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 Current Perspectives
Current
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Current Perspectives on
Current Perspectives on Modern Equity Markets

Copyright © November 2010 Knight Capital Group, Inc.

All rights reserved. No part of this book may be reproduced in any form
whatsoever, by photography or xerography, or by any other means, by
broadcast or transmission, by translation into any kind of language, nor
by recording electronically or otherwise, without permission in writing
from Knight Capital Group, Inc.

ISBN: 978-0-578-06874-9

Design and Production: Mighty Media, Inc.

Editor: Sue Freese

Printed in the United States of America

CLS & Associates

1850 M Street, NW, Suite 800
Washington, DC 20036

To obtain a copy of this book, please contact Margaret E. Wyrwas at

Knight Capital Group, Inc., [email protected].
 Contents
preface by Thomas M. Joyce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

chapter 1 Historical Perspective on Equity Markets: How We

Got Here, by James J. Angel . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

chapter 2 Overview of the U.S. Equity Markets Today, by Jamil

Nazarali . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

chapter 3 Imagine an Investor: Washington’s Historical Role in

Shaping the Industry through Regulation and
Legislation, by Arthur Levitt . . . . . . . . . . . . . . . . . . . . . . . . . . .21

chapter 4 The Retail Investor and the Reinvention of Equity

Market Trading, by Fred Tomczyk . . . . . . . . . . . . . . . . . . . . . 27

chapter 5 Liquidity and Volatility, by Lawrence E. Harris . . . . . . . . . . 37

chapter 6 Speed and Equity Trading, by Chester S. Spatt. . . . . . . . . . 47

chapter 7 Man versus Machine: The Regulatory Changes That

Led to the Modern Market, by Daniel Mathisson . . . . . . . 53

chapter 8 The Uproar over Flash: A Flash in the Pan,

by Gary Katz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

chapter 9 Market Structure Reforms: A View from the Buy-Side,

by Paul Schott Stevens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

chapter 10 The Importance of Financial Policy Makers Making

Informed Decisions, by Jennifer E. Bethel and
Erik R. Sirri . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

chapter 11 New Realities in the Era of Global Markets,

by Duncan L. Niederauer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

chapter 12 Where Do We Go from Here? The Utopian

Marketplace, by Brett F. Mock and John C. Giesea . . . . . . 117

index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
 Preface
Thomas M. Joyce
c h a i r m a n & c h i e f e x ec u t i v e o f f i c e r ,
k n i g h t c a p i ta l g r o u p, i n c .

Competition, technology, and innovation have dramatically changed the

way investors of every shape and size interact today. At Knight Capital
Group, we welcome the opportunity to engage in a dialogue about our
rapidly changing equity markets.
We are in the midst of a market transformation. Markets are more
efficient and more liquid than ever before, enabling investors to swiftly
access significant amounts of information and to rapidly execute their
transactions at remarkably low cost. But transformation is not, by nature,
smooth, and with change comes the responsibility of regulators and
policy makers to appropriately monitor its impact on the industry.
At Knight Capital Group, we believe appropriate rules and regula-
tions are needed to help maintain a level playing field for all market
participants. And as technology changes how we conduct business,
the rules that govern our markets need to continue to strike a smart
balance between appropriate regulation and the preservation of a viable
marketplace for competition and innovation. Open, transparent, vibrant
markets provide everyone with the freedom and power to reach financial
independence.
In fact, what interests Knight Capital Group most about this new way
of trading is its potential to continue to improve execution quality for
the average retail investor. A variety of trading platforms have already
benefited investors by enhancing the capital formation process, but they
have also made the equity markets more democratic and transparent
by providing all market participants with unfettered access to the best
trading technologies. Indeed, there has never been a better time to be an
investor—large or small.

v
 vi preface

In an attempt to better understand these profound developments,

Knight Capital Group invited industry experts to contribute their obser-
vations, insights, and recommendations and participate in a broader
discussion. Our goal in creating this book was to provide a body of work
that outlines how U.S. markets were shaped, how they currently work,
and where they may go in the future.
The words and ideas expressed in each chapter are those of its author
alone, and as such, you will find that ideas across chapters are some-
times at odds. Even so, we strongly embrace this platform and put forth
all the ideas for thought and discussion. We thank all of the authors and
their affiliated organizations for contributing to this important project.

November 2010
 chapter
(

Historical Perspective
on Equity Markets
How We Got Here
by James J. Angel, Ph .D., CFA
a s s o c i at e p r o f es s o r o f f i n a n c e , m c d o n o u g h
s c h o o l o f b u s i n es s , g e o r g e to w n u n i v e r s i t y

To understand today’s and tomorrow’s equity markets, we need to

understand how the markets arrived at their present state. Doing so
involves understanding why equities are different from other financial
products and what technological, economic, and regulatory develop-
ments helped form the markets. This chapter provides a brief overview
of these topics.

