Table

Registered Electronic Communication Networks (ECNs)

Archipelago Attain

B-Trade Services The BRASS Utility Instinet Corporation The Island ECN Market XT NexTrade REDIbook

Source: Nasdaq in Black & White, Nasdaq, 2001.

the system. Both sides of the trade benefit because direct crossing eliminates the bid-ask spread that otherwise would be incurred. 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 the traders since they did 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 have captured about 30% of the trading volume in Nasdaq-listed stocks. They must be certified by the SEC and registered with the National Association of Security Dealers to participate in the Nasdaq market. Table 3.5 is a list of registered ECNs at the start of 2001.

While small investors today typically do not access an ECN directly, they can send orders through their brokers, including online brokers, who can then have the order executed on the ECN. Eventually, individuals will likely have direct access to most ECNs through the Internet. In fact, several financial firms (Goldman, Sachs; Merrill Lynch; Salomon Smith Barney; Morgan Stanley; and Bernard Madoff) have combined to build an electronic trading network called Primex, which is open to NASD broker/dealers, who in turn have the ability to offer public access to the market. Other ECNs, such as Instinet, which have traditionally served institutional investors, are considering opening up their services 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.

The NYSE also has announced its intention to go public. In its current organization as a member-owned cooperative, it needs the approval of members to institute major changes. However, 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 challenge of electronic trading. By converting to a publicly held for-profit corporate organization, it hopes to be able to compete more vigorously in the marketplace of stock markets.

fourth market

Direct trading in exchange-listed securities between one investor and another without the benefit of a broker.

electronic communication networks (ECNs)

Computer networks that allow direct trading without the need for market makers.

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, with the aim of enhanced competition among market makers.

In 1975, Consolidated Tape began reporting trades on the NYSE, Amex, and major regional exchanges, as well as trades of Nasdaq-listed stocks. In 1977, the Consolidated Quotations Service began providing online bid and ask quotes for NYSE securities also traded on various other exchanges. This has enhanced competition by allowing market participants, including brokers or dealers who are at different locations, to interact and for orders to be directed to the market in which the best price can be obtained.

In 1978, the Intermarket Trading System (ITS) was implemented. ITS currently links nine exchanges by computer (NYSE, Amex, Boston, Cincinnati, Pacific, Philadelphia, Chicago, Nasdaq, and the Chicago Board Options Exchange). Nearly 5,000 issues are eligible for trading on the ITS; these account for most of the securities 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 Quotation System 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 a 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 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 access. In the wake of growing concern about market fragmentation, some big Wall Street brokerage houses have called for an electronically driven central limit order book. But full market integration has proven to be elusive.

Bond Trading

The New York Stock Exchange also operates a bond exchange where U.S. government, corporate, municipal, and foreign bonds may be traded. The centerpiece of the NYSE bond market is the Automated Bond System (ABS), which is an automated trading system that allows trading firms to obtain market information, to enter and execute trades over a computer network, and to receive immediate confirmations of trade execution.

However, the vast majority of bond trading occurs in the OTC market among bond dealers, even for bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill Lynch, Salomon Smith Barney, or Goldman, Sachs that is linked by a computer quotation system. However, because these dealers do not carry extensive inventories of the wide range of bonds that have been issued to the public, they cannot necessarily offer to sell bonds from their inventory to clients or even buy bonds for their own inventory. They may instead work to locate an investor who wishes to take the opposite side of a trade. In practice, however, the corporate bond market often is quite "thin," in that there may be few investors interested in trading a bond at any particular time. As a result, the bond market is subject to a type of liquidity risk, for it can be difficult to sell one's holdings quickly if the need arises.

Bodie-Kane-Marcus: Essentials of Investments, Fifth Edition

3 How Securities Are Traded

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