Slides on Market Structure

A primer on US equity market structure Prepared for KAIST program Winter 2004

Agenda
The NYSE
The Nasdaq Stock Market Inc.
Regional Exchanges
ATSs/ECNs
Competition within and between markets

Where is the market for AOL?
The common stock of AOL trades in the following stock markets:
The NYSE, primary listing
US regional exchanges: Boston, Chicago, Cincinnati, Pacific, and Philadelphia
Most ECNs and ATs, including Island, Instinet (INET), Archipelago, Bloomberg Tradebook, BRUT, and POSIT
The third market and Nasdaq, including Bernard Madoff Investment Securities, and Knight Capital Markets
The upstairs block trading market
Some large foreign stock exchanges.
Moreover, the “risk” in AOL also trades in derivatives markets:
US options exchanges all trade AOL stock options: CBOE, ASE, Pacific, PHLX, and ISE.
Futures contracts on AOL common stock shares trade at futures exchanges (2002)
IBs tailor synthetic derivatives on AOL for clients.

Where is the market for AOL?
20 results for 'Time Warner' (type= Stocks , market= World Markets )More results for 'Time Warner' found in: Options (2) , Mutual Funds (56) , Indices (2) Stocks Click the symbol for a detailed quote.Showing 1 - 20 of 20 Symbol Name Market Industry
Add to My Portfolio
AOL.BA Time Warner Inc Buenos Aires
AOLc.BA Time Warner Inc Buenos Aires
AOLd.BA Time Warner Inc Buenos Aires
TWX.BE Time Warner Inc Berlin
TWX.D Time Warner Inc Dusseldorf
TWX.DE Time Warner Inc XETRA
TWX.F Time Warner Inc Frankfurt
TWX.H Time Warner Inc Hamburg
TWX.HA Time Warner Inc Hanover
TWX.MU Time Warner Inc Munich
TWX.SG Time Warner Inc Stuttgart
TWX Time Warner Inc NYSE
TWXq.L Time Warner Inc London
TWTC.BE Time Warner Telecom Inc Berlin
TWTC.D Time Warner Telecom Inc Dusseldorf
TWTC.DE Time Warner Telecom Inc XETRA
TWTC.F Time Warner Telecom Inc Frankfurt
TWTC.MU Time Warner Telecom Inc Munich
TWTC.SG Time Warner Telecom Inc Stuttgart
TWTC Time Warner Telecom Inc NasdaqNM
View Quotes for All Above Symbols
Showing 1 - 20 of 20
NYSE market of primary listing Foreign markets Nasdaq - Intermarket Options Source: finance.yahoo.com

The New York Stock Exchange

The NYSE
The NYSE is a hybrid market
It has floor traders (like a futures pit)
It has an electronic limit order book (like and ECN)
It has designated dealer (the specialist) to maintain liquidity and otherwise coordinate trading.
This mix is the outcome of political, technological, and economic forces over the last 20 years.

What does the NYSE do?
Trading and trading services
The NYSE charges (directly and indirectly) for trades that occur and for software supplied to its members.
Listing
To be listed on the NYSE, a corporation must meet/maintain certain financial standards and pay listing fees.
An NYSE listing is a certification that enhances a firm’s credibility.
Information
The NYSE is (indirectly) an information vendor.
Regulation
The NYSE monitors and regulates the trading activity of its members.
Through the listing relationship and the listing standards, it can affect corporate governance behavior.

NYSE sources of revenue

Organization and governance
The NYSE is a “mutual” organization, a not-for-profit corporation owned by its members.
A membership is a “seat” = trading privileges + ownership rights.
There are 1,366 seats. Last sale price (2/25/2004) was $1.5 million.
The bid is $1.45m and the offer $1.8m.
The NYSE recently considered de-mutualization (conversion to for-profit form with shareholders), but decided against it.
Governed by a board of directors and various committees, which generally have public representation.
In practice, the NYSE represents a balance of diverse powerful constituencies.

Richard A. Grasso
In 2003, there was a scandal involving the compensation package of the Chairman of the NYSE, Richard A. Grasso.
His total pay package of some $140 million dollars was leaked to the media and the membership.
Grasso was eventually forced to resign from his post (9/17/2003), and an interim chairman, Mr. John Reed, was appointed.
He was paid $1.00 per year!!!
Earlier in January, Mr. John Thain, formerly of Goldman Sachs, was recruited to take over the chairmanship of the NYSE.
Governance changes have been implemented to reduce potential conflicts of interest.

Physical layout of the floor
Trading in a particular stock takes place at a particular post.
Posts are arranged around horse-hoe shaped trading booths.
Booths are arranged around the trading floor.
Broker booths are arranged around the perimeter of the floor.
A broker (e.g., Merrill) will have one or more broker booths.

At the post The “crowd”: one or more floor brokers Specialist work station* Specialist’s clerk Specialists * In January, 2002, the Exchange released NYSE OpenBook TM .

