Electronic Trading: Rival Or Replacement For

Traditional Floor-Based Exchanges?

Wayne H. Wagner
Senior Advisor, ITG Solutions Network
Chairman, OM/NI, llc.
4/30/2008 19:26:32 a4/p4

More so than for most human endeavors, speed, information, and reliability are valued in
the exchange of securities. Thus advances in automation and communication of vital data
clearly add liquidity value to investors, and exchanges have usually been among the first to
embrace technological enhancements.

Exchange automation began with the stringing of the first Atlantic telegraph cable in 1886,
which reduced order-to-completion time cycles from six weeks to a matter of hours.
Transaction latency reduced by a ratio of roughly 500:1. In recent years, we’ve seen
increases in speed of the same five-hundred-to-one order of magnitude by switching from
manual order submission to DOT, and similar speed enhancements as we move to fully
electronic trading.

Each of these innovations has reduced time delay (latency), decreased implementation
costs, and, by allowing investors to react to ever smaller nuggets of information, enhanced
liquidity.

The catchwords today are efficiency and effectiveness. The buyside is trying to better
coordinate strategy and execution to make the process more effective and efficient. Thus
both buyside and sellside are driven to continual search for higher productivity and lower
cost alternatives. Monitoring effectiveness before, during and after the trade is becoming
universal.

The current debate rages over there remains any need for physical interaction at the
center of the exchange process such as that which occurs on the NYSE, the only one of
the big stock exchanges that still operates a floor.

At year end 2006, news sources are filled with indications that the exchange and the floor
community are hedging their bets: “Floor Brokers Look for Lifeboats;” “Big Board
Specialists Join Forces to Deal Stocks on CBOE;” and, most impressively “Big Board
Plans to Close 20% of Trading Floor.” Barron’s features “Death of the Floor” as the cover
story in its November 20, 2006 issue.

Many believe that floors are obsolete, a premise the NYSE hotly disputes. They believe
that the NYSE hybrid model represents the best of two worlds, and can do a better job
than NASDAQ in trading less liquid stocks.1

1
Davis, Paul L., Michael S. Pagano, CFA and Robert A Schwartz, Life After the Big Board Goes Electronic
Financial Analysts Journal, Volume 62 Number 5, 2006

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It seems too early to predict the demise of the physical trading floor, although the tide is
clearly running against it. As Martin Sexton points out:

The changes at NYSE and elsewhere show the way forward for all exchanges.
Whether or not it follows the route of demutualising and listing, an exchange must
be run as a business, not a club. Sentiment must be replaced by well thought
through business plans that give customers – investors and traders – what they
want. Technology must be used to enable buyers and sellers to come together in a
regulatory environment that ensures honest dealing but doesn't get in the way of
growth. Exchanges that refuse to accept change must recognise that they have no
right to exist and at best will end up as museums living off state subsidies – until the
subsidies are removed.2

As Sexton suggests, demutualization plays a key role in changing the adaptability of an

exchange. The original exchanges were mutual societies dedicated to the interests of the
limited number of participants. Naturally, voting power was retained by the members
whose livelihood -- even their own sense of self worth – was tied to The Way Things Have
Always Been Done. Seatholders would not chose to open the door that would lead to their
own disintermediation and destroys their accumulated human capital. Thus the exchange
was run by the inmates; and attempt to innovate invariably led to tedious arguments,
compromised decisions and vicious power plays.

A good term for the activity that used to predominate on the floor is information central:
When there was interest in a stock, floor brokers would gather around the specialist to
work things out. The floor brokers were representing institutional orders, although they
were usually bound to “best efforts” rather than specific instructions. The institutions had
very little direct control; they relied on the relationship to and clout over the brokerage firm.
They may not even know the name of the person representing their order in the crowd.

The old NYSE design granted the specialist an enormous advantage of seeing more than
anyone else could see about order flow. But the specialist’s role was conflicted –
representing public orders while allowed to trade for his own account. This conflict was
tightly constrained by Exchange rules, but history teaches us that the temptation to exploit
loopholes never goes away. While actual cases of specialist malfeasance have been
remarkably few, each has left a bad taste in the mouths of institutional traders and
regulators.

The operative phrase describing the floor negotiations was “nobody looks bad.” In other
words, the price movements were controlled by the specialist so that everyone got a good
enough deal, presentable to the investors. The floor brokers placed a lot of faith in this
system, but to the investors it looked mighty suspicious.

2
The Handbook of World Stock, Derivative and Commodity Exchanges 2005 Edition.
http://www.researchandmarkets.com/reports/300254/300254.htm#

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The floor was quaint, it was fun, the relationships were rich and rewarding, the sense of
being part of “the greatest market in the world” was intoxicating, and if you were any good
you could make a handsome profit year after year. But to the customers it was opaque,
slow, uncontrollable and prone to mischief. In a casino, the house always wins, and the
nagging thought of institutional traders was that they were the suckers in this game.