Why Equity Markets Are Different

from Other Financial Markets
Equity markets are fundamentally different from other markets. In partic-
ular, equity markets tend to be highly structured and organized around
exchanges, while most markets—even most financial markets—are not.
Most goods and services trade quite nicely in decentralized, over-the-
counter markets. For example, we would not think of hiring a broker

1
 2 historical perspective on equity markets

to send an order for paper clips to the New York Paper Clip Exchange.
Instead, we would just call our local office supply store. Even most finan-
cial products trade without heavily structured and regulated exchanges.
Currencies, bonds, loans, and many derivative markets thrive without
centralized exchanges.
This difference between equity markets and other markets is driven
by information. It is relatively easy to price most goods and services and
even most financial products. The price of paper clips does not fluctuate
much, and it is pretty easy for customers to know if they got a good
price. Bonds are similar. If we know the term structure of interest rates
and current yield spreads, we can price most bonds. Knowing the spot
price of an asset and an estimate of volatility leads to accurate pricing
of most derivatives.
Equities are another story. No one really knows what an equity secu-
rity is worth. While owning a high-grade bond results in a nearly certain
cash flow, the cash flow accruing to an equity holder is highly uncer-
tain. Even identifying the correct discount rate to use is a matter of great
controversy and debate. Most pricing models for equities are highly
sensitive to the assumptions used. Small changes in assumptions can
lead to large changes in the estimated value. Indeed, Fischer Black—one
of the architects of the famous Black-Scholes option-pricing formula—
felt that markets got prices “within a factor of two … at least 90%” of
the time.1
Furthermore, while there is little private or inside information about
government bonds and currencies, there is a good deal of private infor-
mation about the value of the more than 10,000 equities that trade in
the United States and the more than 30,000 equities that trade world-
wide. When investors trade, they reveal some of their private informa-
tion about the value of a stock. This makes information about recent
trades and information about trading interest extremely valuable.

1 Fischer Black, “Noise,” Journal of Finance 41, no. 3 (July 1986): 533.
 current perspectives on modern equity markets 3

Naturally, traders and investors do not want to give away this valuable
information for free. Keeping it confidential gives them an advantage
over other market participants. However, traders do need good market
information to make sound trading decisions. As traders often note, they
want other investors to reveal confidential information while they want
to reveal none of their own. This leads to a so-called prisoner’s dilemma
of trading,2 in which each investor is better off revealing no information,
even though all investors would be better off if each revealed a little.
Organized equity exchanges arose as a solution to this prisoner’s
dilemma. Organized exchanges and trading platforms require the disclo-
sure of at least some information as part of the price of access to the
exchange. Participants agree in advance to follow the exchange rules,
even though they may prefer not to disclose particular information about
their own trading activity. Some of that information is known only within
the trading system. For example, on the old floor of the New York Stock
Exchange (NYSE), brokers sometimes revealed partial information to
other brokers to find the other side of the trade. In modern “dark pools,”
the information is revealed only to the pool operator, who attempts to
match trading interest.
Assuring proper settlement and reducing counterparty risk are other
reasons for the existence of organized exchanges, especially derivative
exchanges. Having the buyer and seller agree on the terms of the trade
does not necessarily guarantee that it will be consummated according
to those terms. Exchanges quickly learned that they had to limit their
membership to honest participants with adequate financial resources
who would live up to their trading commitments.

2 The prisoner’s dilemma is a famous problem from game theory. In it, the police hold two
prisoners and interrogate them separately. The police offer each prisoner the choice
of whether to cooperate, with a penalty based on what the prisoner decides. In each
case, the prisoner receives a less severe penalty by cooperating, even though both pris-
oners are better off if neither cooperates with the police. See Anatol Rapoport and A. M.
Chammah, Prisoner’s Dilemma (Ann Arbor: University of Michigan Press, 1965).
 4 historical perspective on equity markets

The Network IS the Market

Another important point is that the equity markets involve a lot more
than a single exchange or trading platform. They comprise an entire
network of market participants. This complex network is comprised of a
wide range of institutions, including the following:
· Regulated exchanges for equities, options, futures, and other
derivatives
· Alternative trading systems
· Clearance and settlement organizations
· Financial intermediaries that trade for their own accounts, such
as dealers
· Financial intermediaries that provide access to the market
· Information intermediaries, which provide data ranging from
trade and quote feeds to advanced analytics and fundamental
research
· Technology intermediaries, which provide communications and
technology infrastructure, such as data centers
· Financial institutions, which operate the payment system
· Lending institutions
· Media companies, which produce and disseminate content
· Regulators charged with maintaining fair and orderly markets
· Registrars and transfer agents
· Proxy solicitation firms
· Regulatory institutions
· Investors and traders

Along the lines of Sun Microsystems’ popular slogan “The network IS the
computer,” all market participants should remember that “The network
IS the market.” Focusing on only one part of the network can lead to
major misunderstandings of market behavior.
 current perspectives on modern equity markets 5

