Chapter 8: Institutions and Procedures in Secondary Markets A. Exchanges and Floor Markets The Securities and Exchange Act of 1934 defined an exchange to be: any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange. An exchange is typically a physical or virtual meeting place drawing together brokers, dealers and traders to facilitate the buying and selling of securities. Thus, exchanges include the floorbased markets as well as many virtual meeting sites and screen-based systems provided by Electronic Communications Networks (ECNs). In the United States and most other countries, exchange transactions are executed through some type of auction process. Exchanges in the United States are intended to provide for orderly, liquid and continuous markets for the securities they trade. A continuous market provides for transactions that can be executed at any time for a price that might be expected to differ little from the prior transaction price for the same security. In addition, exchanges traditionally served as self-regulatory organizations (SROs) for their members, regulating and policing their behavior with respect to a variety of rules and requirements. However, the Financial Industry Regulatory Authority (FINRA) has provided for self-regulation of the two major U.S. stock markets since the 2007 consolidation of the National Association of Security Dealers (NASD) and the Member Regulation, Enforcement and Arbitration operations of the New York Stock Exchange. NYSE Euronext and its Acquisition by ICE The New York Stock Exchange, dating from 1791, is the largest securities market in the United States. After a decade of significant change and several acquisitions in the early part of the 21st Century, NYSE Euronext was acquired by the IntercontinentalExchange Group, Inc. (ICE) in 2013, which then operated 23 regulated exchanges and marketplaces along with 5 clearing houses (firms that conduct the activities that provide for securities delivery after transactions are executed). As of August 2011, NYSE Euronext, the world’s largest exchange and its first global exchange, listed over 8,000 issues (excluding European structured products) from 55 countries on six equities exchanges and six derivatives exchanges in six countries. NYSE Euronext was launched on April 4, 2007, the result of a merger between the New York Stock Exchange Group and Euronext, NV. The New York Stock Exchange Group was formed by the earlier 2006 merger of the New York Stock Exchange and the Archipelago Exchange, and now operates the New York Stock Exchange (NYSE) with its now diminishing physical trading floor, the Archipelago Exchange (NYSE Arca), an electronic exchange that evolved from the Pacific Exchange, NYSE Amex, formerly the American Stock Exchange and NYSE Alternext, created in 2005 to list small and mid-sized companies. Together, these exchanges along with its European equities exchanges, represent one-third of the worlds equities markets. Euronext, NV was created by the merger of the Amsterdam, Brussels and Paris bourses, and later added the Lisbon Exchange and London's International Financial Futures and Options Exchange (LIFFE).
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As of early 2014, all of these markets operate under the NYSE Euronext umbrella. However, ICE plans to spin off the Euronext Group in a mid-2014 IPO. As of October 2008, the New York Stock Exchange, which traditionally has maintained the most stringent listing requirements, listed securities of 2,447 companies with a combined market value of over $10.3 trillion (post-crash). As of October 2008, AMEX listed 516 stocks with a combined value of $145 billion. These exchanges have since merged. At the same time, Nasdaq, which had been divested by the NASD in 2000/01, listed 2,934 stocks with total capitalization of $2.6 trillion. By June 2011, NYSE listing capitalization had grown to $13.791 trillion and Nasdaq listing capitalization totaled $4.968 trillion. See Table 6 for more comparisons. The Way it Was National and Regional Exchanges Traditionally, the New York Stock Exchange (NYSE) and the American Exchange (ASE or AMEX) were regarded as the two national exchanges in the U.S., but the NYSE acquired the ASE in 2008, incorporating its equity business into its own. Smaller companies from the ASE traded on the NYSE Alternext market and others have been listed on NYSE Amex Equities. Until the 1990s, numerous "regional exchanges" continued to operate. Regional exchanges, a term that is now somewhat in flux, traditionally included all but the two national exchanges. Such exchanges have included those in Chicago (formerly the Midwest Exchange), Boston and Philadelphia, the descendant of the Philadelphia-Baltimore-Washington Exchange. The Pacific Exchange, which originated as two separate regional exchanges in San Francisco and Los Angeles, maintained separate trading floors in San Francisco and Los Angeles, and was eventually acquired by Archipelago. Again, Archipelago has since merged (in 2006) with the New York Stock Exchange to form the New York Stock Exchange Group. These and other regional exchanges traditionally listed stocks that would not qualify for national exchange listing as well as provide local or competing markets for a number of national exchange listed securities. However, many regional exchanges no longer fit this mold, and most do not consider themselves to be regional. In some instances, either lower transactions costs or better prices can be obtained for clients for dual-listed securities on the regional or smaller exchanges; to some extent, competition provided by these regional exchanges may provide lower transactions costs for investors. In addition, different market structures and rules might provide for unique execution opportunities for clients and investors. There also exist a number of exchanges for other securities such as the Chicago Board of Trade (CBT - for futures contracts), The Chicago Board Options Exchange (CBOE), the Kansas City Board of Trade (commodities and futures) and the Commodities Exchange (COMEX). Many exchanges have no physical trading floors, including the National Exchange (formerly the Cincinnati Exchange, currently located in Chicago) and the International Securities Exchange (ISE). These exchanges operations are based entirely on electronic platforms. Table 1 provides a more comprehensive listing of the 16 stock, options and futures exchanges recognized by the S.E.C. as of February, 2014.1 In addition, there are exchanges and trading facilities that are not registered with the S.E.C. such as ICE's swap execution facility (SEF) for OTC Credit Default Swaps and bilateral financial energy markets. U.S. Stock and Options Exchanges
1

These markets have registered with the S.E.C as exchanges, pursuant to Article 6 of the Securities Exchange Act of 1934. Table 1 is taken from http://www.sec.gov/divisions/marketreg/mrexchanges.shtml.

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NYSE MKT LLC (formerly NYSE AMEX and the American Stock Exchange) BATS Exchange, Inc. BATS Y-Exchange, Inc. BOX Options Exchange LLC. (Boston Options Exchange) NASDAQ OMX BX, Inc. (formerly the Boston Stock Exchange) C2 Options Exchange, Incorporated Chicago Board Options Exchange, Incorporated Chicago Stock Exchange, Inc. EDGA Exchange, Inc. EDGX Exchange, Inc. International Securities Exchange, LLC The Nasdaq Stock Market LLC National Stock Exchange, Inc. New York Stock Exchange LLC NYSE Arca, Inc. NASDAQ OMX PHLX, Inc. (formerly Philadelphia Stock Exchange) U.S. Futures Exchanges Board of Trade of the City of Chicago, Inc. CBOE Futures Exchange, LLC Chicago Mercantile Exchange One Chicago, LLC The Island Futures Exchange, LLC NQLX LLC Partially Exempt Exchanges Arizona Stock Exchange SWX Europe Limited (f/k/a Virt-x) Table 1: U.S. Stock and Futures Exchanges as of February, 2014 Early Ancestors to Modern Exchanges Until recent years, U.S. and many other stock markets had evolved rather slowly over the centuries, hanging on to their roots, traditions, rules and regulations. Much of their current structures and idiosyncrasies still draw from this evolution. Understanding how markets and exchanges functioned in the past is helpful to understanding their current structures, policies and procedures. Precursors to modern stock exchanges might have existed in Egypt as early as the 11th century, where it is believed that Jewish and Islamic brokers traded a variety of creditrelated instruments. 13th century Bruges (Belgium) commodity traders assembled in the van der Beurse family home (and inn), ultimately becoming the “Brugse Beurse.” Additional bourses opened elsewhere in Flanders and Amsterdam. The Amsterdam Stock Exchange opened in the early 17th century, trading shares of the Dutch East India Company. The exchange continues to operate as a unit of Euronext, and as the world's longest continuously operated exchange. Several older exchanges began in coffee houses and taverns, where brokers and dealers would meet to trade securities. For example, the London Stock Exchange started operations in about 1698 in Jonathan’s Coffee House on Change Alley.