It is easy to understand the members’ desire to see the floor live on, in the same way it is
easy to understand nostalgia for steam trains. Walking onto the floor is a magical
experience that thrills all who experience it. The pulse of action, the camaraderie, the
sense that something immensely important is being conducted in a very clever manner
cannot fail to impress. The problem of the exchange floor may be that of the steam train:
while peculiarly both quaint and impressive, they were too noisy, too dirty, too slow, and,
most importantly, technologically outdated.

John Thain’s clever solution to this problem was to buy off the seatholders by buying them
out. In a situation where seat prices had declined from $2.6 million to under one million,
seatholders were attracted to a premium that recognized the value of corporate control.
Substituting a corporate culture for the mutual benefit society gave the exchange the
flexibility to innovate. The quid pro quo to the former members was an attempt to retain a
relevant functionality for the floor in the hybrid market.

Many observers conclude that the floor-based exchanges are outmoded: aren’t all market
places going to be electronic in the near future? Or not?

Assuredly, the floor was a vital institution for centuries, evolving with the changing needs of
its customers. The pace of change is quickening, calling into question the floor’s very
survival. This raises some important questions: Does the floor still add value? Will it
survive? Is the vaulted eye-to-eye interaction truly necessary? Or will the floor population
find it more to convenient to operate the same functions in a computer-filled floor booth, in
an upstairs office or at home in their pajamas?

To answer these questions, we need to consider the value-added functions of any

exchange, and discuss how they have been allocated to the floor. We will explore the
steps that got us to where we are, then discuss what an ideal market might look like, and
conclude with how close to ideal we are likely to come. In the process we will discuss
whether a fully automated exchange is likely or desirable. By “fully automated exchange”
we mean one in which the computer performs, among other automated functions, the
drawing of liquidity and price discovery.

Competition on Commissions, then on Spreads

Some might date the beginning of the demise of the floor (if that’s what it turns out to be) to
the regulatory changes that instituted fully directed commissions on May 1st. 1975.
Everyone knew deep down that commission schedules based on retail-sized orders could
not survive the rapidly growing domination of institutional trading, yet no one knew what
the post May Day world would bring.

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Commissions fell as expected, but the sky didn’t fall as many feared. The fortress was
breached, and the focus of the exchange became far more customer-oriented. Changes in
commission structure were gradual and evolutionary. Commissions fell quickly from
roughly 40¢ per share to half that amount, then gradually slid to the 5-10¢ prevalent in the
1990’s. Institutional investors were pleased, and responded to the lowered commissions
by trading a whole lot more.

The next big change forced on the exchanges came with decimalization and the Order
Handling Rules implemented mid-2001. The preceding years had seen much electronic
innovation both inside and surrounding the exchanges. The infrastructure was highly
developed. The NYSE found ways to speed order introduction to the floor, the NASDAQ
operated happily without a floor, and ECN’s found ways to compete for a portion of the pie.
But cutting the minimum spread changed the trading business profoundly. It became
obvious that the spread, not the commission, facilitated and protected the previous
business structure and incentives.

When spreads fell to pennies, many long-standing broker practices became unprofitable.
NASDAQ marketmakers by the thousands sought new careers, even though institutional
buyside traders bewailed the silence on the other end of the phone line.

Most importantly, the news was not depressing for investors. Institutional trading costs
have declined precipitously since decimalization. According to measurements from the
Plexus Group3 universe of institutional trading, large cap trading costs fell from 1.57% in
second quarter of 2001 to 0.55% five years later, a decline of almost two thirds. Small cap
trading costs fell even more, from 2.54% to 0.79%, The chart shows that despite
decimalization, total transaction costs remained high to the end of the frenzied internet
market. They began to decline steeply in 2003 and have continued downward in recent
quarters, even as the market returns have recovered. Clearly, investors benefited from the
regulation-induced changes.
Cost of US Institutional Trading

250

200

150
Cost(bp)

Large Cap
Small Cap
100

50

0
1998

1999

2001
1997

2000

2002

2003

2004

3
Now part of ITG Solutions Network, LLC.

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The cause-and-effect runs something like this: the buyside, eager to trade at lower cost,
pressures regulators to modify the exchange rules. The regulators set rules that reduce
spreads. As spreads collapse, the sellside pulls capital and people from the now
unprofitable market making function, which makes it harder for the buyside to complete big
trades. Small investors celebrate lower costs, but traders at large investors confront
communication gaps that make their job more difficult.

How, then, are the big blocks previously assigned to institutional brokers for execution to
be done? One popular solution for highly liquid issues is through the use of algorithms.
The most popular algorithms chop large trades into retail sized pieces that can be
completed without human intervention, executed in such a rapid-fire succession that only a
computer can provide the moment-to-moment responses.

While algorithmic trading often gets the job done, it reduces trade activity to tiny
increments and stretches out execution time. A 2001 study performed by Plexus Group
found that 46% of manager orders but 85% of NYSE trade s were for less than 2100
shares. On the other end of the scale, over 35% of the dollars traded by managers were in
trades of over a quarter million shares, while only 1.1% of the dollars traded were in orders
over 250,000 shares.

