Lecture 5 Secondary Equity Markets – III NYSE and NASDAQ

Overview Examples: –NYSE –NASDAQ. Tick size and its effects. Payment for order flow.

NYSE and Nasdaq Understand the evolution of these two major equity markets. Evaluate the importance of institutional features, which sometimes are seem quite negligible at first glance. Understand the effect of regulatory environment on market performance.

NYSE The first exchange in the US; became the leading world stock exchange. Type of market: trading floor / electronic order delivery; call auction in the morning; continuous double auction (LOB) + specialist and floor traders during the day. Membership close to 1,500; over 400 specialists.

NYSE Recent History YearShare volTurnov Trades$ VolumeAver. PriceSeat Price (000')% Mln 19683,29824%9,704$145$44.00$515, ,20527%10,050$200$27.70$105, ,85055%17,739$1,356$33.20$820, ,74576%135,840$7317,9$43.10$2,000, ,09999%933,111$11,618$31.65$1,150,000

Specialists Their mandate is …to maintain a fair and orderly market. Lean against the wind. Why should they do this, rather than making money? Because this is conducive to making money in the long run. They act mostly as facilitators, brokers, and dealers. Can step before the limit order, if improve the price, but has the last priority if does not.

Order Delivery and Quotes Order delivery systems: –SuperDOT (Designated Order Turnaround) – 600 messages per second capacity; –BBSS (Broker Booth Support System): directly to the specialists Display Book; or to the floor broker. ITS (Intermarket Trading System) Boston, Phily, Chicago, Cincinnati, Nasdaq, and ECNs. Upstairs market. Crossing networks (POSIT).

Listing requirements SRO – very strict listing requirements. Few firms do IPOs on NYSE; they mostly transfer from other exchanges. Large spin-offs of existing firms, large IPOs (Goldman), and foreign firms. Rule 500 – now repealed.

Listing Requirements Distribution and Size Criteria (all) 1.Round lot holders or Shareholders Market value of public shares: Public companies $ 100 m., IPO - $ 60 m. Financial Criteria (at least one) 1.Aggregate pretax earnings of $10 Mln over the 3 recent years. 2.Revenues for recent fiscal year of $75 m. and global market capitalization of at least $750 m.) 3.Short term assets of at least $60 m. (when the firm has less than 3 year operating history).

Performance Volume shoots up when fixed commissions are abolished in Spreads declined over the last decade as volumes increased; and became much lower following the introduction of penny ticks (percentage spreads declined even more since prices rose). NYSE volume share declines from 86% to 83% in 10 years. Much less in small transactions (close to 50%). Payment for order flow: will discuss later.

Nasdaq Dealer market with no floor (market makers). Competition among the dealers as a comparative advantage. Traditionally considered as a Farm Team for the NYSE and AMEX. Place for firms to go public, before joining the big league. Fragmented trading venues.

Perfect Competition? Nasdaq was frequently used in economics classes as an example of a perfectly competitive market: –homogeneous product – common stock; –many participants – market makers; –free entry – easy to become a market maker; –immediately observable prices, quoted in advance witnessed over 80% decline in spreads, which are the costs of immediacy for small and medium orders. Large orders faired less well.

NNM Initial Listing Requirements

Continued Listing Requirements

The Nasdaq SmallCap Market

History Creation of a computer network connecting the dealers - automated quotations SOES (Small Order Execution System); Black Monday – demand for reform SOES becomes mandatory (SOES bandits); Payment for order flow is deemed OK; Christie and Schultz – odd eighths avoidance; New Order Handling Rules; 1/16th tick; 2001 – Decimalization: tick = penny.

Average daily volume (Mln. shares) Average daily volume ($ Bln.) NYSENASDAQNYSENASDAQ

Prior to 1997 Fragmented trading venues (* indicates where the price grid was a binding constraint): –quotations (*); –SOES trades (*); –preferenced order flow (* for market orders); –telephone; –SelectNet; –ECN; –Crossing networks.

Digressions Tick size and its effects. Odd eighths avoidance – not a trivial matter. Payment for order flow and its effects on the markets.

Tick Size Minimal price increment imposed by the exchange. History. Constraint on prices. Could be beneficial to investors, but in many cases is detrimental. Monopoly versus competition.

Small Tick Size (penny) – P =$100

Larger Tick Size (dime) – P =$100

Very Large Tick Size ($0.5) – P =$100

Competition with Discrete Prices You sell a product in a market with many competitors: Cost per Unit = $0.9. Prices are on a $1 grid: $1, $2, $3... What is the equilibrium price? –$1 is always an equilibrium. –But so is $2 if the number of competitors is less than 11. IF n competitors, then the alternatives are: getting 1/n times $1.1 or getting 1 times $0.1. –Not $3.

