all orders.

While market integration seems like an desirable goal, the recent growth of ECNs has led to some concern that markets are in fact becoming more fragmented. This is because participants in one ECN do not necessarily know what prices are being quoted on other networks. ECNs do display their best-priced offers on the Nasdaq system, but other limit orders are not available. Only stock exchanges may participate in the Intermarket Trading System, which means that most ECNs are excluded. Moreover, during the after-hours trading enabled by ECNs, trades take place on these private networks while other, larger markets are closed and current prices for securities are harder to assess. Arthur Levitt, the chairman of the Securities and Exchange Commission, recently renewed the call for a unified central limit order book connecting all trading venues. Moreover, in the wake of growing concern about market fragmentation, big Wall Street brokerage houses, in particular Goldman Sachs, Merrill Lynch, and Morgan Stanley Dean Witter, have called for an electronically driven central limit order book. If the SEC and the industry make this a priority, it is possible that market integration may yet be achieved.

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