Benn Stiel4 identifies the mismatch succinctly:

The problem is that continuous electronic auction markets, as useful as they are,
have flaws that are apparent to any institutional trader. They require institutional-
sized orders to be chopped up into small bits, each often as little as 1% of actual
order size, and executed over days or weeks in order to avoid huge market impact
costs. That's why in every major US or European marketplace - New York,
NASDAQ, London, Frankfurt, Paris - about 30% of trading volume is executed in
blocks, 'upstairs', away from these systems.

More importantly, new electronic systems are expanding to make this block trading
more efficient. Liquidnet is the most prominent example. By foreswearing limit-order
display, or 'pre-trade transparency', in favour of a structure in which potential
matches are revealed only to the relevant buyer and seller, institutions are
encouraged to reveal their true order size to the system.

Algorithmic trading appears to be more of a work-around than a work-through solution.

Dicing the order slows down the trading, which increases adverse price movement risk
before the trade is complete. Failure to execute quickly imposes a dangerous liquidity cost
that can work against the portfolio manager’s objectives. Worse, it doesn’t work well for
imbalanced trading in illiquid names, the traditional providence of information-central.

4
Steil, Benn The End Of History And The Last Trading System: Fukuyama Comes To Market Reg, The
Handbook of World Stock, Derivative and Commodity Exchanges 2006 Edition
https://www.exchange-handbook.co.uk/index.cfm?section=articles&action=detail&id=60621

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The Exchange As A Process.

What is this thing called a market? The dictionary definitions of a market or marketplace
aren’t especially insightful: e.g. “a body of persons carrying on extensive transactions in a
specified commodity.” Technically correct but not very illuminating.
We need to think of “exchange” as a verb, not a noun.

The standard economists’ model of an effective market describe a forum in which

indications of trading interest are publicly displayed, ranked by price and time of
submission within price, and the execution of orders strictly determined by this priority. In
this model, all trades are interactions between visible limit orders and demands for
immediacy in the form of market orders. Again, the focus is on the mechanics.

This model works when all traders are roughly the same size and arrive frequently enough
to offset buying and selling interest. That might be a nice description of a farmer’s market,
but is deficient in describing today’s equity markets for several reasons:

1. Institutional players need to trade in amounts that dwarf the trading desires of
individual investors. This imbalance creates most of the difficult problems
confronting market designers.
2. These traders are often more interested in size than price; they may be willing to
forego better market prices at tiny volumes to get their enormous block done
expeditiously.
3. The traders are acutely aware that displaying their trading interests would only
serve to motivate frontrunners and copycats to jump ahead while causing potential
trading partners to withdraw or delay until a clearer picture (and likely an inferior
price) develops.
4. In a market where the best price may evaporate in a flash, assurity of a trade
completion might be more important than strict price priority.

Martin Sexton defines the purpose: “. . . [to] enable buyers and sellers to come together in
a regulatory environment that ensures honest dealing but doesn't get in the way of
growth.” Again, focus on the mechanics.

Arnold Picot provides a better starting point:5 “a discovery and learning process which
rewards the best informed participants with the greatest knowledge arbitrage profits.”

That’s worth dissecting. It defines the purpose: parties that trade with the most knowledge
use the exchange to secure the value of that knowledge. It recognizes that the purpose of
the exchange is to arbitrage out special information so that the prices of assets represent
true economic value. Finally, by describing the exchange as a process, it focuses on the
dynamics, not the floorboards.

5
Picot, Arnold, Christine Bortenlanger and Heiner Roehrl, http://jcmc.indiana.edu/vol1/issue3/picot.html

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However, it misses the central reason for the existence of a securities market – the pricing
of assets and investment risk and thereby expected returns. A definition that includes this
goal – and gets rid of that awkward “knowledge arbitrage profits” phrase – would read as:

A discovery and learning process that prices assets and investment risks and
rewards the best informed participants with the greatest returns from
research and risk bearing.”

With that in mind, we can go back and consider some of the working parts that an
exchange provides:

1. A forum, a place where buyers and sellers can come together. The forum may be
physical or electronic.
2. A means for buyers and sellers to address that forum, either in person, through an
agent, or self-representing electronic messages.
3. A means of discovering a price satisfactory to both buyer and seller.
4. A means of intermediating time so that buyer and seller who arrive at uncoordinated
times and can find each other.
5. Dissemination of information about [1] prices and quantities of available
merchandise, and [2] records of executed trade prices and size. This is advertising,
plain and simple.
6. Rules for orderly conduct so that transactors are not taken advantage of by
unscrupulous exchange insiders or outside parties. Investor confidence is essential
to any market competing for business.
7. Efficient payment and delivery systems; a guarantee that counter parties will
perform or the exchange will step in as guarantor of the trade.