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The first securities exchange to operate in the United States was in Philadelphia, then the center of finance in the U.S., which opened operations in 1791. The New York Stock Exchange began operations outdoors after the May 17, 1792 signing of the “Buttonwood Agreement.” This contract, signed by 24 brokers under a buttonwood tree at what is now 68 Wall Street, fixed brokerage commissions among its signors and prohibited off-board trading (i.e., traders and brokers were to trade only with each other). In earlier days, exchanges often operated outdoors so that brokers could call out their orders from their office windows to the street where transactions actually took place. In late 1793, this group of brokers obtained the Tontine Coffee House, which was used for cold weather trading until the 1880s. In 1865, the New York Stock Exchange adopted its current name. The American Stock Exchange, known as the New York Curb Exchange until 1953, did not move indoors until June 27, 1921. For most of its history, Nasdaq was not considered to be an exchange because it did not have a physical trading floor. Founded in 1971 by the National Association of Securities Dealers (NASD), Nasdaq formerly known as the National Association of Security Dealers Automated Quotation System (NASDAQ), has served as an electronic stock market allowing brokers and dealers to efficiently transmit bid, offer and close prices for securities. Traditional New York Stock Exchange Structure Since the New York Stock Exchange is arguably the largest and most important exchange in the world, we will first emphasize its structure and organization, first past and then present. Until 2006, the NYSE was a sort of hybrid corporation/partnership whose members faced unlimited liability.2 At the same time, the NYSE structure was unaffected by the death or departure of any one of its 1366 members. Only members who owned or leased seats had trading privileges and there were four types of members, discussed below. Each member was an individual and most were sponsored by or associated with a brokerage firm or other organization (typically called a member firm). A membership was referred to as a seat, which was purchased (for as much as $4 million in 2005, and last sold on December 29, 2005 for $3,505,000) through a competitive market process. Full membership was limited to 1366 seats, though there had been special limited trading permits issued as well. Now, under its new structure, one can join the 1366 members by purchasing a license that permits the member to trade for one year. As of August 2011, the annual fee for a license was $40,000, billed monthly. The four types of traditional memberships were as follows: House Broker: also known as a commission broker executed orders on behalf of clients submitting orders through brokerage firms. Until 2006, approximately half of the members on the floor were commission brokers. This and other broker roles have been taken over by "Trading Floor Brokers." Independent Broker: also called a two-dollar broker, executed orders on behalf of commission brokers when activity was high. Alternatively, sometimes commission brokers executing orders on behalf of off-floor clients were referred to as floor brokers. This type of distinct membership no longer exists. Floor Trader: execute orders on their own trading accounts. As of 1992, there were approximately 40 floor traders on the NYSE and this number continued to decline through 2006. However, the NYSE has since created the "Supplemental Liquidity Provider" role, which is intended to enhance market liquidity by
2

This type of organizational structure for exchanges, quite common until the 1990s, is becoming increasingly rare.

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allowing for proprietary trading. We will discuss this new role shortly. Specialist: was charged with the responsibility for maintaining a continuous, liquid, orderly market for the securities in which he specializes. He also kept the book (records) for unexecuted transactions and bought and sold on his own account. There were approximately 400 specialists on the NYSE in 1992. Specialists were typically selected on the basis of their performance as specialists for other securities and other qualifications. Specialists were involved in approximately 20% of NYSE transactions as a principal. Because of their dual roles as running the market for securities on behalf of the exchange and as trader buying and selling those securities at a profit, the specialist's role was particularly interesting and somewhat controversial. The specialist was expected to fulfill his obligation to maintain a continuous, orderly and liquid market; this role may have conflicted with the desire to earn trading profits. (The specialist has been replaced by the Designated Market Maker (DMM), to be discussed shortly). Traditionally, trading activity for the shares of approximately 2779 listed firms (prior to 2006) centered about trading posts located around the floor throughout various rooms. Brokers and traders would congregate about these posts and specialists who oversee trading activity. Clerks employed by the exchanges record trading activities and relayed records to systems that disseminated data to the investing public. However, this system has mostly given way to automated screen-based trading, designated market makers who are expected to maintain liquid and orderly markets for specific stocks and off-floor supplemental liquidity providers who are paid fees by the exchange to execute transactions. Transforming the NYSE On April 20, 2005, the New York Stock Exchange dropped a bombshell on the investing public, announcing its intent to be taken over by Archipelago, the successor to the Pacific Stock Exchange. In a single sweep, the NYSE would be merged, privatized, expanded into derivatives markets and have its springboard for its transformation to an electronic trading market. Stock markets have traditionally emphasized roles of the specialists (replaced by designated market makers) who conduct auction markets and maintain liquidity for off-floor brokers and traders. Since the founding of the NYSE in the late 1700's, exchange markets have brought together widely dispersed brokers, dealers and individual investors, creating highly organized, visible and regulated environments intended to facilitate trading and price discovery. The traditional floorbased stock exchange in the U.S. centered around a specialist with a regular "trading crowd" that focused its energies on a small number of stocks. The specialist conducted an auction market for the trading crowd that gathered about. Floor brokers entered the trading crowd with orders initiated by larger off-floor traders while smaller and routine orders were more likely to be routed to the specialist through an electronic routing system such as the now-obsolete SuperDOT, the “Super Designated Order Turnaround System." The merger with Archipelago and the embrace of modern technology has completely changed the way the NYSE conducts its markets. Now, the role of the specialist has been passed on to designated market makers (DMMs) whose responsibilities and rights differ somewhat from their specialist predecessors. Designated market makers have no trading advantages relative to other market participants, have no special access to order books and are compensated by listing

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firms to provide liquidity. The NYSE has overhauled its technologies. For example, in July 2009, the SuperDOT system was replaced by the NYSE Super Display Book system (SDBK) for routing and processing orders. This new system enables customers to execute orders in as quickly as five milliseconds. Sophisticated traders are very concerned with the development of fast and efficient buyand-sell order processing systems, order executing (clearing and settling) systems and systems for the analysis of investments. Technology affects order processing, routing and matching of trades as well as valuation, hedging and portfolio risk management techniques. The NYSE has responded with numerous enhancements to facilitate trading activity. For example, it has dramatically increased its ability to handle increasing transactions volume (averaging over 1.3 billion equity shares per day in December 2014) due to improved technology. For example, the NYSE's ECN, the Super Display Book system (SDBK) permits orders to be routed electronically by brokerage firm for execution. Most program trades are also submitted through the SDBK system, accounting for over 10% of all orders. Overall, the SDBK system executes approximately 99% of all NYSE orders. For these SDBK orders, the brokerage firm need not have the order presented at the trading post by a commission broker. This means that the order can be executed faster, perhaps within 5 milliseconds. Those equities orders that are executed by a broker on the floor itself average 29,000 shares. When the NYSE opens at 9:30 EST, orders that have accumulated in the Opening Automated Report Service (OARS) are matched and the designated market maker attempts to establish a market clearing price. The designated market maker will attempt to open the security through this system at a price that deviates as little as possible from the prior day's close at 4:00 PM.

Access: PC, Phone, Wireless Communication Device, etc.

Order

Confirmation

Brokerage Firm Confirmation

Exchange Market Maker

Internalized ATS/ECN

Order Executed Order Settled

Figure 2: Securities Order Routing Process As recently as the turn of the century, the majority of retail transactions were initiated

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with client telephone calls to their stock brokers. However, this routing process has obviously changed markedly. Figure 2 depicts the routing process for a typical electronic or Internet-based discount broker transaction. The process for a “brick and mortar” broker would be the same except that client access to the broker is by telephone, and, of course, much slower. ATS transactions often eliminate the broker from the process. Internalized orders are executed by the broker itself, where orders are confirmed without reaching an outside market. Demutualization and Governance Changes A mutual organization is owned by members, typically employees, clients or suppliers. Mutual stock exchanges are owned by members who have trading rights in the exchange’s market. Accompanying the improvement of exchange technology in trading has been a trend to demutualize exchanges. This demutualization trend has meant that many exchanges have restructured to become stockholder-owned corporations. Euronext, the Australian, Pacific and London Exchanges were among the first to demutualize in 1997, 1998 and 1999, following the Stockholm Exchange in 1993. NASDAQ demutualized in 2000 and the NYSE in 2006. Most exchanges justified restructuring to for-profit institutions based on their needs to raise capital to finance their technology and infrastructure expenses. Exchange demutualization has also provided for more intense competition between markets. Exchange self-regulation and other regulatory issues remain important concerns for these restructured institutions. To avoid conflicts of interest, the NYSE Group created a not-for-profit corporation, NYSE Regulation, Inc., with the New York Stock Exchange LLC as its sole equity member. This new corporation performs all the SRO (self-regulatory organization – to be discussed later) regulatory responsibilities that had been conducted by the NYSE. NYSE Regulation seeks to ensure that listed companies comply with NYSE listing regulations, actively engages in the exchange rule-making process and monitors exchange trading activity for suspicious behavior The NYSE merger followed on the heels of the Richard Grasso compensation quagmire, where former CEO Grasso and the NYSE were heavily criticized for his $180 million pay package. Grasso resigned in 2003 and was followed in several months by John Thain who approached Archipelago about merging. The $6 billion merger deal granted the 1366 NYSE members about 64% of the combined firm's shares and the remainder to Archipelago shareholders (30%), NYSE top management (5%) and lower-level managers and employees (1%). Interestingly, the 5% granted to NYSE CEO John Thain and other top managers was valued at approximately $300,000,000, more than the disputed sums paid to former CEO Richard Grasso. A number of NYSE member-seat holders, notably Kenneth Langone, former Chairman of the NYSE Board of Directors complained about the price accepted by NYSE management. However, a seat on the NYSE sold for $960,000 in January 2005, $1,600,000 on April 20, 2005, shortly before the takeover announcement and for $3,000,000 in July 2005, shortly after the takeover announcement. By year-end, the price of a seat had risen to $4,000,000 before dropping to $3,505,000 at year-end. In addition, some NYSE members complained about Thain's former employer, Goldman Sachs representing both sides in the deal. Furthermore, Goldman Sachs owned several seats on the NYSE and maintained substantial holdings of Archipelago shares. However, two other investment banks, Greenhill and Lazard did required due diligence for the deal. The deal was valued by these institutions at between $3 and $5 billion, a substantial discount below the value implied by the July 2005 market price of Archipelago shares. Diminished Floor Trading Activity

