A Forecast: Trading in 2001: Of Markets and Mania.
In the late '90s there is a looming threat to the markets that have heretofore remained immune to seismic shifts: the emergence of electronic communications networks, which promise to connect buyers directly to sellers, without the need for intervening parties.
ECNs are not operating in a vacuum, but against a backdrop of market structure, practices and customs that have grown and evolved over centuries. But the change accelerated by the ECNs will transform the old world of securities trading. Market-makers, ECNs and exchanges all will suffer. The genie is out of the bottle: Incumbents must develop a strategy for surviving in this even harsher new world.
After the Confusion
With the rise of electronic trading - and after today's dust settles - just how will investors adjust? Will there be a place for brokers? How many markets will exist? And what will they look like?
Not surprisingly, the institutions most radically affected by the changes in the financial world will be broker/dealers, market-makers and the exchanges themselves. Because they all know how the current arrangement works, and have developed business models and technical infrastructures that make them money in that framework, they have little incentive to change the system.
If incumbents refuse to adapt, however, investors will bypass them. Change is being forced upon them by upstarts with little vested interest in the current system or by farsighted, established players who have seen the handwriting on the wall and decided that they want to be part of the new world. By exploiting opportunities that the incumbents have had little incentive to go after, the new entrants will radically alter the business models of all market participants.
In a world with only a single conduit that matched all buy and sell orders for all securities, commission costs would be virtually non-existent. But there would be significant problems, problems that exchanges today address. There would be no entity with an economic interest in guarding against market manipulation. While the SEC could perform that function, it does not have the same financial stake in ensuring regulatory compliance that the NYSE does, for example. There would be no market-makers willing to set a price in the absence of other activity. Thinly traded stocks could have little or no price information available about them. Order imbalances could take small investors unawares, and the concept of a trading halt would be nonexistent. There would be no listing requirements, which would not be a problem for big, actively traded stocks, but could be for smaller ones.
So there is a valuable role for markets. But ECNs threaten some of their core functions. Where will we end up?
We believe exchanges and ECNs will converge in the next three years. The functionality they provide is too similar for them to coexist. Yet it's unlikely that they will converge into a single mega-market. Instead, the most likely outcome is that two markets (exchanges/markets/ECNs) will develop, each offering a different value proposition. One will offer bare-bones crossing of trades, while another will offer most of the services of exchanges today. The no-frills model will likely focus on large, listed stocks, while the full-service version will offer all of the services available today for second-tier stocks. And the physical exchange of the NYSE will suffer from an increasingly large cost disadvantage compared to its electronic competitors, leading to its eventual move away from the trading floor. There will continue to be a role for regional exchanges, serving as the off-Broadway trial for smaller stocks until they reach the big-time of the national stage.
Several critical questions remain, however. While these questions have long-term answers, in the short term there will be confusion and disorder as market participants adjust to the upheaval.
Who will provide regulatory oversight?
Regulatory oversight of market and member firms has been one of the key functions provided by the NYSE and the NASD. Members of these organizations pay a fee that helps support market and member supervision. If members are making less money or if they see no benefit to membership, then regulation may suffer. Perhaps more importantly, if both the NYSE and the Nasdaq become publicly traded entities, then the disposition of the non-money-making regulatory function remains exceedingly unclear. Self-regulation takes place alongside SEC supervision, but is generally seen by member firms as preferable to government intervention - the federal regulatory process is often seen as being slow and its punishments severe.
Australia provides a useful lesson. When the Australian Stock Exchange (ASX) went public in October of 1998, the country passed a law that limited individual ownership in the exchange to 5 percent. In this way no person or company can gain control of ASX. Regulatory issues, on the other hand, still need to be resolved. Currently, the ASX still has regulatory powers although they are subordinate to the Australian Securities and Investments Commission (ASIC). This arrangement is similar to the NYSE and the SEC, but the exchange is currently looking into creating a separate regulatory company. And the ASIC has stated that the regulatory picture will need to change if there is significant competition among Australian exchanges in the future.
What will be a market order?
Price determination and dissemination are key functions of a market. Today, when an investor places a market order, particularly in an over-the-counter market, the execution capabilities of his broker matter. Market-makers pay brokers for order flow, and the price of a market order at one broker may be different than at another. In the end game, there should be only one consolidated order book for each stock, so execution should be a matter of simply buying at the lowest price or selling at the highest.
In the interim, however, the picture is much cloudier. ECNs should theoretically aggregate the postings of all participating market-makers, perhaps on a consolidated basis in the near future. But the meaning of a market order if there are no bids or asks is currently unknown. Many ECNs and after-hours exchanges attempt to deal with this by requiring limit orders only, but in the long run this is an impractical solution.
Individual investors, for example, currently often have little idea of what the correct price should be. The notion of a true market order may disappear and all orders will be limit orders. If investors do not want to be constantly scanning order books to decide the price at which they want to trade, then they can use a broker, and the broker will charge for his advice in determining what limit to set.
What will be the price of liquidity?
An essential component of a well-functioning market is liquidity - something that most people fail to notice until there isn't enough of it. But investors who want liquidity must pay for it, even if they don't realize they're doing so. Market-makers today play a critical role in providing liquidity, and are compensated for doing so via the bid/ask spread. Yet ECNs can perform the same function - the unique role of a market-maker is providing liquidity when no one else is willing to do so.