The hybrid structure of trading
The specialist work station contains the limit order book.
Most orders are delivered electronically to the work station.
It looks roughly like the screen of an ECN, and has similar functionality.
The crowd comprises floor brokers representing customer orders and (less often) their own orders.
The crowd is similar to the crowd in a futures pit.
One broker has a unique role – the specialist
The specialist’s key function is to provide liquidity when no one else is willing to do so.
In this respect, the specialist is acting as a dealer.

How do orders execute?
At the NYSE, even marketable orders do not automatically execute.
The specialist or the clerk must hit a key to complete the trade.
Automatic executions are available for:
Odd lot orders (< 100 shares)
Market orders designated as “NYSE Direct.”
NYSE Direct and odd-lot orders are executed immediately against the specialist’s account.
Order size is max 1,099 shares, but this size limit is about the be increased very soon…

What do floor brokers do?
Floor brokers are members (seat holders).
Floor broker may work for a large brokerage firm (e.g., Merrill), or they may be independent.
Floor brokers manually handle large almost exclusively institutional orders.
They trade these orders manually by representing them in the crowd.
They may also delegate the execution to the specialist.
Floor brokers also gather information, and help bring out latent liquidity.

What does the specialist do?
The specialist is the designated dealer.
There is one per stock, but a single specialist may be the designated dealer for as many as a dozen stocks.
The specialist is physically present at the stock’s post.
The specialist is responsible for “maintaining an orderly market.”
Specialist posts bid and ask quotes, and sizes.
Specialist affirmative obligations
Narrow spreads, price continuity, act as agent.
Specialist negative obligations
Yield to public customers, discouraged from trading.

Specialist-SEC settlement 2004
On February 19, 2004, five major specialist firms (there are only 9!!!) reached a settlement with the SEC for at total of $240million.
LaBranche & Co.
Van Der Moolen Holdings.
Fleet Specialists
Bear Wagner Specialists
Spear, Leeds & Kellogg
The charges against the firms were that they had engaged in quote-matching.
They essentially traded ahead of public limit orders by improving the price by one penny.

The Nasdaq Stock Market Inc. Better for companies Better for investors

The Nasdaq Stock Market Inc.
The Nasdaq Stock Market is NOT (yet) an Exchange.
Nasdaq has applied to become recognized as an exchange, but even though the application has been pending for almost 4 years, it has not yet been approved.
The Nasdaq Stock Market is a dealer market.
Each stock has multiple market makers posting best bids and offers, and sizes, for a particular stock.
The market is decentralized, and all order routing and trade execution is done electronically.
The market for trading Nasdaq-listed stocks is highly contested.

Nasdaq players
Market makers have maximum access to Nasdaq trading facilities.
They alone are allowed to post bid and offer quotes.
Any Nasdaq member may execute a trade.
A market maker must satisfy capital rules and maintain a market presence.
Order entry firms collect customer orders.
They route orders to market makers (but don’t make markets themselves).
ECN’s (electronic communication networks), e.g., Island.
In principle, and ECN can function independently (standalone)
The ECN’s rely on Nasdaq systems to display their quotes, report their trades, and access other market participants.
The integration of ECN’s into Nasdaq is frequently awkward and contentious.

What does Nasdaq do?
Trading and trading services
Nasdaq charges (directly and indirectly) for trades that occur and for software supplied to its members.
Listing
To be listed on the Nasdaq, a corporation must meet/maintain certain financial standards and pay listing fees.
A Nasdaq listing is a certification that enhances a firm’s credibility.
Information
The Nasdaq is (indirectly) an information vendor.
Regulation
The Nasdaq monitors and regulates the trading activity of its members.
Regulation is outsourced to NASD-R.
Through the listing relationship and the listing standards, it can affect corporate governance behavior.

Nasdaq’s trading platform
Nasdaq’s trading platform is called SuperMontage.
It is an extremely fast, all computerized, trading system where all marketable orders are executed automatically.
Each registered market maker has to submit their top of file to the system.
This can be either the dealer’s own bid and ask quotes, the best limit buy order and the best limit sell order, or a combination of both.
Market makers can submit their interest at multiple price levels.
Market makers can preference, and internalize trades through the system.
The system allows anonymous orders, as well as orders with “hidden” size.
Order-entry firms may also enter their orders to the system.
The SuperMontage system is NOT a central limit order book.

Schematic of Nasdaq SuperMontage MM1 MM2 ECN1 MM3 ECN2 MM4 Smart Routers 6,000 $30.12 $30.04 8,000 5,000 $30.10 $30.05 4,000 1,000 $30.09 $30.06 1,500 Ask Size Ask Bid Bid Size

The Nasdaq trading network NASDAQ’s inclusive structure includes market maker firms, ECNs and regional stock exchanges. There are over 400 market making firms, linked electronically from all over the globe, that provide capital support to the trading of NASDAQ securities.
Competing Market Makers
Facilitators of Orderly Market
Independent Dealers Competing for Orders
Proactive Trading
Research Analysis / Corporate Finance
Institutional Sales / Retail Sales
No Limit to the Number of Participants
Display continuous two-sided firm quotes
ECNs
Provide order anonymity
Provide institutional access
Create added competition
Bring competitively priced orders into the marketplace
Enhance liquidity

