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July 31, 2003

At the End of an Era

By Junius W. Peake

Market makers, including specialists on stock exchanges, came about because of the discontinuity of order flow in the trading arena. There was no way to assure the regular, almost simultaneous arrival of like-sized buy and sell orders. Once the New York Stock Exchange moved from a periodic call to a continuous market, at which all trading in each security occurred at one time, some brokers discovered that they could make a substantial sum of money on a regular basis.

That could be done by buying and selling for their own account when corresponding contra orders were not readily available.

For these market makers to become profitable there had to be a limited number of potential buyers and sellers in the trading arena. The fact that the specialist had unique information about the order flow in his assigned securities gave him a significant advantage over regular brokers. A similar advantage accrues to over-the-counter market makers.

The service provided by specialists and over-the-counter market makers is known as "immediacy." The typical investor does not want to wait an indeterminate amount of time for a counterparty to appear. A seller of an unwanted position frequently selects speed and certainty of trade execution over a better price that may be available from another investor. This is the identical economic incentive for a used car dealer: Buy cheap and sell high with lots of turnover.

But here's the key fact: The unwanted position sold by an investor to a market maker is still for sale - and by the market maker! The market has not achieved liquidity; only the seller has done so. The market maker wants to resell his position to another investor and make a profit. Turnover is the name of the game!

The recent advances in technology enabled the creation of worldwide virtual trading arenas. As a result, all possible counterparty order flow became available to an investor. Before this, the need for market makers to be there as "Johnny on the spot" was a vital and necessary part of the market's mechanism.

The size of the minimum price variations also played a large part in reducing the need for market makers. When minimum price variations were 121/2 cents per share, market makers could count on sizable profits. But recently, with a change to a minimum price variation of one cent, market maker profits were greatly diminished or vanished entirely.

Just as the installation of dial telephones reduced the need for telephone operators, and ATM machines reduced the need for human bank tellers, so the centralization of order flow and electronic, virtual trading systems is already leading to a reduction in the number of market makers. When this happens there should be no tears shed for their disappearance by investors. Market makers will have vanished because they no longer served the economic purpose for which they were created.

Both the present chairman of the NYSE, Dick Grasso, and SEC Chairman Bill Donaldson (the former NYSE chairman), have promised to look into decimal pricing. They have promised to see whether the minimum price differential should be raised fivefold to a nickel. However, if that were to happen, these twin pillars of free markets and competition would be subsidizing market makers for performing what the markets are determining is uneconomic.

In 1975, the SEC was ordered by the Congress to "facilitate the establishment of a national market for securities." The word "facilitate" means "to make easy". We still don't have a national market system, and subsidizing market makers and specialists will just move us farther away from one. The way to achieve a national market system is to make certain that all bids and offers in each security are reachable by any trader. The closer that market systems come to achieving this goal, then the fewer market makers and specialists will be needed. The beneficiaries of this change will be the people for whom securities markets are supposed to exist: investors.

Junius Peake is professor of finance at the University of Northern Colorado.