The epic struggle on Wall Street at the moment is not between the bull and the bear. The struggle is between the entrenched market mechanisms – the New York Stock Exchange and Nasdaq – and the upstart trading systems.
Before I examine the ability of the Big Board and Nasdaq to compete with the new mechanisms, let's consider why there are suddenly so many electronic communications networks (and other alternative trading systems). The order handling rules notwithstanding, there are three possible reasons, which are not mutually exclusive.
First, excess profits on the Big Board and Nasdaq invite competition. Second, the Big Board and Nasdaq have failed to efficiently implement new technology. Finally, there are niche markets (reflecting the economic segmentation of order flow.)
Since liquidity attracts liquidity, it is quite difficult for a new trading venue to attract enough order flow to gain a foothold. Thus, the existence of so many new competitors reflects the particularly large gap between the lower competitive trading costs on upstart trading systems, and the higher costs on the Big Board and Nasdaq, even though trading costs in both of these market centers have been falling. Further, recent SEC regulations, especially Reg. ATS, foster competition. Reg. ATS, in retrospect, may be regarded as a brilliant regulatory change.
Computing Power
We are experiencing radical improvements in computing power and networks. These improvements make it easier and less costly to find the other side of trades. Hence, the cost of intermediating trades should fall as new technology is introduced. Traditional market mechanisms, however, have provided serious resistance to fundamental changes that would incorporate new technology and reduce costs. In contrast, ECNs and ATSs are aggressively adopting new technology.
Both the NYSE and NASD view demutualization as the path that will enable them to meet the onslaught of competition. Yet the NYSE has significant obstacles – for example, the enormous tax bite that will hit those holding seats, the huge change in their culture, etc. Nasdaq has fewer demutualization obstacles, but it potentially faces greater immediate competition resulting from its failure to maintain what should be its core competence – namely, a highly efficient network. Further, antitrust enforcement might block demutualized traditional markets from acquiring ECNs and ATSs and thereby limit the budding competition.
At present, SelectNet lags far behind at both the open and even at the much smaller surge at the close of the regular trading day, because of the poor performance of Nasdaq's computing center in Trumbull, Conn. A super montage, decimal pricing, OptiMark cycling, etc., will add enormously to the processing load. Consequently, ECNs are developing their own direct links to avoid both SelectNet slowness (which causes them to eat unwanted trades) and expensive SelectNet charges.
While these links may temporarily reduce the load on Trumbull, they open up the possibility of even more serious competition. How difficult would it be for the ECNs to take the next step of jointly forming their own network to compete with Nasdaq Level II and SelectNet, while contracting with the big-five accounting firms to perform the SRO function?
Further impetus for direct competition with the NASD comes from Nasdaq's attempts to build its own limit order book to compete with the ECNs and ATSs. The NASD's super montage facility contains a virtual' limit order book that reflects market maker and ECN limit orders.
This consolidation of quotes is a natural function for Nasdaq in its role as a network utility. But the super montage, in contrast to Nasdaq Level II, does not identify which ECN is behind each order. Traders are forced to execute through Trumbull rather than going directly to the ECN. Further, the super montage also contains elements of order execution services that compete with ECNs.
The Microsoft model will not work for Nasdaq – the ECNs are not likely to roll over like WordPerfect and Quattro. If the NASD would be satisfied with running Nasdaq as an information utility it would not incite competition.
Fragmentation
The competition we are witnessing among entrenched market mechanisms and ATSs has raised concerns about market fragmentation. Should we be worried? Fragmentation is a synonym for competition. While one deep pool of liquidity sounds theoretically attractive, experience shows that monopolists behave like monopolists – they resist change and build costly fiefdoms. (Given their monopolistic legacy, both the Big Board and the NASD will have great difficulty adjusting their cultures to match the efficiency of the lean and mean ECNs and ATSs, even if they demutualize.) Since order flow is heterogeneous, fragmentation will naturally occur if markets are permitted to operate freely. A classic example is the niche markets of Bernard L. Madoff Investment Securities and the Knight/Trimark Group that bid the excess profits out of small retail trades with payment for order flow. These excess profits result from the negative inventory carrying cost of these orders. Forcing all trades through the same spigot results in cross-subsidization that is economically inefficient.
Fragmented markets should be informationally linked. But they should also be permitted separate simultaneous price discovery.
We are witnessing our wonderful free market system at its best. Naturally, there will be consolidation, but hopefully monopolies will not result. In an ideal world, a utility that operates a highly efficient network would permit ECNs, ATSs and exchanges low-cost entry to order flow competition, both within and among market mechanisms, such as continuous auctions, call auctions, crossing networks, etc. If Nasdaq quickly addresses its Trumbull problem, drastically cuts its costs, and ceases competing with its best customers, it could continue to provide that network. Otherwise the ECNs and ATSs may construct their own network. In either case, as they become exchanges, no longer hampered by Rule 390, they are likely to become aggressive competitors for Big Board order flow.
Dr. Robert A. Wood is distinguished professor of finance, the University of Memphis.