Evolution of the U.S. Equity Market Network

Financial transactions have occurred almost since the beginning of civili-
zation.3 They started with the lending of money and the forming of busi-
ness partnerships. However, modern equity trading began in Amsterdam
around 1610 with shares of the Dutch East India Company (Vereenigde
Oost-Indische Compagnie).
Equity securities represent transferable ownership interests in corpo-
rations. Dividing business organizations into small, affordable pieces
made it possible for entrepreneurs to raise capital from multiple sources.
At the same time, having limited liability allowed investors to diversify
their investments without fear of buying into a black hole of liability that
would devour their wealth.4 This lack of liability also made it easier to
transfer shares to new buyers.
Secondary markets in the securities of joint stock companies quickly
arose as these companies began to multiply. Merchants and traders
bought and sold securities just like other commodities, and specializa-
tion gradually developed. When the traders in these instruments realized
that their markets functioned better when organized, stock exchanges
began to spring up, first in Europe and then in the United States. The
Philadelphia Stock Exchange was founded in 1790, and the NYSE origi-
nated out of the famous Buttonwood Agreement of 1792. In that agree-
ment, a group of 24 brokers agreed to give preference to each other and
to fix minimum commissions; this system of fixed commissions would
last until 1975.
In the late-nineteenth and early twentieth centuries, stock exchanges
arose in the United States not only in large cities, such as New York
and Philadelphia, but also in smaller cities, such as Cleveland, Ohio;
Wheeling, West Virginia; and Beaumont, Texas. Given the limitations

3 Ernst Juerg Weber, “A Short History of Derivative Security Markets” (Social Science
Research Network, June 2008), http://ssrn.com/abstract=1141689 (accessed July 15,
2010).
4 In extremely rare cases, it is possible for courts to “pierce the corporate veil” and make
shareholders liable for the debts of the corporation. See Robert B. Thompson, “Piercing
the Corporate Veil: An Empirical Study,” Cornell Law Review 76 (1991): 1036–1074.
 6 historical perspective on equity markets

on communication in those days, these exchanges handled mainly local

securities for local investors. For example, the Beaumont Board of Trade
handled the stocks of local oil companies following the Spindletop gusher
in 1901.
Technology and regulation have shaped the U.S. financial markets, and
the U.S. markets have always been leaders in the adoption of information
technology. For instance, the invention of the telegraph and stock ticker
in the nineteenth century made it possible to transmit price information
and orders quickly and over large distances. Indeed, it was the skillful use
of the stock ticker to disseminate prices that led to the NYSE gradually
becoming the dominant stock exchange in the United States.
Financial markets display a large amount of network econom-
ics.5 Network markets are those in which the usefulness of a product
increases with the number of users. For example, one telephone by itself,
without a telephone network, is fairly useless. That telephone becomes
very useful, however, when connected to a network of other telephone
users. When two mutually exclusive networks compete, the larger
network usually wins, because its larger user base gives it an advantage
over the smaller network. Competition over technology standards (e.g.,
VHS versus Betamax, Blu-Ray versus DVD-HD, etc.) exemplifies this
type of network effect.
In the past, when communication between markets was difficult, each
market represented its own network of buyers and sellers. Since buyers
want the market with the most sellers and sellers want the market with
the most buyers, having a larger market network was—and still is—a
huge advantage. Or, as traders put it, liquidity attracts liquidity. This
network effect also contributed to the NYSE emerging as the dominant
stock exchange in the United States.
The stock market crash of 1929 heralded the beginning of the Great
Depression. President Franklin Roosevelt’s New Deal policies included
federal regulation of the securities markets, which had previously been

5 Nicholas Economides, “Network Economics with Application to Finance,” Financial

Markets, Institutions, and Instruments 2, no. 5 (December 1993): 89–97.
 current perspectives on modern equity markets 7

regulated at the state level. A series of laws were passed to regulate

financial markets, beginning with the Securities Act of 1933 and the
Securities Exchange Act of 1934. In addition to creating the Securities
and Exchange Commission (SEC), the 1934 act also regulated national
securities exchanges and required exchange-listed stocks to disclose
information.6 The act also established national securities exchanges as
self-regulatory organizations (SROs) responsible for enforcing not only
their own rules but also national securities laws. The SRO model was a
compromise that allowed the industry to police itself (with SEC over-
sight), while sparing taxpayers the direct cost of enforcement. Gradu-
ally, however, the SEC became the primary rule setter for the U.S. equity
market network.
At first, the Securities Exchange Act of 1934 ignored the unlisted
markets. Faced with the regulatory burdens of the new regulatory regime,
many smaller stock exchanges closed down, and many issuers preferred
the less-regulated over-the-counter market. This oversight was corrected
by the Maloney Act amendments of 1938, which required broker-dealers
who were not members of a national securities exchange to join one. This
led to the designation of the National Association of Securities Dealers
(NASD) as the SRO of the over-the-counter market.
Years later, the rise of computer technology fundamentally changed
the economics of markets. In 1970, Instinet launched the first electronic
alternative trading system (ATS), providing computerized matching of
customer limit orders. In 1971, NASD launched NASDAQ as a system to
broadcast dealer quotes.
A major watershed occurred in 1975 with the elimination of fixed
commissions on the NYSE. The result was much greater competition
among brokers, along with lower brokerage commissions. The same year,
Congress passed the so-called National Market System amendments to
the Securities Exchange Act, which directed the SEC to facilitate estab-