So market-makers' comfortable living on most days is punctuated by the relatively infrequent days when they really earn their keep. In choppy markets, the market-maker truly has to act as a principal, buying or selling securities from inventory, rather than as a crossing agent between two parties who have, unbeknownst to them, agreed on a price. In this sense, market-makers are like insurers: One really doesn't notice the value of the services they provide until those services are needed. And just as few people like paying for insurance, investors tend to dislike paying market-makers. Many investors will prefer to pay for only the cost of executing a trade via an ECN, rather than for providing liquidity at some unknown point in the future.
If market-makers aren't being paid to provide liquidity, who will provide it, and how will they be paid? ECNs will provide some amount of liquidity in calm and orderly markets, cherry-picking the easy money to be made on crossing orders. Like much of the new world of Internet financial services, the true test of the functionality and durability of the ECNs will come in volatile and bearish markets. Without the capital to support trading activities and provide liquidity, ECNs will not be able to step in to fully support all of the functions of the market that the market-makers do. In today's benign environment, it's difficult to devise policy solutions for problems that do not yet exist.
While the migration of trading activities to ECNs will hurt market-makers and benefit investors in the short run, it could hurt investors themselves in the long run. If no one stands ready to provide liquidity, then price volatility will rise, trading patterns will become discontinuous, and valuing portfolios will become more difficult.
What impact will 24-hour trading have?
Twenty-four-hour trading has been discussed for decades, but 1999 has seen it truly pick up steam. A host of announcements by ECNs and brokerage firms allowing retail investors to trade at off-hours has proliferated in recent months. The exchanges are also set to toss their hats in the ring, although they have now delayed that process until 2000 amid worries of staffing and logistics.
For all the hype surrounding 24-hour trading, its true impact will be minimal. Liquidity is what makes markets work and this liquidity will be missing for most of the off-hours. While limit orders would seem to be the solution, leaving them outstanding overnight could also subject investors to news that breaks overnight.
But certain minor questions remain. In this world, how will the closing prices for equities be determined? Closing prices today are used to track the performance of securities and indices on a day-to-day basis, to set the daily net asset values of mutual funds and to assess the need for margin calls. If closing prices disappear or become meaningless because there is no closing, some new mechanism will have to be devised to replace them. It will most likely continue to be the end of the official exchange day.
The success of 24-hour trading ultimately will be determined by investor demand. The opportunity for overseas investors to execute orders will help stimulate this demand on the margins, but without a critical mass of investors to provide liquidity, 24-hour trading will remain little more than a curiosity.
Morphing Exchanges and ECNs
Critical mass is a key success factor for any new trading venture. Exchanges and ECNs will be subject to the "tipping" phenomenon, whereby once a certain level of market share is reached, then many more customers will decide that the particular venue will be the winner, and flock to it to take advantage of the liquidity that it therefore provides.
If the exchanges' critical mass of investors begins to erode, then their advantage over smaller marketplaces is lost. The potential exists for customer defections to escalate into a vicious downward spiral that feeds on itself. It's therefore critical for the exchanges to prevent erosion of their customer base to ECNs. While ECNs currently route some volume through exchanges, the exchanges ultimately are an unnecessary step in the process. The Nasdaq and NYSE can either let themselves become the irrelevant link in the chain, or ensure that the ECNs themselves are the link that is made irrelevant.
This critical mass phenomenon will also apply to ECNs. There is no way for the market to support nine different ECNs. Goldman Sachs implicitly acknowledges this with its stake in three different ECNs, each of which competes with the other (and Brut and Strike recently announced plans to merge). As the differences in the business models become apparent, and as users become accustomed to distinctions among fees and ease of use, then the ECNs will consolidate into at most three players as an intermediate step. In the long run, the ECNs will be folded into exchanges, or exchanges will fold into ECNs. In either case, the regulatory function currently provided by exchanges will have to be preserved.
Eventually, there will be at most two national exchanges/ECNs that survive; the rest will have been absorbed.
The bare-bones market will be a crossing network that serves simply as a conduit. It will be the Sam's Club of trading, offering only to match buyers and sellers with no additional services. It may even require a policy of limit orders only so that investors are not whipsawed by price discontinuities or bedeviled by the question of what exactly constitutes a market order and how long those are good for. Stocks likely to be traded on this market are large-cap, household names that enjoy significant liquidity and are followed by a large number of analysts.
The other end of the spectrum will be a marketplace with the functionality of today's exchanges, although it will be electronic, not physical. The challenge for it will be providing enough perceived value to investors that they will be willing to pay the higher commission costs. Its value will be proven, however, in a market downturn or in a period of high volatility. In order to avoid the regulatory function defaulting to the government, there may even have to be some sort of trading tax that pays for the regulatory function. While participants may scoff at the idea, the money they save on commissions should be more than sufficient to pay for this vitally important function.
Much as investors today are not required to use only a single broker, neither will they be required to use a single exchange or ECN in the future. They will instead direct their orders to the market with the features most suited to their needs at a given time. If they need the advice of a broker, then they will use one. If they know exactly at what price they're willing to buy or sell, then they will place their trades directly with the crossing exchange and pay a nominal fee.
Regardless of which exchange/ECN investors use, the world in which they function will be much different and faster than it is today. Investors and all securities markets participants must be more nimble than ever as they adapt to the increased pace of change.
Dan Latimore is director of eStrategy at Cambridge, Mass.-based consulting firm Mainspring Communications. You can reach him at email@example.com. All contents copyright c 1999, Mainspring Communications, Inc. All rights reserved.
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|Date:||Nov 1, 1999|
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