The New Stock Market

Law, Economics, and Policy

Merritt B. Fox, Lawrence Glosten, Gabriel Rauterberg

• Publisher: Columbia University Press
• Year: 2018
• ISBN:
  9780231543934
• Topic: Law
• Subtopic: Administrative Law
• Index: Law

The U.S. stock market has been transformed over the last twenty-five years. Once a market in which human beings traded at human speeds, it is now an electronic market pervaded by algorithmic trading, conducted at speeds nearing that of light. High-frequency traders participate in a large portion of all transactions, and a significant minority of all trade occurs on alternative trading systems known as "dark pools." These developments have been widely criticized, but there is no consensus on the best regulatory response to these dramatic changes.

The New Stock Market offers a comprehensive new look at how these markets work, how they fail, and how they should be regulated. Merritt B. Fox, Lawrence R. Glosten, and Gabriel V. Rauterberg describe stock markets' institutions and regulatory architecture. They draw on the informational paradigm of microstructure economics to highlight the crucial role of information asymmetries and adverse selection in explaining market behavior, while examining a wide variety of developments in market practices and participants. The result is a compelling account of the stock market's regulatory framework, fundamental institutions, and economic dynamics, combined with an assessment of its various controversies. The New Stock Market covers a wide range of issues including the practices of high-frequency traders, insider trading, manipulation, short selling, broker-dealer practices, and trading venue fees and rebates. The book illuminates both the existing regulatory structure of our equity trading markets and how we can improve it.

Foundations

PART 1

The Institutions and Regulation of Trading Markets

ONE

What are securities markets? They enable businesses to create and sell securities, and then allow the initial buyers of these securities ultimately to sell these securities into a market where they may thereafter be repeatedly bought and sold on an ongoing basis. A security, informally put, is a tradable financial instrument. A financial instrument, in turn, is essentially a contract that provides the contract holder with some kind of claim to the cash flows and/or control of a business. The most familiar of these securities are equity and debt. In the case of equity, the individual or institution who initially purchases the newly issued security provides the corporation with money and in return receives the promise of some bundle of control rights over the corporation and a right to its residual earnings.

Thus, by issuing equities, firms sell claims on their future cash flows in return for money from persons with savings now. This primary market for securities involves the initial transaction between a business and the first purchaser of its securities. All other transactions in that security compose the trading market (also known as the secondary market): the life of that security as it changes hands from one purchaser to another, and where the original corporation that issued the security typically has no involvement. This book is dedicated to explaining this secondary trading market for securities, particularly equities. This chapter starts with a brief overview of what the securities markets do and then focuses on five main topics: the institutions of trade; trading patterns over time; the intermediation of trade; the mechanics of trade; and the basic regulatory system.

I. WHAT DO SECURITIES MARKETS DO?

The trading market serves related but distinct social functions. These are discussed in more detail in chapter 2, but it is worthwhile making a first introduction right at the outset. Importantly, the trading market permits individuals and institutions interested in purchasing or selling securities to do so. This is the most obvious reason for a trading market. The market brings together those interested in buying and those interested in selling. In so doing, a market makes it easier to trade.

A well-functioning secondary market also promotes a healthy primary market because investors will pay more for the securities they purchase in the primary market if they expect that they can easily sell these securities down the road. Individuals’ reasons for trading will be many. They may purchase securities as a place to put savings. Later, they may sell these securities in order to generate cash with which to engage in consumption. They may buy or sell to diversify their investment portfolios across many securities in an effort to reduce risk. They may also execute strategies designed to obtain trading profits based on analyses of public or private information.

If the market is functioning well, trade occurs at prices that reflect the information available about the value of the securities being traded. Such a trading market is informationally efficient, with securities prices that reflect all relevant public information. This produces a public good for society. Individuals in the real economy can look at the prices in the trading market as informative signals: if, for example, the price of a business’s stock is plummeting, this suggests that the business is performing poorly. The board of such a corporation may choose to replace current management, or cancel a project that was just announced and precipitated the fall in price.

II. THE INSTITUTIONS OF TRADE

The idea of the stock market may still conjure images of a stock exchange trading floor in downtown Manhattan, where individuals in colored jackets furiously gesture at one another as fortunes are bought and sold. Today’s trading market, however, is quite different. Before we describe the current market, though, it is important at the outset to see how much the stock market has changed in a relatively short time and to identify the forces that have led to this change.