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As the NYSE developed, acquired and improved its ability to handle electronic transactions, actual in-person floor trading activity diminished. As of the end of 2006, the NYSE trading floor exceeded 43,000 square feet. During 2007, the NYSE closed trading rooms, by November 2007, leaving slightly more than half of this trading space available for in-person transactions. In fact, as of 2007, trading activity on the NYSE trading floor produced less than 10% of NYSE revenue. More important sources of revenue to the NYSE now include listing fees charged to firms that want their shares traded on the NYSE and from selling price, quotations and other transactions data to the public. The trading floor crowd (including members, clerks, etc.) has diminished in numbers from over 3000 to less than 1700. Less than half of NYSE volume is executed on the floor, and DMM's (specialists) have been involved in less than 1 in 30 transactions as opposed to 1 in 7 as recently as 2002. Current New York Stock Exchange Equities Membership Types In late 2008, the specialist role yielded to that of the “Designated Market Maker,” who runs auctions for securities, has no advantageous knowledge of the order book and does not necessarily lose trade priority over other traders. In addition, the specialist’s liquidity providing function was taken over by both the designated market maker and supplemental liquidity providers (SLPs), outside firms that commit to maintain liquidity in specific stocks. The Designated Market Maker (DMM) has the obligation to maintain fair and orderly markets and facilitate price discovery in their assigned securities. The DMM opens and closes the market for its securities each day, is required to quote at the NBBO a specified percentage of the time, provide price improvement and match incoming orders based on a pre-programmed Capital Commitment Schedule. Designated Market Makers for a listed security can be selected by the issuer of the listed security or the issuer can delegate authority to the NYSE to select an eligible DMM. NYSE DMM firms include BofA Merrill, Barclays Capital, GETCO Securities, LLC, Knight Capital Group, Inc. and Spear, Leeds & Kellogg Specialists LLC. A second type of NYSE equities membership is the Trading Floor Broker who works orders on behalf of clients on an agency basis. Trading floor brokers are positioned at the point of sale during openings, closings and unique intra-day occurrences to execute trades. The third type of NYSE equities membership is the Supplemental Liquidity Provider (SLP), which is a high-volume member trading off of her own proprietary account that adds liquidity to the NYSE. SLP members are rewarded for aggressively providing liquidity and improve markets. They are expected to maintain a bid or offer at the National Best Bid or Offer (NBBO) in each assigned security at least 10 percent of the trading day. Major NYSE Supplemental Liquidity Providing (SLP) firms include Barclays Capital, Citadel Securities LLC, Goldman, Sachs & Company, HRT Financial LLC and Knight Capital Americas, L.P. Option Exchanges Most stock options in the United States are traded on one of the options exchanges. The oldest stock options exchange is the Chicago Board Options Exchange, which also owns the C2 Options Exchange. The NYSE has grown in stature in options markets with the NYSE Amex and NYSE Arca, acquired through takeovers. Nasdaq OMX operates the NSDQ and PHLX (formerly the Philadelphia Exchange) Exchanges. In addition, the Boston Options Exchange (BOX, which is jointly owned by the TMX Group and seven broker dealers) and ISE (owned by Eurex) both

8

maintain stock option markets. Table 2 provides volume data for all of these exchanges. The Options Clearing Corporation (OCC), jointly owned by the U.S. options exchanges, is technically the counterparty for all options transactions in the United States. This means that all option buyers own options that were written by the OCC and all option writers are obligated to the OCC. This arrangement, given the financial stability of the OCC and each of the exchanges which own and back its obligations and all of the brokerage firms that back the obligations of the exchanges have effectively eliminated default risk in listed options trading. Options trading took place entirely over the counter until the 1973 opening of the Chicago Board Options Exchange (CBOE). The nature of options trading lends itself to technological development at every stage of the trading process. First, because of option-trading strategies' emphasis on relative valuation and stochastic processes, the valuation and portfolio analyses require mathematical analyses that are computer-based. Maintenance of these strategies requires abilities to rapidly trade in and out of multiple positions simultaneously, relying on electronic communication technologies capable of handling larger amounts of data instantaneously. Technologies offered through the Internet offer these capabilities, forcing exchanges to anticipate and quickly improve on developments in order to compete. Cleared Total Contracts Premiums 158,529,881 $36,180,176,001 50,286,898 $12,952,402,034 49,788,089 $9,882,629,258 10,400,904 $1,457,446,499 316,112,979 $60,812,186,839 259,516,879 $45,392,864,394 69,144,416 $16,647,189,711 367,776,704 $121,172,599,631 1,491,204,897 $340,633,377,303 Avg. Daily % of Contracts Total Contracts 1,093,310 10.63% 346,806 3.37% 343,366 3.34% 71,730 0.70% 2,180,090 21.20% 1,789,772 17.40% 476,858 4.64% 2,536,391 24.66% 10,284,172 100.00%

Exchange ARCA BATS BOX C2 CBOE ISE NSDQ PHLX Total

Table 2: U.S. Options Exchanges; Data from January 1, through July 31, 20113 Competition among options exchanges continues to intensify, fostered by a myriad of new technologies and the introductions of equity option multiple listings beginning in the fall of 1999. The International Securities Exchange was launched in May 2000 as the first fully electronic exchange in the U.S., adding a significantly dimension of competition to the then largely floor-based markets offered by the CBOE, AMEX and PHLX. In addition, the ISE traded options with well-established markets on the other exchanges. In addition to the ISE, wellestablished foreign exchanges such as Eurex electronically trade contracts on U.S. equity instruments, further intensifying competitive pressures on major U.S. options exchanges. In fact, practically all European and Asian securities and derivatives exchanges have become entirely or almost entirely electronic. This increased competition has led to a number of important results including narrowing spreads (8% between 1999 and 2000 alone according to an SEC study; also see Battalio, Hatch, and Jennings [2003]), highly uncertain futures for competitors and the development and implementation of innovative quotations and trading systems. Options exchanges have innovated substantial technological advances to maintain and
3

Source: The Options Clearing Corporation.

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even anticipate developments in other markets. For example, among the exchange-initiated technological advances include Nasdaq’s automated exchange, SuperMontage. Options exchanges have experienced launching of the Chicago Board Options Exchange (CBOE) proprietary order routing and quotations HyTS Terminals (Hybrid Trading Systems) that offer trading desks point-and-click access (CBOEdirect) to all exchanges on one screen. Such pointand-click trading systems provide for instantaneous filling and confirmation of orders at the best prices along with transparency of trades. Asset managers rely on such systems to obtain speedy access to information, route and execute orders and to obtain trade confirmations. Several exchanges are providing for off-site market makers such as the CBOE Remote Market Makers (RMM's). These systems facilitate trading by off-floor investors and enhance liquidity by expanding the membership of market makers. These systems offer market makers direct access to the trading floor, enabling them to participate in the provision of market liquidity and subjecting them to the same market-enhancing responsibilities without requiring their physical presence. B. Over the Counter Markets and Alternative Trading Systems During most of the 20th century, the two national exchanges (NYSE and AMEX) along with a small number of regional exchanges hosted all U.S. exchange-based trading. All other trading was conducted either directly between counterparties or intermediated by broker dealers in what was called the over the counter markets. The creation of the electronic bulletin board NASDAQ by NASD, followed by its evolution into a full-fledged ECN, then its recognition as an exchange, along with the introduction of numerous alternative trading systems such as BRUT and BATS blurred the distinction between exchange and over the counter markets. Over the Counter Markets The over the counter markets have traditionally been defined as the non-exchange markets. Where the expression applies, over the counter markets are made up of broker-dealer houses that execute transactions on behalf of client accounts as well as their own. In addition, over the markets include transactions executed directly by trading counterparties. Almost all federal, municipal and corporate bonds are traded in the over the counter markets as well as many derivative products, structured products and the shares of smaller corporations. Brokers and dealers in the over the counter markets are members of FINRA, the Financial Industry Regulatory Authority, which absorbed the National Association of Securities Dealers (NASD). FINRA is an independent, self-regulated agency cooperating with the SEC. As of 2011, approximately 4,525 broker/dealer firms and 631,085 registered representatives were regulated by FINRA. FINRA also operates the largest securities dispute resolution forum in the world, processing over 8,000 arbitrations and 1,000 mediations per year. OTC markets for equities are comprised of a number of venues. For example, the OTCBB (Over-the-Counter Bulletin Board), is an interdealer electronic quotation system that displays real-time quotes, last-sale prices, and volume information for many over-the-counter (OTC) equity securities. OTCBB is not an exchange; securities are not actually traded through the system. OTCBB securities include national, regional, and foreign equity issues, warrants, Unit Investment Trust issues (UITs), American Depositary Receipts (ADRs), and Direct Participation Programs issues (DPPs). Investors do not have direct access to OTCBB. In 2012, OTCBB will be renamed as the Non-NMS Quotation Service (NNQS).