Balancing Varied Interests

So far we’ve been concentrating on the problems of managing the interaction between a
buyer and a seller. But running a successful exchange requires a delicate balancing of the
dynamic tensions between multiple constituencies:

• Buyer vs. seller. Buyers want the lowest possible price, sellers want the highest. Both
sides must be made equally unhappy but satisfied with what they perceive to be a fair
deal.
• Institutional traders vs. retail traders. Retail traders have little to fear about revealing
their trading interests; institutions can easily lose research and risk bearing profits by
revealing their interests indiscriminately.
• Market orders vs. limit orders. Market orders are buyers of immediacy; limit orders are
sellers of time. Limit orders offer valuable liquidity to the market, and are particularly
valuable to an exchange because they display available inventory.
• Sellside vs. buyside interests. A traditional member-controlled exchange extracts
monopoly profits; the buyside wishes to pay only for the value-added;

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• Floor operators vs. investors in the exchange itself. Floor operated exchanges were
owned by the floor operators and were often non-profit organizations. The dynamics
changed with demutualization.
• Listings vs. investors. Companies who list on a market are vitally interested in seeing
that their current and potential shareholders get a square deal from the exchange.
• Regulators, media and the political class, all anxious to preserve and protect investors
against the power of the exchange.

What Can Electronics Bring?

.
Electronics have been part of the brokerage process for as long as computers have been
commercially available. IT budgets have grown steadily among buyside firms, sellside
brokers and exchanges. Information systems are well developed in the securities industry,
applying order management systems, trading algorithms and routing systems using the
widely accepted FIX protocol. Integration effects and connectivity to exchange systems
are being rapidly enhanced. Matching of orders for liquid securities is easily handled, as
is the direct connection of institutional buyers and sellers through the ECN’s. Electronic
clearing and settlement are well underway, although more rapid clearing is still around the
corner.

Electronic exchanges have proven their worth in matching small trades. Trading
algorithms exploit that facility by turning large trades into small trades timed so they do not
create a trading imbalance. But what about those institutional sized trades that do NOT
meet a flow of liquidity on the other side?

In 2002 Plexus Group performed a study of market liquidity per stock by counting the
number of trades per day. Only nine NYSE stocks traded more than 5000 times a day.
68% of stocks traded less than 500 trades a day, roughly once every 1.25 minutes. 20%
of the stocks traded less than 500 trades a day, once every four minutes on average. This
study shows that for many stocks the “continuous” auction concept breaks down due to an
insufficient number of trades or depth.

How can an electronic market deal with these infrequently traded issues? What happens
when the number of shares offered by sellers far exceeds the number of shares demanded
by buyers? (Or vice versa.) What is the electronic computation that times the sequences
of prices that clears the market?` What is the value of human interaction at this critical
juncture? Is that human interaction best performed on a trading floor? And does this
situation occur often enough to warrant the maintenance of a trading floor?

Large trades cannot simply be presented to the market. Signaling by price trend – with a
great deal of advertising – may fill the order over a long sequence of trades, but the risk is
that the pattern becomes readable. This opens up a plethora of unpleasant reactions:
1. Sellers withhold orders for fear of upsetting the market.
2. Buyers hold back in hopes of getting a better price.
3. Alarming signals are sent to the outside world about the state of the market,
possibly provoking panic selling.

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 4. Market orders are executed at dissimilar prices.
5. One-sided markets generating very rapid price movement can easily create positive
feedback and out of control price instability.

Liquidity can be described as lying in layers. 6 Strata near the surface are easily accessed
but thin. Deeper layers can reveal much larger amounts of liquidity, but usually at higher
transaction cost. The chart below illustrates the relationship between trade size, the cost of
trading, and the strata of liquidity required to fill orders of increasing size. Cheapest,
easiest to reach liquidity is at the upper left. As we move down, the amount of available
liquidity increases. We will show how it arrives and why it comes at a higher price.

6
Wagner, Wayne H. The Market Maker in the Age of the ECN, Journal of Investment Management, April,
2004

9
 LAYERS OF LIQUIDITY
Higher Cost Of Trading

Size of Trade
Percent
25% 100% Of daily
volume

Revealed
Flow

Hidden

For hire

Mo
re
hi l Last resort
gh iqui
er dit
co y a
st t

1. REVEALED LIQUIDITY

The first step is to dip into the ebb and flow of the everyday liquidity
stream. This is “natural liquidity,” where the trading counterparty
arrives as a result of an independent exogenously determined decision
process. In other words, trading motivation comes from outside the
exchange, representing an external decision process.

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Trading in this most accessible layer is not as easy as it sounds. The
trader must be careful not to trade in a noisy fashion that tips off market
participants such as day traders, technical traders, short term
momentum traders, and hedge funds. These traders feed off the flow
of information that indicates potential trading interest. They know that
institutions have an information edge and that institutional size will
dominate the volume until it is satisfied. They hope to go along for the
ride. And in today’s markets, these hungry sharks drastically
outnumber the institutional whales.