6 Other important U.S. laws include the Commodity Exchange Act of 1936, the Trust Inden-
ture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act
of 1940. These laws have been amended many times over the years.
 8 historical perspective on equity markets

lishment of a competitive and efficient national market system. The 1975

amendments also increased the regulation of exchanges as securities
information processors (SIPs) and required advance approval of SRO rule
filings, thus increasing the role of the SEC as the primary determinant of
U.S. market network rules.
Additional technological developments continued to change the face
of stock trading. In 1976, the Cincinnati Stock Exchange became the first
fully electronic stock exchange. Toronto launched its electronic CATS
system in 1977.7
A major scandal erupted in 1994, when NASDAQ dealers were accused
of colluding to maintain wide bid/ask spreads.8 The SEC responded in
1996 by imposing the order-handling rules.9 These rules required dealers
to reflect customer limit orders in their quotes. Furthermore, quotes from
other electronic communications networks (ECNs), such as Instinet,
were added to the consolidated quote montage. These changes made
it possible for customers to bypass dealers and trade directly with each
other, which resulted in a narrowing of NASDAQ bid/ask spreads. The
changes also led to an explosion in the number of ECNs.
Following political pressure, the minimum price variation, or tick size,
fell from one-eighth of a dollar to one-sixteenth in 1997 and then to one-
hundredth (i.e., one cent) in 2001.10 Bid/ask spreads fell dramatically as
a result.
Also during the 1990s, many exchanges around the world adopted
fully automatic trading systems, closed their trading floors, and converted
from membership organizations into publicly traded joint stock compa-

7 Donald E. Weeden, Weeden & Co.: The New York Stock Exchange and the Struggle over
a National Securities Market (Greenwich, CT: Author, 2002), and Ian Domowitz, “The
Mechanics of Automated Trade Execution Systems,” Journal of Financial Intermediation 1,
no. 2 (1990): 167–194.
8 William G. Christie and Paul H. Schultz, “Why Do NASDAQ Market Makers Avoid Odd-
Eighth Quotes?” Journal of Finance 49, no. 5 (Dec. 1994): 1813–1840.
9 SEC Release No. 34-37619A, Order Execution Obligations (Sept. 6, 1996).
10 SEC Release No. 34-42360, Order Directing the Exchanges and the National Association
of Securities Dealers, Inc. to Submit a Decimalization Implementation Plan Pursuant to
Section 11A(a)(3)(B) of the Securities Exchange Act of 1934 (Jan. 28, 2000).
 current perspectives on modern equity markets 9

nies. American exchanges were slow to follow this trend, however. The
NASD spun off NASDAQ in 2000, as it gradually evolved from a system
that displayed decentralized dealer quotes into a centralized limit order-
matching engine. The NYSE demutualized in 2006 through its acquisi-
tion of the electronic Archipelago Exchange.
In 2005, the SEC promulgated Regulation NMS (National Market
System), which required stock exchanges to honor the quotes of other
exchanges but only if they were accessible for automatic execution.11
This forced the NYSE to automate its executions. At the same time, it
lessened the network advantage that the NYSE had enjoyed, as it made
it much easier for other markets to compete with the exchange. The
NYSE’s market share in its listed stocks fell from 79.1 percent in 2005 to
25.1 percent in 2009.12
Much like U.S. markets, global markets have also consolidated and
deconsolidated. Both NYSE Euronext and NASDAQ OMX are now
global exchange operators, and cross-border competition in Europe is
eroding the market shares of once dominant local exchanges. Moreover,
liquidity is increasingly provided by so-called high-frequency computer-
ized traders, rather than flesh-and-blood humans. The “flash crash” of
May 6, 2010, resulted in the implementation of stock-by-stock circuit
breakers, which were previously missing from the U.S. markets.
Equity markets have evolved a lot in recent years, and they will
continue to do so with developments in the technology and regulation
of financial markets. Specifically, changes in financial and information
technology will make new forms of trading possible, and regulators will
struggle to understand and catch up with the changes.

11 SEC Release No. 34-51808, Regulation NMS (June 9, 2005).

12 SEC Release No. 34-61358, Concept Release on Equity Market Structure (Jan. 14,
2010).
 chapter
)

Overview of the
U.S. Equity Markets Today
by Jamil Nazarali
s e n i o r m a n ag i n g d i r ec to r ,
h e a d o f t h e e l ec t r o n i c t r a d i n g g r o u p
f o r k n i g h t c a p i ta l g r o u p

For better or for worse, the U.S. equities markets and the U.S. economy
are inextricably linked. While the ups and downs of the market may seem
random, the stock market is actually quite a good forecaster of economic
activity six to nine months in advance. Investors focus on future earn-
ings, determining whether they are confident they can make a return on
the money they invest today.
This predictive capability, driven by the collective wisdom of millions
of market participants, is why the S&P 500 is included in the Conference
Board’s Leading Economic Index and why the Federal Reserve considers
the performance of this index when setting the United States’ monetary
policy. Policy makers are joined by analysts, the media, and the public
in their daily watch of closing prices. All of the nightly news broadcasts
include a segment on the equities markets for a reason: because it
provides insight into where the country is headed.
This collective wisdom can become a virtuous feedback loop or a
negative spiral. If everyone expects the economy to do well and starts to