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Another important OTC equity venue is the OTC Markets Group, Inc. informally known as "Pink Sheets." This group also facilitates trading of shares of non-listed companies, providing quotation, messaging and information services to broker-dealers. Pink Sheets maintains categories based on the level of financial and corporate disclosure provided by companies quoted through their systems. For example, shares quoted in OTCQX, the top tier of the OTC market, meet certain financial standards and are subject to qualitative reviews. OTCQB tier companies (mid-tier) also provide significant disclosure to the marketplace. The OTC Pink tier, or the Speculative Trading Marketplace, is the third tier of the OTC market. OTC Pink has no financial standards or reporting requirements, and firms whose securities are traded there might not provide any public disclosure. The over the counter markets also include the so-called third and fourth markets. Third markets exist for listed securities traded between brokers off any exchange. Fourth markets are those where institutions trade securities directly among themselves in the so-called upstairs markets. These markets are particularly important for bank-to-bank derivative and structured products transactions. Institutions have used these markets for block trades (transactions involving more than 10,000 shares or $200,000 of a security), particularly when such a transaction might pose liquidity problems on an exchange. The upstairs markets might account for as much as one half of all stock transactions volume, though statistics are difficult to estimate and confirm. Stock exchanges and other markets vary with respect to how orders are intermediated. For example, the New York Stock Exchange permits its many of its members to act as both agents (brokers) and dealers. This means that an order counterparty might be either a dealer trading on her own account or a broker representing a client. On the other hand, the Over the Counter Markets are usually dealer markets, where investors transact only with or through dealers. Alternative Trading Systems An alternative trading system (ATS) might be loosely defined as a securities trading venue that is not registered with the S.E.C. as an exchange. Alternative trading systems provide electronic forums for linking dealers with each other and with institutional investors. They also match and cross trades in the upstairs market (fourth market). We will discuss the more precise S.E.C. definition shortly. The four primary types of ATS's are: 1. Electronic Communication Networks (ECNs), which are virtual meeting places and screen-based systems for trading securities. These ECNs include Bloomberg Tradebook (which bills itself as a more comprehensive full-service agency broker), LavaFlow ECN and ARCA Edge. 2. Dark Pools and "Crossing Networks," where quotations for share blocks are matched anonymously. These ATS's include Credit Suisse Crossfinder, Goldman Sachs Sigma X, Knight Capital Link, GetMatched (Getco Execution Services), Liquidnet, Posit Marketplace (ITG), MS Pool (Morgan Stanley) and Citi Match (Citigroup). Participants in crossing markets enjoy reduced transactions costs and anonymity but often must wait for counterparty orders to accumulate before transactions can be executed. 3. Internalization Crossing Networks such as UBS PIN that allows brokers or firms to fill orders from that firm's own internal supply of stock. 4. Voice-Brokered Third-Party Matching.

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A more comprehensive listing of alternative trading systems is provided in Table 3.

Name

Host Country

Instruments Features
Equities Equities Equities, FX and Derivatives European Shares Equities Equities FX Equities FX Equities Equities Continuous trading market platform (ECN) NYSE ATS Bills itself as an integrated full-service agency broker Multilateral Trading Facility Internal Crossing Network Bills itself as the world's largest dark pool; Internal crossing network ECN GETMatched: dark pool ATS or dark pool and other execution services ECN Largest dark pool according to Tabb Group 2008 study Crossing Network ECN Dark pool; Crossing Network Block negotiation (Crossing) Matches executions at exchange mid point of NBBO Dark pool Crossing Network Multilateral Trading Facility, Crossing network Crossing Network Crossing Network Suspended operations as of June, 2011 Crossing network Internal crossing network Crossing network for European stocks

Alpha Canada ArcaEdge (NYSE Euronext) U.S. Bloomberg Tradebook U.S. Chi-X Europe (Nomura, U.K. BoA) Citi Match (Citigroup) U.S. Crossfinder (Credit Suisse) Global Currenex (State Street Bank) U.S. Getco Execution Services U.S. Hotspot U.S. Knight Link (Knight Capital)U.S. Knight Match (Knight Capital) LavaFlow ECN U.S. U.S.

Equities and Derivatives Level ATS U.S. Equities Liquidnet U.S. and Global Equities MidPoint Match (ISE) U.S. Equities MS Pool (Morgan Stanley) U.S. Equities Nasdaq Crossing (Nasdaq) U.S. Equities NYSE Arca Europe (NYSE) France European Shares Posit Marketplace (ITG) U.S. Equities Sigma X (Goldman Sachs) U.S. Equities Track ECN U.S. Equities UBS ATF U.S. Equities UBS PIN U.S. Equities UBS MTF U.S. Equities

Table 3: Major Alternative Trading Systems (A Sampling) The most important of the electronic communication networks (ECN’s) dealing with equities have included BRUT (purchased by Nasdaq) Instinet, REDIBook and Archipelago, with the latter two having merged in 2002. Instinet, the first of the ECNs, was founded in 1967 as Institutional Networks, became a wholly owned subsidiary of Reuters in 1987, took its shares through an IPO in 2001 and merged with Island shortly afterwards before going private again in 2005. The focus of Instinet’s activities was block trading (10,000 or more shares), seeking to provide its clients with a high level of confidentiality. Major ECN’s dealing with foreign exchange include Hotspot and Currenex. The SEC defines an Alternative Trading System (ATS) to be an automated system that centralizes, displays, crosses, matches or otherwise executes trading interest, but is not currently registered with the Commission as national security exchanges or operated by a registered securities association. However, the SEC later redefined the term “exchange” to include “any organization, association, or group of persons that: (1) Brings together the orders of multiple
12

buyers and sellers; and (2) uses established non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.” Under this new definition, at least several ATSs might be considered to be exchanges, even if they are not traditional "brick and mortar" exchanges. In the past few years, several large ATS's, including BATS and DirectEdge have registered with the S.E.C. as exchanges. Thus, consider the following definition provided by Rule 300(a) of SEC Regulation ATS: Alternative trading system means any organization, association, person, group of persons, or system: 1. That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 under the Securities Exchange Act of 1934; and 2. That does not: i. Set rules governing the conduct of subscribers other than the conduct of such subscribers' trading on such organization, association, person, group of persons, or system; or ii. Discipline subscribers other than by exclusion from trading. What the ATS does not do is what distinguishes it from an exchange. However, these sorts of distinctions might remain in flux. The NYSE share of NYSE-listed trade executions have been steadily dropping as electronic exchanges and Alternative Trading Systems have grown in importance. For example, NYSE’s share of trading in its own listed stocks declined to 67.3% in December 2006, down from 76.5% from a year earlier.4 ECN trading of Nasdaq listed securities has been even more significant. Table 4 provides a listing of important equity markets along with their shares of daily volume as of September, 2009.

NYSE NYSE Arca Nasdaq NASDAQ OMX BX Broker-Dealer (Internalization) Direct Edge BATS Dark Pools Other Exchanges Other ECNs

14.7% 13.2% 19.4% 3.3% 17.5% 9.8% 9.5% 7.9% 3.7% 1.0%

Table 4: Equity Trading Centers Volume September, 20095
4

Weber, Joseph (2007). “Behind the Burst of the Bourses,” Business Week, February 5. p. 59. AMEX has since been merged into the NYSE. 5 Source: Securities and Exchange Commission, Release Number 34-61358; File Number S7-02-10, [2010], Figure