Dealers Quoting Discrete Prices Suppose the inside spread exceeds the cost by two tick sizes - does an individual dealer want to reduce the spread? The answer is - NOT LIKELY !

Ask Bid Dealer Cost Tic k Sprea d

Possible Strategies Reduce the Ask price and get a large short position. Increase the Bid price and get a large long position. To unwind these positions – need to improve the prices on the other side as well. This makes it too costly.

Implications At least TWO competitive equilibria exist for any number of dealers. Price greater than cost does not necessarily mean collusion. Collusion in certain spread range cannot be ruled out by appealing to competitive forces. Relevance for NASDAQ.

Odd Eighths Avoidance, or… …Preference for Spreads Two Ticks Above Cost. Coordination by convention. Once established no communication or enforcement required. Easy to break and hard to re-establish.

Hypotheses Preference for spreads that are two ticks above costs regardless of the tick size: Stocks quoted on 1/16th should avoid odd 1/16th quotes. Stocks quoted on 1/16th should not avoid odd 1/8th quotes. Coordination implies higher profits: Stocks which avoid odd 1/8ths must have higher spread, ceteris paribus.

Sample of stocks with P > $10.

Sample of stocks with $10 > P > $5.

Payment for order flow Market makers contract directly with brokers for their entire order flow – NYSE and NASDAQ. Match NBBO. Pay brokers rebates (fees). Internalization – brokers vertically integrate into market making - NASDAQ. Cream skimming, or profit sharing.

Brokers MarketMakers Order Flow

Brokers MarketMakers Large Orders Small Orders

Brokers MarketMakers Large Trades Small Non-preferenced Trades

The Effects of the Payment for Order Flow Avoidance High Spread Preferencing Less Competition High Spread New Technologies / Lower Commissions

Equilibrium Conditions Market for preferenced trades. – Market clearing; – Profit maximization by brokers in the choice of venue; – Profit maximization for market makers (entry and exit).

Equilibrium High profits from market making shift the competition for orders from quoted prices to direct payments for order flow. Small and medium-sized brokers sell their orders to wholesalers; large brokers vertically integrate into market making. Incentives to quote aggressively disappear; thus spreads widen, increasing profits and the payments for order flow.

Brokers Decision Broker s Volume V V Use SOESPreference Vertically Integrate

Back to NASDAQ: Christie and Schultz This paper caused 33 lawsuits, SEC, and DOJ investigations, and market reform. Avoidance was very pervasive – 70% of stocks priced above $10. Avoidance was hard to predict. Affected mostly smaller trades (either SOES or preferenced). The effect on the quoted spread is in excess of $0.20 or close to 1.5% of the stock price!!!

Proposed Hypotheses Preference for round numbers; Saving on negotiations costs; Preferencing; Defense against SOES bandits; Discrete prices yield multiple equilibria: coordination rather than cartel enforcement.

Day Traders / SOES Bandits Parasitic traders, that utilize small changes in the price of the stock to make many trades during the day. SOES bandits – use technology to make money off the dealers quotes. Nuisance, but unlikely to account for the odd-eighths avoidance.

Outcome Settlements: DoJ – NASDAQ pays a $100 Mln. Fine and agrees to invest $400 Mln. In the enforcement of Antitrust. SEC introduces New Order Handling Rules. $1.25Bln in the civil suit. New OHR start in Jan 1997: Limit orders receive preference; Dealers other quotes are shown, Less market fragmentation,

New Order Handling Rules Spreads decline by 27%; Volume does not change; Volatility does not change, The ex post measured cost of trading declines for all trade sizes. Conservatively estimated savings for investors: $2–5 Bln. annually (more, if relative to 1994).

Nasdaq today The sponsorship hypothesis. NASDAQ as a trading venue or as a listing platform: two battlefields. ECNs as the main competitors to NASDAQ. Crossing networks. AMEX acquisition. INET (Island) acquisition.

Market Share: June 2005 Market Center % of Shares % 0f Trades % of Dollars NASDAQ ARCX CINN MWSE + others TOTAL 100 Market Centers: ARCX - Pacific Exchange; CINN - National Stock Exchange; WSE - Chicago Stock Exchange

Conclusions Competition is a fragile creature: one must provide it with the right conditions. Competition takes many forms. Very important to pay attention to small details – they may determine the outcomes. Self-regulation sometimes needs help: the reduction of the tick size in 1997 and 2001.

Exercise IV Download the evolution of the market share statistics from the NASDAQ Website: Provide a brief explanation(s) for the changes that took place in the NASDAQ market share over the last couple of years. Be brief.