11
 12 overview of the u.s. equity markets today

invest, this by itself can create demand by corporations to hire people,

who in turn will spend more to create more demand for more products,
and on and on. But the opposite effect can also happen. A look back
at the performance of the stock market and economy in the months
following the Lehman Brothers collapse in 2008 reveals that corpo-
rate payrolls were shedding jobs at a rate not seen in decades. Market
psychology can become self-fulfilling prophecy, it seems.
Individual investors have taken on an increasingly significant role in
this feedback loop as their participation in the market has skyrocketed
over the last three decades. From 1980 to 2009, the number of house-
holds that owned mutual funds (which in turn invest in equities and other
assets) grew from 4.6 million to 50.4 million, an average annual increase
of 8.6 percent.1 From 1989 to 2007, the median value of stock invest-
ments among those households participating in the market increased
from $9,000 to $35,000.2 Much of that growth came from increased
participation in retirement plans such as IRAs and employer-sponsored
defined contribution plans such as 401(k) accounts. The total amount
of assets in these plans was $8.6 trillion in the first quarter of 2010, up
from $700 billion in 1985.3
It’s been a rough couple of years for investors. At the time of this
writing—the close of July 2010—U.S. investor confidence remains signif-
icantly lower than it was in the aftermath of the 9/11 terrorist attacks,
with almost half believing that U.S. economic conditions are getting
worse.4 Ponzi schemes, big bank failures, sovereign debt, and other crises

1 Investment Company Institute, 2009 Investment Company Institute Fact Book: A Review of
Trends and Activity in the Investment Company Industry, 49th ed. (2009), http://www.ici.
org/pdf/2009_factbook.pdf.
2 Federal Reserve Board, “Survey of Consumer Finances: 2007,” http://www.federalreserve.
gov/pubs/oss/oss2/scfindex.html (accessed August 2010).
3 Investment Company Institute, “The U.S. Retirement Market, First Quarter 2010,” Research
Fundamentals, http://www.ici.org/pdf/fm-v19n3-q1.pdf (accessed August 2010).
4 Rasmussen Consumer Index, Rasmussen Reports, http://www.rasmussenreports.com/
public_content/business/indexes/rasmussen_consumer_index/rasmussen_consumer_
index (accessed August 23, 2010).
 current perspectives on modern equity markets 13

have piled on the fear and made investors reticent to invest surplus cash,
let alone remove it from under the mattress.
The U.S. equity markets have been unfairly caught up in the tumult.
Through it all, the stock market has continued to serve its vital role in
the U.S. economy: to allow for the efficient allocation of capital to start
new ventures and help companies grow and to allow for individuals to
pursue their dreams.

The Primary Market and the

Capital Formation Process
In its essence, an equity market is a public facility in which parties can
come together to trade stock, or shares of a company, at published prices.
An equity market can be a physical location for trading, such as the New
York Stock Exchange (NYSE), or it can be a virtual world where trading is
conducted electronically. NASDAQ, Direct Edge, and BATS all fit this bill.
Within this framework, there are two types of equity markets, both
critical to the health of the U.S. economy all the way down to the finan-
cial well-being of individuals. To appreciate the whole, it will be helpful
for us to focus on a specific interaction.
First, there’s the interaction of the growing company and the equity
markets through what’s called the primary market. Since the beginning of
the NYSE in 1792, the U.S. equities markets have evolved into a complex
matrix of investors, brokers, dealers, exchanges, and alternative venues.
Companies use the equity markets to raise capital, which is then used
to grow their businesses, pay their debts, or simply provide their owners
with a means to reduce their stakes by creating a market for their compa-
nies’ shares.
For example, Starbucks started selling coffee in its first store in 1971.
Armed with the belief that consumers would seek and pay for an Italian
coffeehouse experience, the company began opening locations outside
its hometown of Seattle in 1987. As a private company, Starbucks had
limited access to capital, and so it turned to the public equity markets
with an initial public offering in 1992.
 14 overview of the u.s. equity markets today