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C. The Decline of Brick and Mortar The natural monopoly power associated with the old exchange-based open outcry stock markets owes its early existence to a nearly complete absence of technology and communications systems. Investors were far too dispersed to conduct unaided securities transactions and security traders required a central physical meeting site for competitive executions. This site, or exchange enabled large networks of local broker offices to execute securities transactions on behalf of these widely dispersed investors. New York's Wall Street district provided an excellent venue for this purpose and the regional exchanges filled specific niches in the securities markets. As telecommunication technology advanced in the early decades of the 20th century offering market access to millions of investors, U.S. securities markets nearly self-destructed, only to be salvaged by regulatory authorities and intense efforts by exchanges to curb market abuse. Exchanges have since facilitated the monitoring for regulatory compliance in much the same manner that they facilitate trading. Shortly after passage of the Securities Exchange Act of 1934, the SEC gained authority over the exchanges that, in turn, monitored and regulated their members. Until the mid-1970’s, brokerage firms maintained their monopoly with a system of fixed transactions fees. All of their transactions were routed through the principle exchanges and offfloor markets. Exchanges had limited competition for securities listings. The primary sources of competition among securities brokers were in the arrays of services that they offered. After the price controls were lifted, the market saw formation of a number of discount brokerage houses that unbundled non-transactions services such as research and were able to offer drastically reduced execution costs. The market segmented to an extent, with some firms offering only transaction executions and others offering the full array of brokerage house services such as client advice. However, the vast majority of transactions were still routed through the principle exchanges and off-floor markets. More recent technological developments in telecommunications, wireless communications, the Internet and globalization have imposed enormous competitive pressures on U.S. securities exchanges. With the electronic NASDAQ system beginning in 1971, competition from foreign fully-automated exchanges trading U.S. Securities (e.g., Eurex), development of fully automated exchanges in the U.S. (e.g., the ISE) and ECNs such as the Instinet, Island and Posit systems that allow direct trading between institutions, exchanges have been forced to accept and even innovate technological development to survive. The natural monopoly enjoyed by traditional “brick and mortar” markets had been enhanced by a number of barriers to entry. Overhead outlays were required for large investments in office facilities, communications equipment, fixed exchange fees and memberships, broker training and licensing and building client bases. Each of these overhead outlays were accompanied by significant time lags and increasing times required for recapturing initial investments (payback periods). In addition, traditional brokerage offices experienced significant returns to scale (see Stigler [1961]), making it almost impossible for smaller and newer firms to compete against larger better-established firms. Each of these barriers to entry into the securities brokerage business applies to the creation of overhead-intensive “brick and mortar” securities exchanges and markets. For example, in the late 1990’s, the Chicago Board of Trade and the New York Mercantile Exchange constructed new futures pits that cost $180 and $228 million,
6. This table depicts trading volume for NMS shares.

14

respectively. However, recent electronic and other technological developments, particularly the Internet substantially relieve these costly barriers to entry. First, the majority of prospective clients already have Internet access and usage skills. Transactions costs are substantially reduced through use of equipment already installed in client homes. Whereas the typical U.S. customer stock transaction executed through a phone call has a variable cost of about $1, its cost is reduced to just $0.02 executed online. Similar disparities exist in open-outcry and electronic markets. For example, the open outcry LIFFE charged about $1.50 per for long and short positions on the Bund futures contract in the late 1990’s; its electronic German competitor DTB charged only $0.66 for the same contract. Open outcry exchanges in the United States charged fees of approximately $1.50 contract (see Cavaletti [1997]). More significantly, overhead expenses for Internet brokers run approximately 1 percent of assets, as opposed to 2-3 percent for brick-and mortar offices. Time required for Internet brokerage firm start-ups is substantially reduced relative to brick and mortar start-ups. In addition, the Internet and other technological advances have reduced economies of scale for brokerage firms. For example, as the Internet has largely replaced “cold-calling,” the fixed costs of seeking and soliciting the business of small clients have dropped significantly. Furthermore, clients of electronic brokers trade far more frequently than those of full-service brokers, with some estimates ranging to 10-25 times as frequent (Varian [1998]). Hence, smaller individual investors are able to play larger roles in securities markets at smaller costs. The increased participation of smaller investors, acting as day traders, enables them to replace specialists and market makers, at least to some extent, in the provision of liquidity to the market. In addition, the reduction of scale economies has increased competition among brokerage firms, in large part because so many of their services (e.g., advice, loans and cash management) could be unbundled and commoditized through automation. Some of these services require very little initial capital outlays and no unique technology. Removal of fixed brokerage commissions has substantially increased competition in the brokerage industry as reduced costs of service provision have softened barriers to entry. Brokerage commissions and fees had fallen from an average of $52.89 per trade in early 1996 to $15.67 in mid-1998. By 2000, a few online brokerage services had temporarily reduced their commissions to zero, and most still charge less than $15 per transaction. This particular scenario is interesting and quite controversial because it seems to be in part, a direct result of payment for order flow, where brokerage firms and other institutions receive compensation from electronic exchanges and ATSs as payment for directing their order flow to those markets. However, this practice has grown more widespread, and in 2010, even the NYSE began making payments for order flow to providers of liquidity. Barriers to entry based on ownership of physical facilities are disappearing, and existing firms are being forced vary their product lines and to merge into other institutions. Combinations, alliances and mergers between exchanges have also enabled previously smaller and less efficient markets to compete against larger ones. These combinations have enabled exchanges and markets to mutually benefit from one another’s technological resources. Some of these combinations have been domestic such as OneChicago, LLC, an alliance created by the Chicago Board Options Exchange and Chicago Mercantile Exchange to trade equity futures contracts and the Pacific Exchange and the Archipelago Exchange merger. On the international scene, the New York Mercantile Exchange opened a satellite open-outcry trading floor in Dublin for trading in a Brent crude oil futures contract and mergers among exchanges in other countries such as those forming Euronext and Eurex (combining the Deutsche Börse

15

AG/SWX Swiss Exchange). Each of these latter combinations offered improvements in investors’ abilities to trade on a global basis. Electronic versus Open Outcry Which trading and brokerage platforms result in lower trading costs? For example, does open outcry result in superior trading performance relative to electronic execution? In an interesting study, Bakos et al. [2000], with $60,000 provided by the Salomon Brothers Center at New York University, opened a series of accounts at various full-service, discount and electronic securities brokers. Their commissions for 100-share lots averaged $7.50 for electronic brokers and $47 for full-service voice brokers. They found that full-service brokers were more likely to route orders to the principle exchanges than electronic brokers and that such orders were more likely to be improved. However, for smaller orders, these price improvement advantages are more than offset by the higher brokerage commissions. Hence, specialists and market makers on exchanges were able to provide better order executions while brokers using electronic markets charged smaller commissions. It appeared that smaller investors fared better with discount electronic brokers while larger transactions resulted in better after-commission executions on the principle exchanges. Many of the studies of electronic versus open-outcry trading have used bid-offer spreads as a liquidity metric (e.g., Battalio, Greene and Jennings [1997]), where wider spreads indicate lower liquidity. Shyy and Lee [1995] found that spreads appeared to be wider in electronic markets than in open-outcry markets; Pirrong [1996] found just the opposite. Pirrong argued that miscommunications and misunderstandings between trade participants reduce efficiency of open-outcry markets and that these issues are avoided in electronic markets. Regardless, time to execute trades is certainly reduced in electronic markets. In addition, screen-based trading has facilitated after-hours markets. Now, a number of exchanges are offering investors opportunities to trade after normal business hours. The evidence concerning the provision of liquidity by open-outcry exchange markets relative to electronic markets is both ambiguous and mixed (e.g., Pirrong [1996], Breedon and Holland [1997]). Some electronic systems have driven floor-based open outcry markets from contention. For example, Breedon and Holland describe how during 1997-‘98, the computerized Eurex drew practically 100% of the trading in German Bund futures from the open outcry LIFFE which had held a 70% market share only months earlier. By 2000, LIFFE had abandoned openoutcry entirely for LIFFE CONNECT, a fully automated system. However, LIFFE did retain the bund options contracts, probably because of the more complicated strategies associated with them. In 1998, MATIF operated its open outcry and electronic systems simultaneously. Within two weeks, the computerized system had taken all volume from the open outcry markets that had to be closed. The Hong Kong Futures Exchange and the Sydney Futures Exchange both abandoned open-outcry during this same period. Frino et al. [2004] found that spreads narrowed on the Sydney and Hong Kong Exchanges; spreads widened on the LIFFE. In addition, according to Frino et al., bid-ask spreads on all three exchanges appear to widen in response to price volatility at a faster rate under electronic trading than with open-outcry trading, suggesting that the specialist-based system may offer better price continuity in periods of uncertainty. One of the difficulties of screen-based trading is the ability to efficiently disseminate significant amounts of information concerning trades. While it is easy enough for screens to display bid and offer prices, open outcry participants are able to more easily communicate verbally order types and combinations as well as other more complicated trade details. Such

