At an AEI conference last June, Professor Kenneth M. Lehn and his colleagues presented a ground-breaking paper that compared the effect of market stress—when the markets receive new positive or negative information—on the bid-ask spreads in the NYSE, NASDAQ, and the electronic communications networks (ECNs). The June paper indicated that ECNs performed better than the other trading venues for large capitalization stocks and that the NYSE performed best for low capitalization stocks. In a new paper, the Lehn group now compares these trading venues—for the period 1999–2003—for market quality under similar conditions of stress.
|1:45 p.m.|| |
|2:00||Introduction:||Peter J. Wallison, AEI|
|1:45||Comparing the NYSE, NASDAQ, and the ECNs|
|Presenters:||Kenneth M. Lehn, University of Pittsburgh|
|Sukesh Patro, University of Pittsburgh|
|Kuldeep Shastri, University of Pittsburgh|
|Discussants:||Frank Hatheway, NASDAQ|
|Eric Roiter, Fidelity|
|Bob Hill, Archipelago|
Comparing the NYSE, NASDAQ, and the ECNs for Market Quality, Market Depth, and Price DiscoveryOn October 13, AEI continued its conference series on market structure with a presentation and paper by Kenneth Lehn, and his colleagues Sukesh Pastro and Kuldeep Shastri, from the University of Pittsburgh. At an AEI conference last June, Professor Kenneth M. Lehn and his colleagues presented a groundbreaking paper that compared the effect of market stress--when the markets receive new positive or negative information--on the bid-ask spreads in the NYSE, Nasdaq, and the electronic communications networks (ECNs). The June paper indicated that ECNs performed better than the other trading venues for large capitalization stocks and that the NYSE performed best for low capitalization stocks. In this new paper, the Lehn group compared these trading venues--for the period 1999-2003--for market quality under similar conditions of stress.
Kenneth M. Lehn
University of Pittsburgh
A major issue currently facing the Securities and Exchange Commission (SEC) is its regulation of securities market structure. Recently, the SEC issued proposed Regulation NMS, in which it observes that the historical divisions between traditional auction exchange--for example, the New York Stock Exchange (NYSE) and dealer markets (e.g., the "old" Nasdaq)--are eroding as new forms of competition from automated quote-driven market centers emerge such as Archipelago, Inet, and ATS. In short, the SEC is grappling with the issue of whether investors are better served by competition among market centers that may fragment order flow and reduce liquidity, or by consolidation of order flow in a centralized market that may enhance liquidity but reduce competition among market centers.
To examine this issue, we focus on two days in 2001 and two days in 2003 when stock prices changed rapidly in response to new macroeconomic information. Using a matched sample of 388 NYSE and Nasdaq stocks that span various size categories, we examine several measures of market quality before and after the release of the relevant information on the four days to gauge how the two marketplaces perform under stress and whether their performance changed from 2001 to 2003.
The results reveal several interesting findings: First, during both the calm and stress periods, quoted and effective bid-ask spreads are significantly lower for NYSE versus Nasdaq stocks, a result generally consistent with the existing literature. However, the difference in NYSE and Nasdaq spreads is small for stocks with large market capitalizations, and the difference declined from 2001 to 2003. Within Nasdaq, ECN spreads are approximately 30 to 40 percent lower than the corresponding spreads of traditional Nasdaq dealers across all firms of all size categories.
Second, we find that quoted and effective bid-ask spreads increase significantly for both NYSE and Nasdaq securities during stress periods, but relatively more so for NYSE securities. This result holds after controlling for various attributes of securities, including firm size, stock price, volatility, and trading volume. The result appears to contradict the position that the NYSE is better able to handle stress than other marketplaces. The relatively better performance of Nasdaq during the stress periods is most pronounced among large capitalization stocks. Furthermore, we find that within Nasdaq, ECN spreads increase significantly less than spreads of more traditional market makers. This suggests that the relatively better performance of Nasdaq during periods of market stress is driven largely by the performance of the ECNs.
