For anyone interested in the creation, flourishing and demise of markets, Harvard University’s Professor Anthony Oettinger’s congressional testimony on the breakup of AT&T should make for a good read. The testimony was delivered over three days in September 1976 but many of its observations on the state of markets, market participants and human nature continue to ring true.
For all intents and purposes, AT&T was a monopoly; a giant that dominated its US market from 1877 to 1984. Its break up, catalyzed by the legal action of an aspiring competitor, had ramifications not just for the market for the provision of telephony services in the US but also for national security. For example, who would be responsible for the well functioning of a nationwide telecommunications network if AT&T was no longer AT&T? But above all are the insights we glean from this testimony on the nature of markets that continue to be of relevance and the idea that markets are created, expanded, shrunk, redefined, and destroyed by the strokes of legislative and/or regulatory pens should form part of the bedrock of our understanding of how businesses compete.
In some ways, exchanges and stock markets are business environments that result out of the interaction of two elements: regulation and microstructure (please see Stock Market Notes III). And just as legal and regulatory moves caused the break up of Ma Bell and opened up that sector for competition so it was for stock markets and exchanges when the Markets in Financial Instruments Directive (MiFID) came to be implemented in 2007.
MiFID is a European Union law that provides for harmonized regulation of investment services in EU member states with the main goal of increasing competition and consumer protection in investment services. There are competing persuasions as the ultimate impact MiFID will have on capital markets: Will it lead to increased liquidity or fragmentation? Will it result in fairer securities markets or price ambiguity? Will we see one EU ticker tape, real or de facto, or a conglomeration of price discovery belts that do not add up to a transparent whole?
MiFID, a regulatory revolution, coincided with another upheaval in the Information Technology sector. And just as Lotus 1-2-3 helped democratize the world of finance and capital markets by enabling smaller and newer players to compete with older, blueblood banks and establishments so it was that advances in trading systems (better and cheaper) enabled a similar dynamic to emerge in the exchange sector; alternative trading platforms and electronic communication networks continue to proliferate, competing with established exchanges who themselves have started to redefine their product offerings because of this competition. The marketplace, and a well regulated one we hope, will be the ultimate judge as to whether a particular strategy is an indication of the advent of meritocracy in a traditionally stratified sector, or mere folly.
As competition between stock markets, exchanges and alternative trading facilities increases, the choice of a trading system influences a player’s competitive advantage. Generically speaking, a trading system, a major component of a market’s microstructure, fulfills three functions: trade execution, the process by which orders are transformed into trades; order routing, the process of delivering orders from investors and brokers to trade execution; and, data dissemination, the transmitting of pre- and post-trade data to market participants.
A trading system can be one of three types:- A Continuous Limit Order Book System where bids and offers are submitted to the market continuously during trading hours and transactions can occur at any time during trading. All such systems have a price discovery mechanism whereby price is determined within the system based on order flow and regulations regarding priority and execution. Some of these systems have market maker operations.
- A Single Price Auction System where bids and offers can be submitted over a period of time but all trades are executed together at one price at one time (price discovery is part and parcel of these systems).
- A Passive Pricing System that determines execution prices by referring to activity on other markets (no price discovery mechanism).
Continuous trading can be realized through several techniques. However, the main two applications are Dealer Markets and Order-Book Markets. In Dealer Markets, dealers are responsible for offering prices at which to buy or sell securities. As such, the dealer is in charge of maintaining the market and is rewarded for this via the bid-ask spread and other privileges. In Order-Book Markets traders place the prices at which they are willing to buy or sell a security in an order book. Orders are matched and transactions take place. Buyer orders determine transaction prices, which tend to reflect information known to them. No one is in charge of maintaining the market.
Other variations on Continuous trading include the way orders are processed. This can take the form of orders transacted at market prices, Market Orders, or at a specified price, Limit Orders. Differences also exist in automation. For example, some markets are completely automated while some are automated for certain shares only.Hence, trading systems impact transaction costs on a particular market as well as a market’s overall quality, making a trading venue more or less attractive.
Although a common definition of market quality is difficult to come by, three factors are typically focused on to discern this: Liquidity, Informational Efficiency, and Volatility.
The importance of liquidity was covered in Stock Market Notes II but perhaps the speed factor in liquidity warrants some attention here. Speed depends on the ability of the trading system to handle trades within a certain period of time. Slow systems increase transaction costs. To put things in perspective, the Tokyo Stock Exchange recently debuted its upgraded trading system. Among other things, the new system reduces the time needed to process orders from two or three seconds to five milliseconds.
Informational efficiency denotes a market's ability to quickly and correctly reflect information into prices. A trading system can increase information efficiency through the information service it provides to market participants and by facilitating and encouraging transparency. Inefficient revelation of information raises the cost of trading as uninformed trades could be had at unfavorable prices.
Information does not arrive all at once but over a period of time. As a result, transaction prices seldom resemble the true equilibrium price; the price which assimilates all available information regarding a particular security. This leads to volatility and it is here that the function of an efficient information system becomes clear; the faster a trading system enables traders to incorporate new information into new orders, the less volatility there is in a given market.
Some studies have indicated that the choice of a trading system should move from efficiency, or quality, considerations to those of cost. Recent literature indicates that although competing trading systems differ in certain aspects, the differences are usually offset by advantages in other ways. Hence, the assumption is that new technology adoption requires clear cost savings.
*In collating these notes I benefited from the works of exchange experts that are too many to mention. I am grateful to all of them.