16

matters grow in importance when trade sizes are larger or when, for example, an options trader is attempting to leg into a spread or other position. While screen-based trading provides for a greater level of anonymity, many traders prefer a market where their counterparties can be identified. In addition, Sarkar and Tozzi [1998] argue that open-outcry exchanges provide for more liquidity in more active markets while newer, less active issues are less likely to be found in open-outcry markets. One of the more troubling aspects of electronic brokerage transactions is that customers do not normally have a say in order routings and that orders need not necessarily be routed to the markets with the best prices. Many electronic markets have agreements with particular exchanges and markets to route transactions through them. These exchanges and market makers pay for order flow that might result in worse prices for clients. This practice, "payment for order flow," was pioneered by the famed Ponzi-schemer Bernard Madoff.6 This means that a brokerage firm will receive payments from an exchange or other market for routing orders to that market. For example, in 1999, the Knight/Trimark Group paid $138.7 million for order flow, with over 10% of this sum received from Ameritrade, a large electronic brokerage firm (Bakos et al. [2000]). Specialists and market makers on the major exchanges have resented this controversial practice of order flow payment and many discount brokerage clients seem unaware of it. But, as we discussed earlier, February 2010, even the NYSE will be making payments for order flow to providers of liquidity. D. Crossing Networks and Upstairs Markets One of the most vexing problems faced by institutional traders is the price pressure, called slippage, associated with large transactions. For example, placing a large sell order will force prices down against the seller. In fact, merely attempting to execute a large sell order reveals negative information to the market. Crossing networks are alternative trading systems that match buyers and sellers with respect to agreed-upon quantities. Crossing networks do not publicly display quotations, thereby enabling participants some degree of anonymity. Trades are priced by reference to prices obtained from other markets rather than by the more traditional auction systems.7 Traders using crossing networks announce their order sizes. The crossing network then matches buy and sell orders at prices obtained from more traditional markets such as the NYSE. This crossing procedure enables institutional traders to execute without exposing their order flow to competitors. The crossing network, by having prices determined elsewhere, also prevents the price impact or pressure typically associated with auctions of large blocks of shares. Because crossing networks do not reveal prices or client identities, and that they represent non-displayed liquidity, they are sometimes referred to as dark pools of liquidity. MidPoint Match and Nasdaq Crossing provide traders with opportunities to match orders anonymously at known benchmark (e.g., the mid-point of the spread) or closing or other prices several times a day. For example, trades can be executed after regular market hours, providing liquidity outside normal trading sessions. The match price is typically the volume weighted average price (VWAP) of all trades during the day. As of 2005, ITG’s POSIT Group was used by approximately 550 institutions and broker-dealers, crossing about 35 million U.S. shares per

6 7

We will discuss both payment for order flow and Bernard Madoff separately in Chapter 12. The Securities and Exchange Commission [1998] defines crossing networks as ‘‘systems that allow participants to enter unpriced orders to buy and sell securities. Orders are crossed at a specified time at a price derived from another market’’ (i.e., a continuous market such as the NYSE).

17

day.8 Total daily market volume averaged approximately 98 million shares in 2005, compared to approximately 1.8 billion for the NYSE. POSIT systems allows traders to enter order quantities that are matched during listing market trading sessions with execution prices at the midpoint of best bid and offer currently prevailing in the listing market. We discussed Liquidnet in Chapter 1, which is a negotiating venue that matches institutional buyers and sellers of large blocks of equity securities, enabling them to directly bargain and trade confidentially with one another. Liquidnet provides an electronic format for this negotiation process. Traders use the system by entering symbols for securities that they wish to buy or sell. If Liquidnet finds a potential match, it notifies the counterparties, who bargain anonymously with each other in a virtual meeting room using the Liquidnet system. This facility for bargaining distinguishes Liquidnet from the other crossing systems discussed here. Thus, trade counterparties negotiate directly with each other the terms of their trade. Counterparties will know prices from other markets, leaving relatively little room for significant pricing disagreements. If they come to terms, they report the transaction to Liquidnet which arranges the transfer and takes a commission on each share. The New York Stock Exchange also conducts several after-hours crossing markets. First, the NYSE offers Crossing Session I from 4:15-5:00 p.m. after the NYSE closes regular floor trading. Crossing Session I, when in effect, enables traders to match single stock orders at closing price. In addition, the NYSE offers Crossing Session II from 4:00-6:30 p.m. to enable program trades for 15 or more securities, regardless of their value. Furthermore, the NYSE MatchPoint system is an electronic facility that matches aggregated orders at predetermined fixed times (up to seven times daily, as of September 2008) with prices that are derived from ongoing floor trading. NYSE MatchPoint’s After-Hours Matching Session runs at 4:45 p.m. This matching system uses the closing or last transaction price from NYSE trading during the day and ATS’s. NYSE MatchPoint covers all NYSE, Nasdaq and regional stocks. It is also accessible via the Internet while crossing session orders are routed through SDBK. One market difficulty with these systems is that, like other crossing systems, they contribute little to the price discovery process. Internalization Internalization occurs when brokers execute their own client buy orders against their own client sell orders, representing both sides of a trade and without routing them to central markets. Internalization allows brokers to execute transactions more easily and at a lower cost. Of course, internalization does present some obvious potential problems. First, internalization may inhibit the broker’s ability to properly represent the client as the client’s agent, particularly when the broker is also representing a client on the other side of the transaction or acting as a dealer. Second, internalization results in fewer transactions being executed in the central market, which increases market fragmentation and reduces transparency and potential price competition. These problems can lead to reduced liquidity and increased price volatility in the central market. Internalization can lead to violations of price and time priority. Perhaps worse for the broker’s clients, the transaction may be more susceptible to manipulation or may not be executed at the best possible prices, consistent with the point above concerning the broker’s ability to represent the client. Internalization of customer orders is not possible for options markets transactions because options transactions must be executed on options exchanges as per rules of each options
8

According to Degryse, van Achter and Wuyts [2009], citing Towerwatch statistics

18

exchange. Some customer orders may be executed by the exchange's automatic execution system, but others are subject to the options trading crowd. However, some brokerage firms will submit their own orders simultaneously with their customer orders, such that there is a reasonable possibility that they will execute against each other. On the other hand, the trading crowd might "break-up" one or both sides of the orders, perhaps at better prices, such that the brokerage firm only participates in the executions of parts of one or both orders. E. Quotation, Inter-market and Clearing Systems The Securities Act of 1975 amended the Securities Exchange Act of 1934 to facilitate development of a national market system for securities transactions. With the national system created by this Act, Congress intended to increase competition, efficiency and price transparency in securities markets, and to promote best execution and order interaction. In this system, national and regional exchanges would list security prices simultaneously. The purpose of this national market system was to ensure that investors would receive the best possible transactions prices for their securities. The Securities Industry Automated Corporation (SIAC), now fully owned by NYSE Euronext, which maintains the primary systems for disseminating price and quote information to the public. The following represent some of the systems for providing price quotations and for executing and clearing trades that have arisen from this effort: Consolidated Tape (CTA): High-speed electronic system maintained by SIAC for reporting transaction prices and volumes for securities on all U.S. exchanges and markets. Consolidated Quotations System (CQS): Provides traders with price quotes through SIAC from the various exchanges and FINRA and calculates the NBBO. The CQS does not time delay as the Consolidated Tape can during periods of heavy volume. Intermarket Trading System (ITS): Displays quotes in different markets and links markets for trade executions to facilitate investors’ access to the best quotes. This system might be considered to be the centerpiece of the National Market System. Efforts to create this national market system also intended to protect investors placing limit orders from superior executions in other markets and enabling exchange members to execute off-floor transactions for exchange-listed securities. In addition to the national market systems listed above, the following quotation, inter-market, insurance and clearing systems are important:   Order Book: The order book stores limit orders and might be open (visible) to floor traders and market makers as on the Tokyo Stock Exchange or NYSE (NYSE OpenBook). Securities Investors Protection Corporation (SIPC): analogous to FDIC in that it insures investors' account for up to $500,000 in securities and $100,000 in cash, but only when the investor’s brokerage firm fails. Thus, this coverage is very limited. SIPC does not provide protection from declines in security values nor does it provide protection for losses from securities not registered with the SEC.