But where is the liquidity? In today’s fractionalized markets, the

institutional traders need to systematically search all the uncoordinated
venues. Traders may try low cost (electronic) venues first, then trading
floors. The undone portion of the trade often falls to the hands of a
block broker to perform an “information-central” role.

2. FLOW LIQUIDITY

Flow liquidity is like revealed liquidity, except that it hasn’t arrived yet.
The problem for the institutional trader is that he cannot anticipate
when, or even whether, someone else will independently decide to sell
what he wishes to purchase. If the order awaiting liquidity has a low
information content, waiting may not be a problem. In contrast, if an
information “edge” underlies the order, delay might be costly as other
investors become aware of the information. This leaves the trader with
the fundamental trading decision: is the best strategy to wait for liquidity
to arrive, or is it more effective to seek quicker – often more expensive
– liquidity by other trading techniques? Since information or trading
necessity underlies all the largest and most important institutional
trades, most institutional traders tilt toward trading faster rather than
awaiting natural flow liquidity.

But when the stream of liquidity is inadequate, it is necessary to look

deeper for pockets of liquidity.

3. HIDDEN LIQUIDITY

Hidden liquidity lies a step below the revealed and flow liquidity. The
commitment to trade has been made; the order is live. The order may
be known only to the trader holding a large institutional order, or it may
be revealed to his block broker (e.g., “participate, do not initiate”
orders). The buyside trader may keep it in his pocket. Hidden liquidity
can easily be larger than revealed liquidity.

On the floor of the NYSE, the traditional information-central

marketmaker is aware of the liquidity but trusted to keep it secret. If the

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marketmaker senses an opportunity to put together a buyer and a
seller, the hidden liquidity can be revealed to both parties.

If free-riding and front-running were rare events, we wouldn’t be talking

about them here. To the contrary, these are all day/everyday
occurrences. They are, for example, the raison d’etre of the day
traders and many hedge funds. They are a major concern to
institutional traders.

Thus large trading interest is seldom shown publicly in order to protect

the proprietary value of the order. Information on the desire to trade
will not be revealed without a suitable quid pro quo: the information will
be traded either for an execution or for information – trading or
fundamental – of perceived equal value. It will not be intentionally
released to untrustworthy parties who can gain from the knowledge at
the expense of the initiator. A primary duty of an institutional trader is to
protect the value of this information to secure the research and risk
bearing profits for his clients.

Active managers act from an information edge, particularly motivating

the very largest orders. Trading is necessary to capture the knowledge
profit, and size is a requisite for significant portfolio impact. But the
initiator cannot act in the marketplace in size unless someone of size is
willing to trade with him. The order cannot be completely hidden; it
must be known to someone who [1] can be trusted to protect the
information and [2] is situated to know when a counterparty arrives. If
both buyer and seller notify a marketmaker of potential trading interest,
a.k.a. hidden liquidity, the marketmaker can effect a trade.

4. FOR-HIRE LIQUIDITY

Above we described trades occurring through the matching of

exogenous trading decisions. But what happens when no “natural”
arrives to balance buying and selling interests. The last two categories
of liquidity derive from market participants who respond to calls for
liquidity. They will accommodate liquidity demand by buying at a
discount or selling at a premium. In other words, they sell liquidity to
any party anxious enough to pay for it. The information edge these
traders work from is endogenously determined, inside-the-box
information about the market. The order itself is the inside information.

From the institution’s perspective, liquidity providers can be incented by

giving up a portion of the potential alpha in order to coax out the
desired liquidity. The trade will be profitable as long as the payment for
liquidity does not exceed the potential alpha.

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There are many sources of endogenously determined liquidity. [1] A
marketmaker might undertake this role. [2] The block trading desk or
proprietary trading desk of a large brokerage firm can commit capital to
accommodate good customers. [3] Aggressive non-broker traders
such as hedge funds may take a short-term position if they believe they
can turn a profit. One of the roles of information-central is to alert these
potential liquidity sources.

At first glance, signaling these endogenous liquidity providers appears

to breach the confidential nature of the order. While knowledge of the
trade is a valuable proprietary asset of the initiator, it is also knowledge
that the marketmaker purveys as his stock in trade.

The marketmaker aids his customer by transmitting information that

attracts liquidity. The distinction is not clear-cut: no bright line distinction
exists between “trying to find the other side” and “tipping off his pals to
frontrunning possibilities.” The marketmaker cannot accelerate liquidity
arrival without revealing trading interest. Nor is the institutional trader
able to complete his order expeditiously without revealing at least a
peek. The trader must balance the costs of revealing information
against the cost of failing to find liquidity.

It is tempting to call this false liquidity, since the accommodating sellers,

who are not investors, will have to turn around and buy stock to clear
their short position.

This cat-and-mouse situation frustrates the institutional trader. They

must trust their agents but cannot verify their fidelity. Potential conflicts
of interest are rife among the parties he must deal through. Even
worse, he has no ability to monitor the marketmaker’s information
dispersal. No paper trail exists, no phone records can be relied on;
information could be passed on by a code, a blink, a hesitation, or
silence at the pregnant moment.