Going public on the NASDAQ changed Starbucks forever, allowing

the company to open 16,000-plus locations in more than 50 countries.
One might even say that this event changed our coffee-drinking habits
forever. But it’s not an exaggeration to say that company access to the
primary market has changed the world and continues to do so.
Take, for example, the effort to reduce reliance on oil and otherwise
“go green.” Wind farms, bio fuels, and other alternatives all require capital
to pursue and build out ideas. How about the race to cure diseases such
as cancer? Pharmaceutical companies, medical device manufacturers,
and other innovators need equity to help fund their research. And the
list goes on. Guaranteed, we wouldn’t be Googling on our iPhones for the
nearest Starbucks location if these companies hadn’t been able to seek
equity investors in the public market.
Companies do have the option of private investment. Venture capital
(VC) firms may help fund a start-up, but it’s their confidence in the U.S.
equities market that allows them to raise money. VCs and their clients
want their money back eventually—with a healthy return—and they seek
it through a public stock offering. There’s also debt, but the fixed income
markets can’t compete in terms of cost and transparency with equi-
ties. One of the primary benefits of raising equity versus debt is that a
company doesn’t need to make interest and principal payments, freeing
funds for use in other corporate activities.
While the U.S. equity markets are strong, we can find plenty of exam-
ples of the opposite. The effort to build a much-needed power plant to
meet the needs of an exploding population in India or China, for example,
is hindered by the lack of a deep, liquid market, forcing the intervention
of the government or a foreign investor. There’s little ability to build infra-
structure without burdening the general population or opening the door
to outside political influence.
Further, there’s growing recognition that industries such as utilities and
airlines can be more efficient and competitive as publicly owned compa-
nies than as state-owned enterprises. We’ve seen increasing denation-
alization in countries such as the United Kingdom and Russia. Here at
home, U.S. citizens have recently become acquainted with government’s
 current perspectives on modern equity markets 15

influence on business and, for the most part, expressed extreme discom-
fort with Uncle Sam’s ownership in banks and auto manufacturers.

The Thriving Secondary Market and the Investor

Once a company goes public, its shares can be traded in the secondary
market, or aftermarket. Just as the health of the equity markets impacts
innovation, job formation, and the like, it’s also the key to individual
wealth formation.
Enter the investor. Let’s say his name is John. One of John’s dreams is
to save money for his daughter’s college education. To get a little extra
out of his savings, John seeks a way to make his money go farther. He
looks to the equity markets to buy shares of companies like Starbucks,
taking the chance that he will make a profit on his investment when he
goes to sell his shares down the road. John is joined in the marketplace
by other individuals and institutions such as mutual funds, hedge funds,
pension plans, and insurance companies. The path of a typical trade is
illustrated in Figure 2.1.

Figure 2.1.
Typical trade execution path in U.S. equity market

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 16 overview of the u.s. equity markets today

For investors big and small to wade into the U.S. equities markets,
they have to know that they can access their investments quickly, easily,
and cheaply. John may need cash in the short term if he loses his job, or
he may be close to retirement and want to change his allocations and
manage risk.
Again, individual investors—already spooked by gloomy news—have
become even further on edge because of recent events, including the
May 6, 2010, “flash crash.” They’re questioning whether the U.S. equi-
ties markets are working as they should. They’ve pulled back from direct
investment in the markets as well as from mutual funds and other invest-
ments through institutions.
The vitality of the markets should not be in doubt. In the U.S. stock
market, the liquidity is readily available for John to get in and out as
he desires, as smoothly as possible, as his situation—his life—changes.
Even in the depths of the recent crisis, during the fall of 2008, the U.S.
equities markets never stopped working. Investors may not have liked
the value of their investments on the computer screen, but if they were
willing to sell at that price, they could always have found a buyer.

Liquidity and the Role of the Market Maker

Today, the market has never been more liquid. The number of shares
available at the national best bid/offer (NBBO), as well as within a 6-cent
range of the NBBO, has trended steadily upward over time.5 John there-
fore has a high probability of selling 1,000 shares at or near the price he
sees on the screen. Technology, regulatory changes, and competition have
created this depth—with interconnectivity between various exchanges
and pools of liquidity—and made it possible for market participants to
electronically make markets and post quotes away from the old exchange
floors. In fact, it is the market maker who plays a critical role in making
sure the U.S. equities markets continue to work as well as they do.

5 “Equity Trading in the 21st Century,” Knight Capital Group, February 23, 2010, http://
www.knight.com/newsroom/researchAndCommentary.asp.
 current perspectives on modern equity markets 17

When John is ready to sell out of one of his more volatile tech hold-
ings for a utility or another typically safer stock as he nears retirement,
another individual buyer at the same price, size, and moment in time
isn’t necessarily ready to take the other side. Rather, when John presses
the button to buy stock through his online broker, that broker will most
likely route the order to a third party. In days past, that third party was
an exchange like the NYSE or NASDAQ. However, regulatory changes,
technology, and competitive dynamics fueled competition and the rise of
alternative sources of liquidity, including the market maker, where most
brokers now route their orders for execution.
One of the reasons the U.S. equities markets are so efficient is that
when a market maker receives a customer order, it can “cross” it with
other customer orders. For example, if the market maker receives a
market order from a customer at Merrill Lynch to buy 100 shares of IBM
and there’s another order to sell the same stock at the same price from
Scottrade within the market maker’s books, the orders will cross and the
trade will be executed at subsecond speed. If the market maker doesn’t
have an opposing customer order for that buyer of 100 shares of IBM, it
can fill the order by selling IBM shares from its own account, otherwise
known as internalization. In this case, the investor gets the price at the
NBBO—the best publicly available price at the time of the trade—or even
better. So in addition to speed, market makers can provide investors with
the opportunity of price improvement.
Sometimes, the market maker decides—based on market condi-
tions, its current inventory, and/or its view of the market—to route a
customer order to another venue for execution. Traditionally, the NYSE
and NASDAQ were the primary recipients of U.S. equity orders for most
U.S. equities. However, in 2005, Regulation NMS changed the competi-
tive landscape. Now, the best quote is protected no matter where it was
posted. Newer exchanges, such as Direct Edge, ECN, and BATS, can
compete with the old guard by posting a better bid and ask.
As the market has evolved during the last few years, more choices than
ever have become available in which retail trades can be executed outside
the primary listing exchange, including dark pools, electronic communi-
 18 overview of the u.s. equity markets today