Clearing and Settlement

19

The general clearing process involves two primary tasks: trade comparison (matching of trades) and settlement (delivery of securities or book entry). Clearing refers to the set of activities resulting in the settlement of claims of financial institutions against other financial institutions. The operations department of a financial institution, often referred to as the institution’s back office, is responsible for handling or overseeing the clearing and settlement processes. Only approximately 5% of over 5,000 brokerage firms are self-clearing; that is, only 5% are capable of clearing trades for themselves. Other brokers, known as correspondent firms, forward their orders to a clearing firm. A clearing firm is authorized by a clearing house (defined below) to manage trade comparisons and other back office operations. Leading clearing firms include Pershing, LLC, JPMorgan Clearing Corp. and National Financial Services, LLC. A clearing house clears transactions for a market such as the NYSE and is typically established by that market or members of that market. A clearing house facilitates the trade settlement between two clearing firms (also called as member firms or clearing participants) and seeks to ensure that the clearing firms honor their trade settlement obligations. The clearing house will typically guarantee the obligations of its member firms, and often require collateral to ensure that settlement obligations are fulfilled. The collateral is pooled into a clearinghouse guarantee fund. The clearing house will step into a transaction to be settled by its members and assume the settlement obligations of both counterparties to the transaction, in effect becoming the counterparty to both sides of every transaction, a process known as novation. Thus, the clearinghouse, acting as a central counterparty, acts as the counterparty for each party to every transaction, and assumes all credit risk associated with each party. Option clearing houses will handle the process of option exercise. In the United States, the National Securities Clearing Corporation (NSCC, a division of the Depository Trust and Clearing Corporation, described below) and the successor to the combined clearing corporations of NYSE, AMEX and NASD is the major clearing agent for equity markets. NSCC serves as the clearing agent for these three major equity markets as well as for many bond markets. Its primary facility for clearing is the Securities Industry Automated Corporation (SIAC), which maintains the computer systems for clearing. Clearinghouses clear and settle trades for most options, futures and swap markets. The Board of Trade Clearing Corporation (BOTCC) clears and guarantees trades for the Chicago Board of Trade. All U.S. options exchange transactions are cleared through and guaranteed by the Options Clearing Corporation (OCC). The OCC clears transactions for options and futures on equity instruments, stock index contracts, currencies and certain interest rate contracts as well as a number of contracts in other markets. Confirmation is the first step of the clearing process. When trades are executed, buyers and sellers record trade details. Brokers and dealers receive confirmations that the trade has been executed and pass on details of the confirmation to clients. The typical confirmation document received by the client reports the stock's name and CUSIP number (the security’s 9-character alpha-numeric identifier issued by the Committee on Uniform Security Identification Procedures), the number of units traded, the security price, the broker commission and other fees, along with trade and settlement dates. Trade comparison is the second step in the clearing process. Comparison matches counterparties in transactions. Trades are compared and are said to be cleared when the counterparties’ records are identical. This happens for the vast majority of trades. Out-trades in futures markets or DK’s (Don’t Knows) in other markets, which are trade reports with discrepancies resulting from recording errors, misunderstanding and fraud, are sent back to

20

traders to resolve or reconcile. The number of securities transactions that occurs each day is huge, requiring some sort of process to simplify the process of changing title to securities and moving corresponding cash proceeds between accounts. Netting is the simplification process used by clearing firms, and is one of the most important functions of the clearing process, and of the NSCC. Netting is the process of adding all of an institution’s purchases of each security, adding the sales of each security, deducting sells from buys to determine the net change in holdings of that security for the institution and computing the net cash flows associated with all transactions. The NSCC uses an automated system through the Securities Industry Automation Corporation (SIAC) to “net down” or reduce the number of trading obligations that require financial settlement.9 Since most brokerage firms execute large numbers of both buy and sell transactions for the securities that they trade, netting down results in only about 3% of the total reported matched or offsetting transactions actually having to be settled between financial institutions. At the end of the netting process, the NSCC delivers to each brokerage firm settlement instructions. Trade settlement occurs when buyers receive their securities and when sellers receive payment for their securities. Stock ownership in most cases is evidenced by a certificate. The Depository Trust & Clearing Corporation (DTCC), holds stock certificates of member firms, registering them in member names and maintaining computerized records of ownership and transfers.10 As of year-end 2006, the DTCC was holding over 5.5 million stock certificates worth over $36 trillion and had processed over 8.5 billion transactions during the year. Overall, the DTCC settled more than $1.48 quadrillion in securities transactions in 2009, including equities, fixed income instruments, mutual funds, insurance products, etc. Equity securities are held in street name, meaning that securities are held in the names of brokers (nominee names), who, in turn, maintain their own records of ownership in client accounts. Settlement of a trade is completed when the DTCC transfers the ownership of the shares from the selling firm to the buying firm in its automated book-entry recordkeeping system and transfers money between firms with net credits and net debits. Firms that have net credit after end-of-day netting are owed more by other brokers than they are owed. The National Securities Clearing Corporation (NSCC) transfers money to banks of these net credit firms from accounts of brokers with net debits through the Fedwire system. Federal law requires that settlement occur within three days after the transaction. In addition, the DTCC provides cost basis information and other information services. The DTCC provides clearing services at a very low cost, averaging approximately $.0000066 per share. In the 1960s, securities clearing involved the physical transfer by messenger of paper securities and checks. However, by 1967, this system was failing. The Depository Trust Corporation (DTC) was set up in 1973 to handle the clearing business for the major stock exchanges. Since 1999, the DTCC has owned the Depository Trust Company and the National Securities Clearing Corporation. The DTCC also owns the Fixed Income Clearing Corporation and Deriv/SERV, LLC. The DTCC is owned by its customers, exchanges and ECNs that clear through their facilities. The NSCC and the DTCC require brokerage firms to maintain collateral to ensure that they fulfill their obligations.

9

More generally, SIAC, a subsidiary of the NYSE, runs the computer systems and communications networks on behalf of the NYSE and performs clearing functions on behalf of clearing firms. 10 In the case of Direct Registration Systems such as Dividend Reinvestment Plans, the issuing firm will place the security certificates with a transfer agent, which is normally a bank with an affiliate structured for this purpose.

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F. Brokerage Operations Until 1975, brokerage firms in the United States functioned as a rather exclusive cartel, fixing commissions and offering clients a wide array of services ranging from providing trade executions and margin opportunities to offering advice and management services. Brokerage firms were all said to be full service, and included firms such as Merrill Lynch, E.F. Hutton, Paine Webber and Smith Barney. The industry was forced by the federal government to break its cartel and compete with respect to brokerage commission levels. Numerous discount brokers opened operations, competing against full service brokers by offering trade executions with lower brokerage commissions. Discount brokers initiating operations in the 1970s included Quick & Reilly and Charles Schwab. The Internet’s development in the 1990’s and shortly afterwards created opportunities for Internet brokers such as Ameritrade, ScottTrade and E-Trade to further reduce commissions and execute transactions for clients without actually speaking live with brokerage account representatives. Investors wishing to open broker accounts need to consider their trading needs and interests to properly select their brokers. Investors needing substantial advice and counsel along with other services may find their needs better fulfilled by full-service brokers such as Merrill Lynch, Raymond James or UBS. In addition, there is some statistical evidence (discussed earlier) suggesting that larger full-service firms better provide for transactions price improvement (executing the client’s transaction at a price that is better than the best bid or offering at the time of the transaction). Investors who are comfortable with their trading experience and who expect to execute smaller trades, particularly more frequent smaller trades might prefer the lower commissions offered by an Internet broker such as ScottTrade or T.D. Ameritrade. These on-line brokers will often offer low flat-rate commissions, sometimes even dropping to zero, particularly when the brokerage firms receive payment for order flow. J.D. Power and Associates regularly provides broker quality information based on its customer satisfaction surveys. Important evaluation criteria include commission levels, percentage of orders showing price improvement, frequency of limit order executions, margin and cash interest rates and customer satisfaction. Barrons conducts similar surveys. Such surveys are useful in making broker-selection decisions. Most stock orders in the United States are placed through stockbrokers who are compensated with commissions. These commissions are typically charged as a fraction of the dollar volume of the transaction and as a function of the number of shares associated with the order. In many instances, the broker's commission will be a function of the Bid-Ask Spread; that is, the difference between the lowest price a trader is offering for the security and the highest price an investor is willing to bid for that security. Over the counter markets and particularly exchanges will provide for Trading Priority Rules, which designate which orders will be filled or the sequence in which orders will be filled. Frequently, priority rules are designated according to transaction price, size, location of origination of order timing, etc. G. Markets around the World As discussed above, the oldest continuously operating stock exchange is the Amsterdam Bourse, which first traded stock of the East Indies Trading Company, and now is part of the NYSE Euronext Group.11 The New York Stock Exchange started trading in the streets, the Paris Exchange, organized under the regime of Napoleon, started on a bridge (Pont au Change) and the
11

Some material in this section was adapted from Solnick [1991].