It gets worse. As information moves down the chain of trading, other

parties with no connection or obligation to the customer tune in. A
weak marketmaker may have neither the capital to finance the trading
nor the treasured relationship with the institution, and may “daisy chain”
the trading by laying off positions to other brokers or hedge funds.

Liquidity providers can be drawn from a myriad of directions. The most

innocent way to find potential sellers is to call up those who are known
to own the security and those who have been recent sellers. This is
clearly part of the information-central role. An options marketmaker
might find a way to profit from an arbitrage against the options. A

13
 hedge fund might sell stock and buy a mathematical hedge of other
companies to control the exposure.

If these are such effective methods of raising liquidity, why didn’t the
buyside trader try them himself? He will not want to call other investors
because he would just as soon they didn’t know what he was doing.
The trader has neither the time, the resources nor particularly the
contacts.

Ah, but the marketmaker does have the contacts. It is the heart of his
business. Maintaining this network of contacts is time consuming and
expensive. Only someone with an on-going, everyday mission to be
privy to everything knowable about a stock’s supply and demand can
profit enough to cover the high cost of network-maintenance.

5. LAST-RESORT LIQUIDITY

Suppose a company unexpectedly restates earnings, leading to a panic

of intensely motivated sellers. Everyone, including the for-hire liquidity
providers, hangs back until price reaches a bottom. In this situation
there are no buyers at the current price, and stock for sale will
overhang the market until the price reaches a level where last-resort
liquidity comes into play.

Who are these buyers of last resort? Deep contrarians who are
motivated to trade by a deep, deep discount. Donald Keim7 has
documented how one fund manager, Dimensional Fund Advisors
(DFA), systematically adds value by standing as buyer of last resort.
The lower line on the following chart, taken from www.dfafunds.com,
shows that stock prices decline on average 10% over 20 days prior to
DFA block purchases, then bounce back and stabilize. This is the price
pattern we’d expect to see from a buyer of last resort.

7
Keim, Donald: An Analysis Of Mutual Fund Design: The Case For Investing In Small-Cap Stocks. Journal
of Financial Economics 51 (1999)

14
 Value investors are constantly on the prowl for these situations and will
likely uncover them without marketmaker assistance. They will step in
when the price falls farther than their assessment of the fundamentals.
The danger is the unknown information motivating the other side.
Consequently, these are risky trades that demand big price
concessions to offset the risks of buying too soon or buying fatally
damaged goods.

“Color”

There are two ways to correct a buyer/seller imbalance: advertise the imbalance through
an easily read pattern of consistent price movement and wait until investors react, or
stimulate interest on the other side by signaling those parties that are likely to respond.

Securities traders like to describe the latter with the word “color.” Barclay, Hendershott and
Kotz8 provide a definition for the Treasuries market that is perfectly applicable to equity
markets:

“Market color can best be described as non-payoff relevant information about short-
lived variations in supply and demand that voice brokers collect from interactions
with their customers.”

They go on:

… when a dealer calls a voice broker, the voice broker may collect more information
than just the price and quantity to which the dealer is willing to commit. This
additional qualitative information, which often is referred to as “market color,” can be
valuable to the voice brokers’ customers because it allows the broker to match
natural counterparties that otherwise would have difficulty finding each other. The

8
Barclay, Michael J., Terrence Hendershott and Kenneth Kotz Automation versus Intermediation: Evidence
from Treasuries Going Off the Run, http://opim-sun.wharton.upenn.edu/wise2004/sat311.pdf

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 better matching of customer orders compensates the dealers for the higher
commissions charged by the voice brokers.

This is information-central at work, in this case conducted without face-to-face contact.

Electronic orders, in contrast, are anonymous and indistinguishable. Written in the stiff,
stilted language of high-speed messaging, they are black and white – without discernable
personality. Reading this torrent of electronic messages to interpret market conditions and
reactions is problematic.

Electronic exchanges have tried to replicate the function of the voice broker with limited
success. For example, auto-refresh algorithms, reserve orders and dark pools of liquidity
are all attempts to add at least a tint of color to trader communication without granting or
incurring a competitive disadvantage. Accessing dark liquidity is still shooting in the dark.

Another way to safely provide color is to filter the lines so only selected individuals have
access to it. Liquidnet and crossing networks like ITG’s POSIT restrict membership to
institutional traders; Pipeline sets a high threshold for minimum trade size. Both systems
filter out most free riders and quote jumpers. The problem, as always, is that separate
pools inhibit total liquidity. And illiquidity is not without cost.

The prudent act for the seller might be to issue private notification to a highly selected list
of potential counterparties. The public quote and transaction dissemination system is
clearly not designed for private messages, for vetting information to assess its authenticity,
or for judging its relevance.

