The Third and Fourth Markets

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The third market refers to trading of exchange-listed securities on the OTC market. Until the 1970s, members of the NYSE were required to execute all their trades of NYSE-listed securities on the exchange and to charge commissions according to a fixed schedule. This schedule was disadvantageous to large traders, who were prevented from realizing economies of scale on large trades. The restriction led brokerage firms that were not members of the NYSE, and so not bound by its rules, to establish trading in the OTC market on large NYSE-listed firms. These trades took place at lower commissions than would have been charged on the NYSE, and the third market grew dramatically until 1972 when the NYSE allowed negotiated commissions on orders exceeding $300,000. On May 1, 1975, frequently referred to as "May Day," commissions on all orders became negotiable.

The fourth market refers to direct trading between investors in exchange-listed securities without benefit of a broker. The direct trading among investors that characterizes the fourth market has exploded in recent years due to the advent of the electronic communication network, or ECN. The ECN is an alternative to either formal stock exchanges like the NYSE or dealer markets like Nasdaq for trading securities. These networks allow members to post buy or sell orders and to have those orders matched up or "crossed" with orders of other traders in the system. Both sides of the trade benefit because direct crossing eliminates the bid-ask spread that otherwise would be incurred. (Traders pay a small price per trade or per share rather than incurring a bid-ask spread, which tends to be far more expensive.) Early versions of ECNs were available exclusively to large institutional traders. In addition to cost savings, systems such as Instinet and Posit allowed these large traders greater anonymity than they could otherwise achieve. This was important to them since they would not want to publicly signal their desire to buy or sell large quantities of shares for fear of moving prices in advance of their trades. Posit also enabled trading in portfolios as well as individual stocks.

ECNs already have captured about 30% of the trading volume in Nasdaq-listed stocks. (Their share of NYSE listed stocks is far smaller because of NYSE Rule 390, which until recently prohibited member firms from trading certain NYSE-listed stocks outside of a formal stock exchange. But the NYSE has since voted to eliminate this rule.) The portion of

74 PART I Introduction

Table 3.5 Major Investors in ECNs



Island ECN

Datek Online


Reuters Group


Spear, Leeds; Charles Schwab; Donaldson, Lufkin & Jenrette


Goldman Sachs; Merrill Lynch, J. P. Morgan

Brass Utilities*

Sunguard Data Systems

Strike Technologies*

Several brokerage firms

*Brass and Strike announced in July 2000 an intention to merge.

*Brass and Strike announced in July 2000 an intention to merge.

trades taking place over ECNs will only grow in the future. For example, the trading giants Charles Schwab, Fidelity Investments, and Donaldson, Lufkin & Jenrette announced in July 1999 that they would form an ECN based on REDIBook, which is an ECN already run by Spear, Leeds and Kellogg, a large stockbroker. Some of the trades of these firms presumably will be moved through the new ECN. Moreover, most of the big Wall Street brokerage firms are linking up with ECNs. For example, both Goldman Sachs and Merrill Lynch have invested in several ECNs. The NYSE is considering establishing an ECN to trade Nasdaq stocks. Table 3.5 lists some of the bigger ECNs and their primary shareholders.

While small investors today typically do not access an ECN directly, they can send orders through their brokers, including online brokers, which can then have the order executed on the ECN. It is widely anticipated that individuals eventually will have direct access to most ECNs through the Internet. In fact, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney have teamed up with Bernard Madoff Investment Securities to develop an electronic auction market called The Primex Auction that will begin operating in 2001. Primex is currently available to any NASD dealer but eventually will be open to the public through the Internet. Other ECNs, such as Instinet, which have traditionally served institutional investors, are considering opening up to retail brokerages.

The advent of ECNs is putting increasing pressure on the NYSE to respond. In particular, big brokerage firms such as Goldman Sachs and Merrill Lynch are calling for the NYSE to beef up its capabilities to automate orders without human intervention. Moreover, as they push the NYSE to change, these firms are hedging their bets by investing in ECNs on their own, as we saw in Table 3.5.

The NYSE also plans to go public itself sometime in the near future. In its current organization as a member-owned cooperative, it needs the approval of members to institute major changes. But many of these members are precisely the floor brokers who will be most hurt by electronic trading. This has made it difficult for the NYSE to respond flexibly to the imminent challenge of ECNs. By converting to a publicly held for-profit corporate organization, it hopes to be able to more vigorously compete in the marketplace of stock markets.

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