In the last decade, most of the world's major stock markets have converted to electronic form, in which orders are matched by a computer. At first, this seems relatively easy to envision. If a seller wants to sell 100 shares of a stock at $25 and a buyer is willing to pay that amount for 100 shares, the match occurs. But what if the seller's price is $25.01 and he or she is selling 1100 shares. No match is possible in this case unless the seller lowers the price to $25 for just 100 shares or the buyer agrees to pay $25.01.
We can easily understand what would happen in a human-mediated auction market such as the New York Stock Exchange. The broker representing the buyer in the crowd around the specialist's post would decide to pay $25.01, or the specialist would buy the shares at $25.01 for his own account in order to maintain an orderly market.
But how does something like this happen in a market that is mediated only by computers--operating in milliseconds and controlled by algorithms that direct particular responses under varying circumstances?
The extraordinary popularity of electronic order matching around the world tells us that it offers something that is superior at least in some ways to human-mediated markets. Certainly, one of those things is speed. Another is anonymity. A third is confidentiality-an order placed by an informed institutional trader like a mutual fund looks pretty much like an order placed by anyone else. But these advantages are in a sense only tactical; they are valuable only if the basic function--matching buyers and sellers--actually works well enough to compete with an open outcry auction market.
Today we will have an opportunity to see how the NASDAQ electronic market works. Frank Hatheway, NASDAQ's chief economist, and Peter Martyn, a vice president in NASDAQ Trading and Market Services, will show us the NASDAQ electronic market in operation in close to real time. And if everything goes according to plan, we should be able to see how trades are made in hypothetical securities. At the end of this demonstration, we should also be able to get a sense of the advantages that electronic markets offer.
This will not in itself resolve the question of whether the NYSE or NASDAQ offers the best trading environment for investors. That question involves many considerations, including the very important issue of whether a market structure like the NASDAQ market--where many trading venues compete--is better for investors and issuers than a centralized market like the NYSE. But understanding exactly how the NASDAQ market operates is an essential step in understanding the issues involved in the market structure debate.
Peter J. Wallison is a resident fellow at AEI and the codirector of AEI's program on financial market deregulation.
