Tài chính doanh nghiệp - Lecture 17: Brokers, dealers, exchanges & ecns

Lecture 17: Brokers, Dealers, Exchanges & ECNsBrokers, Dealers Exchanges & ECNsBrokers deal with public. Example: Merrill LynchDealers execute tradesExchanges are places where dealers operate. Examples: NYSE, Nasdaq, Arizona ExchangeElectronic Communications Networks (ECNs) allow investors to communicate with each other, and to exchange. Examples: Island, Instinet (now Inet)BrokersDeal with public, know potential buyers and sellersChurning versus providing informationSEC penalizes “rogue brokers” who churn.Stockbroker Robert Magnan was convicted of criminal offense of churning, and barred from securities industry for life, 1999.Magnan’s clients had an annual turnover rate of 11, and investments would have had to earn annual return of 50% to pay transactions costs.DealersStand ready to buy and sell at posted prices, bid and askedAnalogy to antiques dealersWhy are antiques dealers’ bid-asked spreads so much wider than stock dealers?ExchangesNew York Stock Exchange, established 1792 by the Buttonwood Agreement among 24 brokers. Exchanges provide standards and codes of ethics for broker members, standards for stocks.Regional Exchanges: American Stock Exchange, Philadelphia ExchangeListing requirements for stocks. Delisting too.NASDAQ –National Association of Securities Dealers Automatic Quotation System, 1971, first electronic exchange, replaced old “pink sheet” system for over-the-counter stocks.Markets to Lend (Not Sell) Shares“Loan Crowd” on floor of NYSE 1926-33 led active marketWall Street Journal reported “Loan Rate” often negative (Charles Jones & Owen Lamont)J. Edgar Hoover, Crash of 1929Equilend was established in 2001 ( sponsored by Barclays Global Investors, Bear Stearns, Goldman Sachs, JP Morgan, etc.Equilend ModelNew ExchangesNASDAQ in 1971 did not require that stocks have ever made a profit before listing, listed IPOs immediately.Intel, Microsoft refused NYSE switchForeign imitators of NASDAQ: Neuer Markt, Germany, Mothers, JapanNeuer Markt shut down 2002ECNsInstinet: for professionals. Until 1999, it was the biggest ECNIsland: for individuals, became the biggest ECN. In 1999 it did 4.9% of all Nasdaq trading volume, compared with 3.0% for InstinetOther ECNs: Redi-Book, Bloomberg, ArchipelagoIntermarket Trading System (ITS)Securities Act of 1975 called for a national market systemIn response to this act, the ITS, an electronic system, was opened in 1978. Displays quotes on all exchanges where a stock is listed.Today the ITS is a relic, too slow to be of much use.Payment for Order FlowBrokers drum up orders, deal with customersBrokers sell the order flow to crossing networks, who profit from the order flow.November 2000 SEC posted rules that brokers must post composite statistics on fraction of order flow going to various places.Firms must also report statistics on their order-execution qualityThe Battle of the PlatformsExchanges merge to try to gain critical massRumors of possible NYSE-Nasdaq mergerEuronext merges European stock exchangesInstinet buys Island 2002 (to form Inet.com). Offered automatic trading facilities that Nasdaq lacked. (Nasdaq responds with Supermontage)The Pacific Exchange acquires Archipelago.com 2000, then REDIBook. ArcaEx trading systemShares Traded per Day (Dec. 2003)New York Stock Exchange 1.3 billionNasdaq 886 millionInet 586 millionPacific Exchange 526 millionLimit Order BookThe Island ECN shows its book on the web from 2002, example of Dell is at right.Color blocks indicate orders at same priceOrders are expressed in dollars and centsIsland was the first US exchange to list go to penniesInside spread is 35.625 to $35.73Central Limit Order BookIsland Exchange shows only its own orders.Nasdaq Level 1 shows only inside spread, few have Level 2In January 1997 SEC forced NASDAQ to list ECNs orders on its order book, among dealers’ quotesKinds of OrdersMarket OrderLimit OrderStop Loss OrderMarket orders dangerous for thinly-traded stocksIsland did not allow market ordersThe “Book” on NASDAQNASDAQ’s book is visible to everyone who orders NASDAQ Level 2 serviceNYSE says it has plans to make its specialist’s book more widely availableGambler’s Ruin ProblemStarting with $S, betting $1 on heads on a coin toss with probability p of coming up heads, continuing to toss until ruin, probability of eventual ruin equals 1 if p is less than or equal to one half, otherwise equals:Gambler’s Ruin DerivationCall probability of ever failing, playing forever, given that one has S dollars today Pr(S). Then, Optimal Bid-Asked SpreadDealer must set a bid-asked spread in consideration of the ultimate probability of ruin and dealer’s utility weighting of this outcomeDealer has inferior information, expects to be “picked off” by superior traders.Must set bid-asked spread so that the amount of gain from spread offsets the expected loss.NYSE: The Specialist’s Post, Book and the CrowdNYSE specialist maintains a book like Island’s, but it is not public, yet.NYSE, AMEX, and Montreal are about the only remaining specialist exchangesSpecialist has obligation to maintain an orderly marketNYSE Rule 390 (prohibiting members from trading off exchange) abolished May 5, 2000The Crowd, NYSEFloor brokers cluster around specialist post, and trade among themselvesAbout 50% of NYSE share volume (though only about 10% of trades) go through floor brokers, not through specialist’s bookIn addition to the crowd, there are the “upstairs traders” who handle very large orders.Myth: Stock trading is going all electronicElectronic trading remains a venue for small tradesIf they close the NYSE floor, the floor traders will just go upstairs.Frankfurt, London, Paris, Toronto electronic exchanges: between 40% to 60% of trades were never orders on the book (though trade may be ultimately reported there.)Books have too much transparency, large orders tip their hand too much by putting it on book.Criticism of NASDAQWilliam Christie & Paul Schultz , Journal of Finance, Dec. 1994, pointed out that “odd eighths” spreads were rare on NASDAQ: dealers rarely quote prices ending in 1/8, 3/8, 5/8 and 7/8.Therefore inside spread is always at least ¼.Day after study reported in news, spreads narrow.Authors interpret as evidence of tacit collusion.Federal class action lawsuit against NASDAQ won $1.03 billion in 1998.Disadvantage to Limit OrdersPlacing a limit order is being a sitting duck. If more in-the-know investors realize stock price is higher than in your sell order, they will buy from you at your price. In an expected value sense, your orders can be filled only in this unfortunate case. Problem is enhanced by decimal trading. When a specialist has the slightest inkling that there is greater demand for the stock, can pick up shares selling for just pennies above market. “Getting pennied by the specialist.”The CNBC EffectSuccessor of Financial News Network 1983NYSE trades above, color indicates direction of tradeNASDAQ trades belowThe CNBC EffectRapid Dissemination of financial innovationCnnFn, Bloomberg New are the two cable TV competitors to CNBCClaims that because of CNBC, markets respond much more rapidly to information.But viewership on a typical day is no more than a few hundred thousand.