Evolution of Nasdaq Trading Trading in Nasdaq securities has undergone a period of intense competition and fragmentation over the last several years. As alternative trading venues have become more viable, an increasing number of trades have been reported to regional exchanges to take advantage of tape revenue benefits.
Timeline
2000 and 2001: All ECNs are part of Nasdaq
2002
Island ECN (now INET) begins reporting trades to Cincinnati Stock Exchange (now NSX).
Nasdaq launches SuperMontage.
Archipelago merges with REDI ECN.
Island ECN merges with Instinet.
2003
ARCA completes merger of its ECN and the Pacific Stock Exchange (PCX) to become first US exchange to trade all securities listed on NYSE, AMEX and Nasdaq.
BRUT and NASD member firms begin printing trades to Cincinnati (NSX) and Boston Stock Exchanges (BSX).
Markets linked by direct connections and third party vendor trading systems.

Nasdaq’s organizational form
Nasdaq is a publicly traded company that never did an IPO…
Nasdaq was sold to its members, and to select large players in the securities industry in late 2001.
The stock was restricted, but the restriction expired in June, 2002.
The previous owner, the NASD, has a golden share, with all the voting rights!
This is the only way Nasdaq can operate a trading platform without exchange status, without being an association of securities dealers, and without being a broker.

Nasdaq’s stock: NDAQ (OTCBB)

Nasdaq revenue sources

ATSs/ECNs

Successful Entrants (Courtesy of the SEC): ECNs and ATSs

Successful Entrants (Courtesy of the SEC): ECNs and ATSs Source: http://www.capis.com/research/ecn_2002.pdf

Successful Entrants (Courtesy of the SEC): ECNs and ATSs

What do ECNs do?
ECNs provide electronic limit order books.
ECNs are brokers, hence they do not trade for their own account and they do not take the other side of subscriber orders.
ECNs provide fast, anonymous, trading for both NYSE and Nasdaq listed stocks.
ECNs interact with Nasdaq’s trading system by plugging directly into the Nasdaq open architecture.
ECNs interact with the NYSE trading systems by using a clumsy system called ITS.

How do ECNs make money?
ECNs charge subscribers an access fee.
ECNs pay a liquidity rebate to standing limit orders that get filled.
ECNs charge marketable orders for consuming liquidity.
ECNs have also recently started benefiting from profit sharing schemes.
In return for printing their trades on one of the US regional exchanges (NSX, BSX), they have negotiated to obtain a share of the resulting market data revenue.
ECNs cannot get listing fees.

Can ECNs become exchanges?
Yes, Archipelago obtained exchange status (ARCX) by purchasing the Pacific Stock Exchange.
Island/Instinet have applied for exchange status, and their application is pending at the SEC.
It is doubtful, however, if they ever could attract listings.
NYSE and Nasdaq brand names are very strong!

The market for NYSE stocks today broker-dealers public investors SEC U.S. markets direct access non U.S. markets Instinet 10 ECNs NASD broker dealers ARC NYSE CSE PHLX CHX BSE ITS Knight Madoff Liquidnet Millennium HarborSide Posit Crossing Network

The market for Nasdaq stocks today broker-dealers public investors SEC non U.S. markets CHX direct access Posit Crossing Network Liquidnet U.S. markets Island ARCA Instinet NASDAQ SuperMontage 10 ECNs Amex CSE PHLX Merging NASD broker dealers

Volume distribution - NYSE listed stocks Source: Goldman Sachs Trading & Market Structure Analysis Seeing through Nasdaq InterMarket
Single-counted, share volume
Internal matches only
All hours
Excluding ETFs
October 2003

Volume distribution – Nasdaq stocks October 2003
Share volume
Single-counted
Internal matches only
All hours
Excluding ETFs
Mostly broker-dealer upstairs trades
But also small activity on:
Brut (also in SM)
NexTrade (also in SM)
MarketXT (also in SM)
Attain (also in SM)
TradeBook (also in SM)
Other ATSs
2 to 5 percent? Source: Goldman Sachs, Trading & Market Structure Analysis

Why have ECNs been successful in Nasdaq but not the NYSE?
Nasdaq built its business model on “open architecture.”
Nasdaq made it easy for ECNs/ATSs to link into the Nasdaq trading platform.
The links were fast, which reduced the double jeopardy problem.
Order flow externality is weak (all orders are displayed, limited if any disadvantage from not trading in Nasdaq systems)
The NYSE built its business model on defending its market share.
The NYSE made it difficult to trade NYSE listed stocks away from NYSE trading systems.
ITS is antiquated, and extremely slow, exacerbating the double jeopardy problem.
Order flow externality is strong (floor broker orders, non-displayed liquidity significant, disadvantage from trading off-exchange)

What are the current issues?
On February 26, 2004, the SEC submitted a new market structure proposal, Regulation NMS, for comment.
Trade through rule
Fast versus slow markets?
Intermarket Access
ITS is antiquated and needs updating!
Sub-penny Pricing
Market Data

Slides on Market Structure

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