This paper examines the comparative performance of the NYSE and Nasdaq on two days in 2003 when securities markets received important new information that induced large stock price movements and heavy trading volume. We find that the spreads on both NYSE and Nasdaq securities widen significantly around the time of the news releases, indicating that the information shocks impair liquidity in both markets. However, spreads widen less for Nasdaq securities, contradicting the view that the NYSE is more adept at providing liquidity during times of market stress. This result is especially strong for large capitalization stocks. Furthermore, Nasdaq's comparatively better performance during periods of stress appears due, at least in part, to the superior performance of ECNs. Finally, we find no significant difference in market depth on the NYSE and Nasdaq during periods of stress, after controlling for various firm and trade characteristics.
This study uses macroeconomic events to explain how markets respond. This issue is important because risk is inherent in trading transactions, so if one market or another makes trading more difficult during times of market stress, there needs to be a cost associated with trading in that market. If investors are demanding a price for bearing risk, the cost of capital is raised for the issuer. This study is clever because it uses macro-economic events to explain how markets respond in any trading environment. Why is there a difference among the trading venues? Specialists would say they have access to more information--they have a better read on the data and can therefore get a better price. However, today specialists do not see the amount of order flow that they have in the past. Now, they compete with other venues, like Nasdaq, to get the same information for their customer.
Really this is a study on the philosophy of market structure--Nasdaq functions as a dealer and an order book, the NYSE has specialists and an order book, and the ECNs offer an order book. This paper recognizes that the dealer is and can be separated from the order book. It separates the two behaviors. Participation matters because information is essential. Specialists used to have the monopoly on this, but as we come together individuals and firms can reflect a common wisdom: when participation increases, capital increases and the market gains depth and liquidity, which benefit the investor. No longer is this a benefit only the specialist can offer.
One thing to clarify, Archipelago is no longer an ECN--we are now a full-fledged stock market. We trade over eight thousand stocks, including everything that Nasdaq and the NYSE list. One key point is that all of the information we have collected recently is identified as a separate exchange, and the information can be used to determine whether we functioned as an exchange or an ECN. An ECN is a separate, functional form of a market maker. It is an order-matched system. For a long time it was difficult to regulate, and it fell slowly under Nasdaq and was treated as a market maker. However, it has become an order-matching system. We are now an exchange, and as an exchange we do not fall under the regulatory guidelines or rules of Nasdaq, AMEX, or the NYSE. We have our own determination as to our role in the market. We perform some order matching and hold two auctions a day, but we do not do market making. Our day at Archipelago begins with an auction at 8:00 a.m. and moves into the continuous order matching system. At 9:30 a.m. we hold another auction for market orders that did not want to execute in the early session, then we have a closing cross at 4:00 p.m. and continue to trade in an order matched system until 8:00 p.m. Part of our market structure "sends out" trades if we do not have the best price internally, and we will then go out and execute with the NYSE, Nasdaq, or another exchange.
As the paper shows, the net result of tighter spreads exists where there is no intermediary. People want to be in the marketplace, and they want to be there in the most effective way possible to get their order executed. In times of stress, delays and approvals are too costly. This paper evaluates the by-product of trading--quotes. Quotes reflect the trading interest in the market. The more quotes indicate a deeper market with more liquidity. The fact that there is instantaneous access and certainty of execution, especially in times of market stress, is the reason more people will turn to order matched system like Archipelago.
This is the kind of data and research we try and do at Fidelity, and if this type of work is performed by the participants, then we certainly do not need the government to do it for us. Let competition flourish, let market structures compete with each other, and let informed investors choose where they want their orders to go. The government cannot keep pace with the work done in the private sector. This is a dynamic marketplace that can only become efficient if the government lets the participants make informed choices and seek their own best execution. We would be open to results opposite from what this paper concluded because it would be an additional insight into the market. This speaks to the futility of the government's effort to force a one-size-fits-all approach.
AEI research assistant Jessica Browning prepared this summary.