cation networks (ECNs), and other market makers. These nonexchange

venues are quite attractive for executing trades, due to their alternate
sources of liquidity and pricing. This pricing structure, combined with
regulatory and technology advancements, is what has enabled these
venues to pick up market share over the last few years. The NYSE has
lost market share of its own listings, from 82 percent in January 2005 to
41 percent in June 2010.6 However, investors have gained.
Dark pools, in particular, have gained share due to their ability to
minimize market impact. Typically, a dark pool matches contra orders
at a single price—often the midpoint between the bid and the ask—at
the time of the trade. The difference is that a dark pool’s order book is
hidden. This is particularly helpful for executing large block orders, since
the trader’s intent isn’t revealed. However, all of these transactions, once
executed, are posted to the consolidated tape within seconds, so the
public always knows when a trade has happened and at what price.
New business models such as dark pools—on top of regulatory
changes and technology advancements—have driven market share
changes. While the NYSE market share in its own listings declined, as
mentioned earlier, competitive pressures have provided a net benefit for
investors. Market makers have passed on the savings they have expe-
rienced to broker-dealers, who have passed on these savings to retail
customers in the form of lower commissions.

Low Cost and Efficiency

Indeed, both retail and institutional commissions are down significantly
over time. What would have cost John as much as $35 per trade in
early 2003—or more if he had gone through a full-service broker—now
costs closer to $10.7 Institutional U.S. equity commissions average 2.78

6 “Transactions and Statistics,” NYSE Euronext, http://www.nyse.com/financials/

1143717022567.html (accessed August 12, 2010).
7 Data from Barclays Capital Equity Research, cited in “Equity Trading in the 21st Century,”
Knight Capital Group, February 23, 2010, http://www.knight.com/newsroom/researchAnd
Commentary.asp.
 current perspectives on modern equity markets 19

cents per share in 2010, while as recently as 2004, commissions were

closer to 5 cents per share—over a 40 percent decrease8—helping asset
managers offer lower-fee products. Even better for the little guy, the U.S.
equity markets represent one of the few marketplaces in which an indi-
vidual can make a trade more cheaply than a big customer. John might
trade 1,000 shares for $10 through his online broker, while a mutual
fund will pay a commission per share. When you multiply the savings
times the 10-plus-billion shares that trade every day, that means tens of
millions of dollars are staying in the pockets of investors.
These are explicit fees. There are also implicit fees in the form of spreads.
In fact, these have also come down over time, because of both competi-
tion and decimalization (after which stocks were quoted in penny incre-
ments versus fractions). So, in the U.S. equities markets, spreads are often
a penny, and investors can buy and sell instantaneously. On a $20 stock,
1 cent is 0.05 of 1 percent. Imagine for a moment that the housing market
worked the same way. That would mean you could instantly sell your
$300,000 house to an intermediary who would hold onto it until finding
a buyer for the mere price of $150. This low trading cost means that for
stock investors, it’s a lot easier to rebalance their portfolios for risk and
access cash when they need it. It’s also a lot easier and quicker, generally,
for the value of the holdings to increase and ultimately cover these costs.
Both explicit and implicit trading costs are important, no matter how
small they are or become, because it’s very hard to beat the overall
market. This is actually a good thing. Millions of buyers and sellers are
in the market every day, analyzing millions of pieces of information. And
in the United States, investors large and small have access to the same
information, leading to an incredibly efficient system. Sometimes, it’s
hard to reconcile that efficiency with wild price movements. Could the
value of a company change so much in so little time? Maybe yes, maybe

8 Greenwich Associates, “U.S. Equity Trading Business Falling Short of Expectations

in 2010,” June 2010, http://www.greenwich.com/Greenwich0.5/CMA/campaign_
messages/campaign_docs/naeif-10-GLG.GR.pdf; and “Brokerage Commissions and
Institutional Trading Patterns,” Review of Financial Studies, 22 (December 2009), http://
www.terry.uga.edu/profiles/pub_docs/rf5175%20commissions.pdf.
 20 overview of the u.s. equity markets today

no. Either way, there’s a collective genius, which makes it difficult for
active managers to outperform indices. And ultimately, this means that
the prices we all see on the screen—whether through a professional
Bloomberg terminal or an online account accessed from a laptop in the
living room—are fair. (All of this makes a case for investing in ETFs and
index funds, but that’s another topic entirely.)
The U.S. equity markets are the envy of the world and the basis for
Americans’ wealth creation and innovation over the last 100 years. The
liquidity is unparalleled, and the fairness, efficiency, and cost unmatched.
Recent events must be put in context. Certainly, changes to the market-
place over the last 10 years—primarily technology driven—need to be
reviewed and addressed, but carefully. Not in a vacuum, not as a knee-jerk
reaction, but as a thoughtful, data-driven effort to protect this treasure.
 chapter
*