A. How the Stock Market Has Changed

The stock market is an institution that connects potential buyers and sellers of companies’ stocks. As recently as the early 1990s, trading in the stock of each publicly traded company of any significance was still largely confined to a single venue, either NASDAQ or the New York Stock Exchange (NYSE).¹ At NASDAQ, a dealer was the purchaser of every share sold by a trader and the seller of every share bought by a trader. The dealer did so at quoted prices generated through the calculation and judgment of an individual human being. At the NYSE, where there was an actual floor, the specialist for a stock (also a human being) often played a similar dealer role, but in addition posted quotes sent in by traders willing to buy or sell at stated prices, held auctions, and helped arrange trades by brokers and traders on the floor.²

Today, in contrast, any given stock is potentially traded in each of almost seventy-five competing venues, including twelve exchanges and more than thirty dark pools.³ The NASDAQ dealers and the NYSE specialists are gone. Almost all of these competing trading venues are electronic limit order books, in which a trader can post a limit order, which is a firm commitment (until cancelled) to buy or sell up to a specified number of shares at a quoted price.⁴ A computer (the venue’s matching engine) matches these posted limit orders with incoming buy and sell marketable orders, which are orders that have terms allowing them to execute at what is then the best available price in the market.⁵

Today, high-frequency traders (HFTs) post a significant portion of the limit orders that are matched in this fashion and result in executed trades.⁶ An HFT uses high-speed communications to constantly update its information concerning transactions occurring in each stock that it regularly trades, as well as changes in the buy and sell limit orders for these stocks posted by others on every major trading venue. The HFT automatically feeds this information into a computer that uses algorithms to change the limit prices and quantities associated with the HFT’s own limit orders posted on each of the various trading venues.⁷ More than three-quarters of all trades in the United States are executed on one or another of these electronic limit order book venues.⁸ Most of the remaining trades involve retail orders executed by off-exchange dealers in the process called internalization.⁹

B. Forces for Change and the Role of Regulation

This transformation to the new stock market is a product of the fantastic increases in the speed of communication and calculation that have arisen from the information technology revolution. The new stock market’s particular structure, though, is also due in important part to choices made by Congress and the Securities and Exchange Commission (SEC). The initial impetus for this new market structure goes back to Congress’s adoption in 1975 of the National Market System (NMS) amendments to the Securities Exchange Act of 1934 (the Exchange Act).¹⁰ Multiple, competing trading venues have the upside of the greater efficiency and higher rate of innovation that are likely to arise from competition. They have the possible downside that orders from potential traders may be fragmented among multiple venues, which makes it less likely that willing buyers and sellers can easily find each other and transact. Congress, in its adoption of the NMS amendments, foresaw that improving information technology could significantly reduce this downside by making it easier for traders to see what is going on in each of these venues.¹¹ The NMS amendments pushed the system to develop in this direction, a push that has been consistently supported by the SEC.¹²

This decision favoring multiple venues is unlikely to be reversed in the foreseeable future. Data concerning the speed of trading, its cost, and the apparent amount of liquidity in the system suggest that the new stock market is a substantial improvement over what came before it.¹³ Today’s technology, if it instead were operating within a centralized single-venue system, might of course have led to even greater improvements—a possibility that is the subject of continuing debate among academic theorists¹⁴—but this is entirely a matter of speculation. Moreover, as a matter of political economy, any attempt to reverse the decision for multiple venues would meet stiff resistance from those who have built businesses based on an assumption that the multiple-venue structure will continue. So, to the extent that the criticisms of the new stock market have merit, the challenge will be to design reforms within the current multivenue system.

C. Trading Venues

One of the striking features of the modern stock market, alluded to in II.B, is the complex range of venues on which transactions occur. This section briefly describes this range of venues. An important feature to keep in mind is that the distinctions among venues are in large part an artifact of regulatory classification, rather than following strictly functional lines, a fact to which we will return in greater depth in chapter 9.

Currently, there are three principal types of trading venues: stock exchanges, alternative trading systems (ATSs), and non-ATS off-exchange trade, which is mostly internalization. The most familiar and still the most important venues for trading stocks are the national stock exchanges, of which there are currently thirteen.¹⁵ In aggregate, around 60–65 percent of equity market trading volume typically occurs ...