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London stock market started in a tavern. Traditional brick and mortar exchanges since have been any one of three basic types. The first, the public bourse, is essentially a public institution, established by and operating under the authority of a government. However, most public bourses, including the Paris Bourse in 1990, have reorganized to become private bourses. The private bourse, such as the NYSE is a private institution established by independent investors and institutions. The NYSE has evolved into a publically-traded stock institution, though it is still a private bourse in this context. These exchanges are still subject to governmental regulation. Finally, the bankers' bourse exists where the primary dealers of securities are banks, where commercial banking functions were not distinct from brokerage functions as was the case in the U.S. In Germany, banker's bourses have served banks who also served as the primary stockbrokers. As of early 2012, the largest stock markets in terms of monetary volume are in New York (NYSE and Nasdaq), Tokyo (TSE) and London (LSE). As of year-end 2010, the New York Stock Exchange listed equities exceeding $13.39 trillion in market value (See Table 6). The Nasdaq and Tokyo Stock Exchanges each listed $3.8 trillion and the London Stock Exchange listed $3.6 trillion. NYSE Euronext (Europe), with several exchanges in several countries listed $2.9 trillion in equities and Shanghai listed $2.7 trillion.12 The U.S. and U.K. have long histories of funding business with publicly-traded equity securities, whereas commercial bank funding has played larger roles in Japan and Germany. This is one of the major reasons as to why the London stock markets are larger than those elsewhere in Europe, despite the relative small size of the U.K. economy relative to that of Europe. Exchange 1 2 3 4 5 6 7 8 9 10 NYSE Euronext (US) NASDAQ OMX (US) Tokyo Stock Exchange Group London Stock Exchange Group NYSE Euronext (Europe) Shanghai Stock Exchange Hong Kong Exchanges TMX Group (Toronto) Bombay SE National Stock Exchange India USD bill. Year end-2010 13,394 3,889 3,828 3,613 2,930 2,716 2,711 2,170 1,632 1,597

Table 6: Major Exchanges of the World Since 1974, China, India and the Pacific region have produced the largest growth rates in equity markets as a percentage of world equity markets. The combined proportions of these markets as a percentage of world markets have grown from 16% to 39% of world markets. Japan has been by far the most significant contributor to this figure. European equity markets as a percentage of the world total have increased from 22% to 26% of the world total. U.S. equity markets have remained fairly constant, declining from 57% to 55% of the world total.13 Over this 37-year period, the world equity market has grown from less than $900 billion in 1974 to over
12

Figures in this section and Table 6 are adapted from reports by the World Federation of Exchanges. These percentage figures are estimates, drawn from somewhat different periods and sum to more than 100%.

13

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$46 trillion as of 2011. Reports from ING Baring Securities and the U.S. Census Bureau indicated that U.S. ownership of foreign stocks has increased from $41 billion in 1985 to $3.977 trillion in 2010.14 This increased investment has been the product of a number of factors, including improved investing technology, reduced constraints on capital mobility, a greater appreciation for benefits of diversification and a belief in the potential for higher returns from foreign investment. Historically, European and Japanese investors have maintained higher levels of international investment, but U.S. equity portfolios have significantly increased foreign holdings. Additional Reading Harris [2003], Chapters 1 to 8, provides a nicely detailed introduction to securities and markets and Chapters 13 to 18 will be very useful for understanding market mechanisms and trading institutions. Schwartz [1988] provides a somewhat dated but very readable discussion focused on equity markets in Chapters 1 to 15. The New York Stock Exchange web site (http://www.nyse.com/), through its “About Us” and “Education” links will offer the latest developments on trading NYSE securities. Other exchanges have similar sites. The World Federation of Exchanges will provide much useful information and data concerning exchanges at http://www.world-exchanges.org. Morris [2009] provides a detailed discussion of the clearing and settlement processes.

14

See the Wall Street Journal, May 28, 1996, p.R23 and "U.S. Holdings of Foreign Stocks and Bonds by Country," Table 1203, The 2011 Statistical Abstract, U.S. Census Bureau.

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References Bakos, Yannis, Henry C. Lucas, Jr., Gary Simon, Sivakumar Viswanathan, Wonseok Oh and Bruce Weber (2000). “The Impact of Electronic Commerce on the Retail Brokerage Industry.” Unpublished working paper, New York University. Battalio, R., Greene, J., and R. Jennings (1997). “Do Competing Specialists and Preferencing Dealers affect Market Quality?” Review of Financial Studies 10, pp. 969-993. Battalio, R.J., B. Hatch, and R. Jennings (2004). “Does A National Market System Exist For U.S. Exchange-Listed Equity Options?” Journal of Finance 59, 933-962. Breedon, Francis and Allison Holland (1997). “Electronic versus Open Outcry Markets: The Case of the Bund Futures Contract.” Unpublished working paper, Bank of England. Cavaletti, Carla (1997). “Commission Rate Ride.” Futures 26, (12), 68-70. Christie, William G., and Huang, Roger D. (1994). “Market structures and liquidity: A transactions data study of exchange listings,” Journal of Financial Intermediation 3, 300–326. Claessens, Stijn, Thomas Glaessner, and Daniela Klingebiel (2000). “Electronic Finance: Reshaping the Financial Landscape Around the World,” Unpublished Financial Discussion Paper No. 4, The World Bank. Degryse, H., M. van Achter and G. Wuyts (2009), “Dynamic order submission strategies with competition between a dealer market and a crossing network.” Journal of Financial Economics, Duhigg, Charles (2009), “Stock Traders Find Speed Pays, in Milliseconds,” Wall Street Journal, July 24, 2009, A1. Frino, Alex, Amelia M. Hill, E. Jarnecic and M. Aitken (2004). “The Impact of Electronic Trading on Bid-Ask Spreads: Evidence from Futures Markets in Hong Kong, London and Sydney,” Journal of Futures Markets, 24, 675-696. Harris, Larry (2003). Trading and Exchanges: Market Microstructure for Practitioners, Oxford, U.K., Oxford University Press. Howe, John S. and Katherine Kelm "The Stock Price Impacts of Overseas Listings", Financial Management, Autumn 1987, pp.51-56. Huang, Roger D., and Stoll, Hans R. (1995). ‘‘Competitive Trading of NYSE Listed Stocks: Measurement and Interpretation of Trading Costs,’’ Working Paper 94–13, Financial Markets Research Center, Owen School, Vanderbilt University (March 13). Huang, Roger D., and Stoll, Hans R. (1996). Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE, Journal of Financial Economics

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41(3), 313–357. Klein, Alec (2004): "Credit Raters' Power Leads to Abuses, Some Borrowers Say." The Washington Post. 24 November 24. p.A01. http://www.washingtonpost.com/wpdyn/articles/A8032-2004Nov23.html. Morris, Virginia B. (2009): Guide to Clearance & Settlement, Lightbulb Press. NYSE Euronext, http://www.nyse.com/tradingsolutions/transacttools/1204674243385.html, Accessed on March 20, 2008. Pandit, Jay (1996) "The Effect of Circuit Breakers on Basis Volatility and Hedge Performance," unpublished memeo, Pace University. Pirrong, Stephen Craig (1996): “Liquidity and Depth on Open Outcry and Automated Exchanges: A Comparison of the LIFFE and DTB Bund Contracts.” Journal of Futures Markets. Schwartz, Robert A. Equity Markets: Structure, Trading and Performance. New York: Harper and Row Publishers, 1988. Securities and Exchange Commission (1998). “Regulation of exchanges and alternative trading systems.” Release Number 34-40760, 8 December. Shyy, G., and J. Lee (1995). “Price Transmission and Information Asymmetry in Bund Futures Markets: LIFFE vs. DTB.” Journal of Futures Markets 15, pp. 87-99. Solnick, Bruno. International Investments, 2nd edition, Addison Wesley Publishing Company, 1991. Stigler, G. (1961). “The Economics of Information.” Journal of Political Economy 49, 213-225. Weber, Joseph (2007). “Behind the Burst of the Bourses,” Business Week, February 5. 59.

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Exercises 1. For a 20-year period beginning in 1986, the New York Stock Exchange was regularly criticized for making less use of electronic and computer technology than most of its competitors around the world, even less than exchanges in emerging and developing countries and than exchanges just starting business. The NYSE would argue that its specialist system required more “face-to-face” contact than other, non-specialist exchanges. a. Why would the NYSE specialist system require more face-to-face contact than its competitors? b. Assume that face-to-face contact hurt investors more through increased trading expenses and reduced trading efficiency than it helped them. That is, assume that the argument that you prepared for part a is simply wrong. Why might the NYSE still resist adopting improved electronic and computer technology? 2. How does a stop order differ from a limit order? 3. Exactly what does an investor expect from her broker when she places a stop limit order with a stop price to buy at 50 and a limit price of 50.10? Why might an investor place such an order?

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Solutions 1. a. The specialist system was intended to maintain a continuous, orderly and liquid market for investors. Participants in a trading crowd on the NYSE trading floor are expected to contribute to this effort. Personal contact with each other enables the specialist and floor brokers and traders to better know each other and establish working relationships and trust. b. The NYSE was a very old exchange with well-established practices that worked very well over the years. In many respects, it is more expensive to change a way of doing business to make it more efficient than it is to create a new one without any history. In addition, the exchange was owned by its members, who had invested their capital and careers into working on the floor of the exchange. It is very difficult to induce members with such heavy investments in this manner of doing business to give up such a large investment. 2. A limit order sets an upper price for a purchase or a lower price limit for a sell, preventing the broker from paying more or accepting less for the security. A stop order instructs the broker to place the buy order once the price has risen above a given level or place the sell order once the price of the security has fallen beneath a given level. The limit order restricts the price; the stop order triggers the order execution. 3. This stop limit order triggers the buy once the price rises to 50, but is executed only if the stock can be purchased for no more than 50.10. Stop orders to buy are often placed when the investor wants to buy the stock on upward price momentum, but the limit is typically placed when the investor wants protection from paying more than she wants for the stock.

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