Imagine an Investor
Washington’s Historical Role
in Shaping the Industry through
Regulation and Legislation
by Ar thur Levitt
f o r m e r c h a i r m a n o f t h e s ec u r i t i es a n d
e xc h a n g e co m m i s s i o n ( 1 9 9 3 – 2 0 0 1 )

During my time at the Securities and Exchange Commission (SEC),

discussions of market structure always seemed to begin with the mantra
of the National Market System (NMS). Congress urged the SEC to expe-
dite the development of a system of multiple, competing markets linked
through technology. The core goals of that system included (1) efficient
execution of transactions; (2) competition among exchanges and other
market centers; (3) transparency of market data; (4) the broker’s duty of
best execution; and (5) the opportunity for the interaction of customer
orders without the participation of dealers.
The clarity of the NMS mantra somehow became obscured once the
discussion turned to what the framework actually required. The SEC and
its staff were faced with difficult and fundamental trade-offs among the
core goals that were daunting in both complexity and detail. These trade-
offs are the key to understanding how the SEC approaches the regulation

21
 22 imagine an investor

of trading and markets in the face of intensive and conflicting political

pressures. For me, the essential guideline for reconciling often competing
NMS objectives is simply to recognize that the point of market structure
is to make markets work for investors.

Market Competition versus Order Interaction

Perhaps the most difficult market regulation trade-off resulted when
Congress rejected the approach of a single central market and opted
instead for a system of multiple competing markets. In doing so,
Congress essentially traded off the optimal order interaction and pricing
efficiency of a single market to achieve the dynamism of competing
markets. This trade-off means that the most aggressive bidder for a
stock may be separated from the most aggressive seller because the
seller’s order is in another market. On the other hand, having multiple
competing markets tends to ensure that markets will drive each other to
innovate, at least in theory.
Some parties, of course, strenuously opposed the trade-off from the
beginning. Early on, members of the New York Stock Exchange (NYSE)
argued that prices suffer when buyers and sellers are scattered across
multiple exchanges, rather than forced into a central meeting place—
preferably, the NYSE floor. Ultimately, Congress was persuaded that the
costs associated with a monopolistic utility were not worth the pricing
efficiency of a single central market.
The same tension between goals of order interaction and market
competition continued into the late 1990s in the debate over NYSE rule
390, which prohibited NYSE members from dealing in listed securi-
ties away from an exchange. While the NYSE and other proponents of
centralized markets argued that the rule prevented the fragmentation of
trading interest, most saw the rule as providing an anticompetitive use
of market power. In the end, the SEC struck a balance in favor of market
center competition and sided with opponents of the rule. It may be that
rule 390, at the time it was abandoned by the NYSE, was of limited prac-
tical significance, in that most market participants had found ways to
 current perspectives on modern equity markets 23

effectively avoid it. Regardless, the NYSE abandoned the rule only when
the threat of SEC rule-making became clear and the symbolism of its
demise was important. In any event, the decade that has passed since
then has seen intense competition among markets.
In particular, the NYSE and NASDAQ have become global, publicly
held technology companies, fueled by their acquisitions of former elec-
tronic upstart competitors. More recently, these exchanges have been
joined by electronic exchanges such as BATS and Direct Edge. Trading
volume has dispersed among these venues, with no individual venue
accounting for more than 20 percent. Significantly, more than 30 nondis-
played venues or “dark pools” now operate, executing approximately 8
percent of marketwide volume in the NMS (according to SEC statistics).
Investors today have a wide-ranging choice of execution venues and
enjoy faster, cheaper, more reliable executions than ever before. In addi-
tion to expanding choice and reducing costs for investors, this competi-
tion has woven a level of resiliency into the U.S. market structure that
simply was not there a decade ago. It seems clear to me that promoting
competing markets has helped deliver greater dispersion and redun-
dancy to the market infrastructure, and in doing so, it has significantly
enhanced U.S. financial markets’ security.
Even so, recent SEC pronouncements make it clear that the commis-
sion is now sharply focused on the potential effects of the dispersion
of liquidity across multiple trading venues on the ability of orders to
interact with one another. The troublesome tension between a system
of multiple competing, ever-innovating markets and an acceptable level
of interaction between buyers and sellers across markets shows no sign
of relenting.

Transparency versus Market Competition

The goal of market data transparency also forces difficult trade-offs with
market center competition. On one level, the data produced and the
types of orders offered by an exchange are at the core of the exchange’s
product and competitive edge. On another level, the key components
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