Color is not information, it is knowledge. Failure to distinguish the two leads to much
confusion. For example, we speak loosely of “information technology,” which is little more
than switching technology for routing a stream of bits we call a message. The
“information” passed makes no distinction between truth and falsehood, reality or fantasy.
It’s just bits, the technology has no means to assess the quality of the information being
transferred. Using such a system requires tacit knowledge –understood without being
openly expressed – and is subject to errors of interpretation. Which is why we
occasionally see a Corinthian College fiasco where the computer sees no difference
between a ten share trade and a ten million share trade. The point is that the electronic
provision of color, necessary to almost any market, has not been solved. There may be no
electronic solution.

Color is valuable, but it is costly to provide. It requires the continuing maintenance of a

network of information. Those who provide color expect to be compensated for their
efforts. Color can be provided on the floor of the exchange, but there is no monopoly.
Institutional block desks and third-market brokers provide similar services.

Governance

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From negotiated commissions to decimalization to the NMS rules, we have seen that the
will of the market regulators plays a role in defining future markets, second only to the role
of technology.

Most of the SEC’s efforts have resulted in substantial benefits to investors, although with
significant unintended consequences along the way. The recommendations appear well-
researched and carefully thought out, but the possibility always exists for a major problem
to crop up. Sarbanes Oxley comes to mind.

The sustained plunge in average trade size is surely aided by the regulatory environment.
As one observer said, “The SEC set up a market for retail-sized trades and then was
surprised that all they got were retail-sized trades”

Larry Tabb9 has pointed out that “The financial markets are highly regulated and the
playing field is anything but level. While we as market participants believe we are in control
of our own destiny, it is the regulators who own the ball, the field and make the rules.” They
may be wise or they may not, but they have the power.

The regulatory solutions strive to consider the needs of all parties – buyers and sellers,
retail and institutional, market orders and retail orders, giant trades and small trades,
legislators and public opinion. (Each, of course, trying to make their own interests
primary.) A “wise” solution meets all those needs, but it’s easy to mess up and end up with
thorny unintended consequences. If the solution isn’t perfect, the buyside and sellside will
collaborate a less effective work-around (e.g., algorithmic trading) so that the essential
trading can be completed. Alternatively, someone will set up another venue or ECN which
provides an improved solution.

Mandated changes can be very expensive to implement, and the value does not
necessarily accrue to those who are required to pay for them. For example, the tsunami of
messages let loose by the decimalization rules – and in all likelihood the new NMS
regulations – force all market participants, from buyside to sellside to the exchanges to
invest heavily in computer and communication equipment just to handle the messaging
load. Needless to say, the investor ultimately foots the bill.

Proliferation of Alternatives

The NYSE hopes that its new Hybrid system will draw back volume that has been lost to
the over the past decades.

As hinted in the previous section, most are, or were initially, niche oriented: finding some
subset of trading interests that is not well covered by the central markets. In recent years,
the distance of the from the central marketmaking has decreased. There are clear

9
Global Market Consolidation: Read the Rules Carefully WS&T June 16th 2006.
http://www.wallstreetandtech.com/opinions/larrytabb/showArticle.jhtml?articleID=189401903

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disadvantages to this proliferation of venues. The first is congestion: under NMS each
system must communicate with all others, sending and receiving messages and
interpreting the implications for processing their own order book. Costly excess capacity
and fail-safe backup systems must be in place and instantly available to handle storm-of-
the-century message flows. Sounds expensive.

More importantly, a market fractured into separate pools is inherently less liquid and
slower. But liquidity is highly valued by investors; the implication is that prices are lower in
illiquid markets. Lower prices in turn lean heavily on the cost of capital and the multiples at
which new issues can be brought to market.

On the other hand, the spunky little have scared the behemoths by stealing market share.
Now is a time for experimentation, so the more the merrier, let a thousand flowers bloom.
All but a few will ultimately whither or consolidate. Out of this adaptive and experimental
process will come workable solutions that will provide the facilities that investors want now
or will come to want in the future.

Clem Chambers10 eloquently points out the centripetal forces drawing liquidity together.

Stock exchanges are natural monopolies because their scale is a direct benefit to
their customers. Liquidity is the advantage that traders value most and trading
naturally flows to the largest player with the most liquidity. This is a self re-enforcing
process. Liquidity is the fuel of any market and the lower the cost of trading the
greater the liquidity. The greater the liquidity the lower costs can be, and the more
liquidity will be created if the costs are optimal for the customer and the exchange.
This loop is the factor that protects the customer from the monopoly and in practice
this appears to be what happens. . . .

In the modern world liquidity is as vital as oxygen….Traders, brokers and

exchanges themselves live or die by the availability of liquidity, because in the end
the market is its liquidity and for once scale is on the side of “the angels.”

The value of intermediaries lies in their ability to enable transactions that would not have
occurred a in timely manner and anonymously. These intermediaries may be brokers who
proactively search for counter parties, auctioneers who bring together large numbers of
potential traders, or dealers who take positions in order to get transactions done.

When costs of waiting are high, liquidity is valuable and exchange-provided services will
demand a premium. However, they are not always needed, particularly in situations which
are naturally highly liquid. Thus the sellside is poised to capture this business by
automating the handling of large institutional orders, internalizing where possible and
intelligently routing to limit information leakage.

