Searching for a New Center: U.S. Securities Markets in Transition

Economic Review - Federal Reserve Bank of Atlanta, Fourth Quarter 2004 by O'Hara, Maureen

Things fall apart; the center cannot hold.

-W.B. Yeats, "The Second Coming"

The apocryphal warning of Yeats carries a particular resonance for the U.S. securities markets. Beset by scandals involving both the leadership and the membership, the New York Stock Exchange (NYSE) has struggled to find its bearings in a more demanding marketplace. And the Exchange is not alone in its efforts to find direction. The Nasdaq has found it increasingly difficult to compete with the host of new competitors invading its traditional dealer market. These competitors, in turn, have added new dimensions to the competitive calculus, such as competition over print revenues and rivalries over execution speeds. The advent of decimalization has transformed the pricing of securities, and technology has rendered the current market linkage system increasingly problematic. Indeed, even the ownership of the markets is changing, with Nasdaq now a publicly traded company and the regional exchanges contemplating public offerings. These ownership changes, combined with the recent problems involving oversight of trading practices, have brought into question the entire issue of self-regulation of the securities markets. The forces besetting these markets are converging from all sides.

In this paper, I set out some of the very important issues surrounding the evolving structure of the U.S. equity markets. My goal is not to determine the "new order" for the markets but rather to set out those issues that are at odds with the traditional structure characterizing both market governance and market operation. That structure, which was the foundation for the National Market System (NMS), envisioned a market characterized by a dominant exchange competing via market linkages with several smaller regional exchanges, a single dealer market operating under the auspices of the National Association of Securities Dealers (NASD), and self-regulation undertaken by the cooperatively run exchanges and the member-owned Nasdaq. With the current market structure now vastly different, the NMS framework is faltering, and the search is on for a new "center" for both firms and markets alike.

The Securities and Exchange Commission (SEC) has entered this debate with the publication of Regulation NMS, a four-part proposal of changes to the existing NMS structure (see SEC 2004). While addressing some specific problems with the NMS, I will argue in this paper that these proposals do not go far enough to address the new environment characterizing the U.S. equity markets. A particular omission is any recognition of the problems posed by changes in exchanges' governance for the self-regulatory structure of equity market oversight. I offer some examples of alternative regulatory approaches that might be more consistent with this new competitive environment. I conclude that the piecemeal approach of Regulation NMS misses the point that a new vision is needed for market regulation, one more consistent with the economic realities of today's markets.

I set the stage for my analysis by briefly detailing the regulatory and governance structures that have characterized the U.S. equity markets for the past quarter-century. I outline the original goals and structure of the NMS, set out some of the realities of the current market structure, and discuss the changing governance of exchanges. I then raise a series of issues relating to three overarching questions in market structure: Specifically, how should markets compete? How should they be linked? And how should they be regulated? Within these broad questions are a wide range of specific topics such as the role of price-time priority, liquidity rebates, tape revenue, pricing increments, and access fees as well as more general issues such as the viability of self-regulation.

Old Visions, New Realities

A natural starting point for our analysis is the passage in 1975 of the Securities Act Amendments, authorizing the SEC to facilitate the establishment of a National Market System for securities. The Securities Act articulated an explicit series of principles to guide the development of a national market but gave no specific guidelines regarding the market structure needed to attain these goals. Nonetheless, the vision was to establish a single national market system that would allow for (1) economically efficient execution of securities transactions, (2) fair competition between brokers and dealers, (3) availability of information with respect to quotations and transparency, (4) the opportunity to execute orders without the participation of a dealer, and (5) best execution of orders.1

As discussed by many authors (see, for example, Seligman 2003a and Blume 2000), these principles, while laudable, were ill defined and often conflicting in practice. The availability of information with respect to quotations, for example, has been criticized for allowing regional exchanges or alternative trading systems (ATSs) to free-ride on the price discovery efforts of other markets. Similarly, Macey and O'Hara (1997) argue that best execution of orders may be virtually undefinable (let alone unattainable) if features such as speed of execution are included in the execution metric. Perhaps a more fundamental criticism of the NMS principles was that it essentially implied a one-size-fits-all framework in which the disparate needs of traders were sublimated to the view that all orders would have equal standing.