Information Central

10
The Handbook of World Stock, Derivative and Commodity Exchanges 2005 Edition.
https://www.exchange-handbook.co.uk/index.cfm?section=articles&action=detail&id=60613

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For the vast bulk of trading, the electronic solutions imbedded in Reg NMS are sufficient;
frequently optimal. But NMS is a black and white solution for a world that also needs color
on very important and influential trades. Yet the sense is that the markets are still
searching for a better solution to the size-meets-size problem. If the German experience is
at all applicable, about half of all volume might be done off-exchange, according to Davis
et al. Recall Benn Steil’s estimate was 30%. Capturing a significant portion of that
negotiated big block trading is nirvana to the NYSE.

Market data drives all the interconnectivity and automated trading. Without ultra-low-
latency access to (clean) market data, none of this electronic trading is feasible. And who
controls the dissemination of quotes and trades? The exchanges. Thus we can expect
that revenues from market feeds will become an increasingly important source of revenue
for the exchanges.

Companies that list on an exchange have to pay for the privilege and listing fees are an
important source of exchange revenue. The NYSE trades off its prestige in setting listing
fees, and needs to maintain the primacy of its market to continue its pricing power over
listing fees.

NMS is not likely the final solution to the problems of market microstructure. If our forward
thinkers get some of the details wrong, traders who must complete their orders will figure
out how to make it right.

The need for marketmakers is clear, but their role can be accomplished as well by phone
as through physical contact, although the crowd concept will give way to one-on-one
conversations. 11

11
With all this talk of inexorable electronic advances driving market evolution, it might seem that all securities
markets are destined to operate electronically. Andy Nybo of the Tabb Group points out that despite
significant investment in bond trading systems during the 1990’s, bond trading remains in large part a voice
based marketplace with the bulk of activity dominated by large institutions and dealers. “The roles of the
major participants have seen little change for more than a century” says Nybo. “The darker, less liquid
sectors of the bond market still are traded in a traditional over-the-counter market whereby the sellside is a
‘market-maker’ and the buyside is a ‘market-taker.’”

Why has automation failed to conquer the bond markets? Nybo points out that the biggest stakeholders are
happy with the way things are. Dealers are so far able to retain control of the oligopoly, buysiders are
satisfied with the status quo, and regulators are looking elsewhere; i.e. the equity markets. Stand pat is still
the order of the day.

The moral of the story is that, in the absence of organized customer dissatisfaction and regulatory
complacency, nothing will change. Only under strong compulsion or outright market disaster will the insiders
alter a lucrative franchise, kicking and screaming their way into the future. Unfortunately for the aficionados
of the NYSE floor, their customers are vocal and organized and the regulators are on their side. Global
Market Consolidation: Read the Rules Carefully WS&T June 16th 2006. See:
http://www.wallstreetandtech.com/opinions/larrytabb/showArticle.jhtml?articleID=189401903

19
Under the National Market System rules, the trade has to go to the best price, wherever
that price can be found. Thus all exchanges will be interconnected in real time, and all will
have the opportunity to compete for the order on equal terms. If the NYSE wants to retain
market share it must offer as good a price as anywhere else. To accomplish that, it must
attract the liquidity and put that to use by the specialists in forming best prices.

The old floor population of the NYSE used to tout that “this is the best market in the world.”
Maybe, maybe not. But it is also a very expensive market to operate and the costs come
out of investors pockets. They’re not happy about it, and the regulators who represent
their interests are determined to make the exchanges work to investors’ best advantage.

As Picot et al conclude,

Complete replacement of human intermediaries will not take place. But it is likely
that there will be an unbundling of the activities of intermediaries so that
consultative [emphasis mine] and pure order handling activities are separated.
Standard transactions will become more and more automated, even their price
discovery, as long as the orders are atomistic and one order has no significant
impact on the price. Intricate transactions will still need human intermediaries but
may be conducted with electronic support

Anyone who provides an electronic facility that proves Picot wrong will make a fortune. So
far, it’s eluded the finest minds in the business. NYSE thinks they have a handle with the
Hybrid market, but this half of their solution is not truly electronic. As we suggested above,
it may never be possible. Silicon based systems complement rather than replace “carbon
based” human solutions.

Perhaps the floor will survive, but at this point the economics and history are working
against it. Assuredly, what functions in the new world will be a pale shadow of the former
hustle and bustle. From a practical perspective, it may matter little whether it survives or
not.

No doubt the NYSE will survive, with or without floor. As Clem Chambers points out, it has
all the advantages in the world in terms of reputation, depth, and with its new corporate
structure, the flexibility to compete in the trenches. They will experiment with trading
hours, trading stocks in other countries, trading bonds, options, futures and who knows
what else. They will continue to earn revenue through listing fees and data access fees.

Look for a change in name: from the New York Stock Exchange to the New York Securities
Exchange. Investment advice? Go long NYS and short downtown NY real estate.

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