For whom the bell tolls: the demise of exchange trading floors and the growth of ECNs.

• Author: Markham, Jerry W.
• Position: Electronic communications networks

1. INTRODUCTION II. EXCHANGE TRADING--SOME HISTORY A. Development of Stock Exchange Trading in the United States B. Development of Futures Trading on Exchange Floors C. The Regulatory Era D. Market Convergence E. The Role of the Exchange. III. ELECTRONIC TRADING ARRIVES A. Automation Arrives in the Futures Industry B. Automation Arrives in the Securities Industry C. Scandals D. The ECNs Arrive E. Nasdaq and NYSE Responses IV. REGULATING THE ECNS A. Securities industry B. Derivatives Industry V. REGULATORY CHALLENGES--POST TRADING FLOOR A. Derivative Markets B. Securities Markets C. Regulatory Challenges D. ECNs: Pros and Cons E. Financial Market Fees F. Effects on Regulators VI. CONCLUSION I. INTRODUCTION

   The colorful "open outcry" trading in the "pits" of the Chicago futures exchanges and the bell--ringing opening of trading on the floor of the New York Stock Exchange (NYSE) have long dominated the public perception of how those markets operate. Those exchanges are now in the midst of radical changes that will soon be erasing those images. Exchange trading floors are fast fading into history as the trading of stocks and derivative instruments moves to electronic communications networks (ECNs) that simply match trades by computers through algorithms. (1) Competition from ECNs has already forced the NYSE and the Chicago futures exchanges to demutualize, consolidate, and reduce the role of their trading floors, while expanding their own electronic execution facilities. (2)

   The amazing growth of the ECNs and their displacement of the traditional exchanges have raised regulatory concerns. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have been struggling with that issue for nearly a decade. The SEC's burdensome regulations are driving capital away from public markets such as the NYSE and Nasdaq and into ECNs, which are more lightly regulated. Many public companies are also opting out of the public markets by going private; institutional trading markets in unregistered securities are growing; and foreign issuers are rethinking the value of listing in regulated U.S. markets. The ECNs are also encouraging U.S. investors to invest abroad. As a result, the SEC and the CFTC are experiencing the effects of regulatory arbitrages as issuers and market participants flee the excessive regulation imposed in domestic markets.

   The CFTC initially tried to prevent virtually all non--exchange trading of derivatives. It then did a volte--face and decided against regulating ECNs that provide execution services only to institutional investors. The CFTC believed those entities had the wherewithal and were sophisticated enough to protect themselves. However, as the result of a number of problems in the energy markets, the CFTC is reversing course once again and is now seeking to regulate those institutional markets in much the same way that it regulates exchanges that service retail investors.

   This Article will describe the growth of the securities and commodity exchanges in the United States. It will show how their traditional trading floors became the center of market activity well into the last century, a dominance which was aided in no small measure by the monopoly positions allowed them by their regulators. The Article will trace the growth of electronic competition that undermined those monopolies and will describe the responses of the exchanges to those upstarts. The Article will then describe the regulatory challenges that these electronic markets are facing in an increasingly global economy and the responses of the CFTC and SEC to these developments. (3)

2. EXCHANGE TRADING--SOME HISTORY

   1. Development of Stock Exchange Trading in the United States

      Trading in stocks and commodities was first conducted in America through auctions that were the favored means for pricing goods of all descriptions in the colonial era. (4) Securities transactions were occurring in New York as early as 1725 at a commodity and slave auction house on Wall Street. However, there were few securities to trade, other than a limited number of bills issued by colonial governments. 6 That situation changed after the success of the Revolution led to the issuance of tradable government obligations by the federal government, and a market in those bills soon developed. For example, in 1790, an auction was conducted at the Philadelphia Merchant's and Exchange Coffee House for the sale of $30,000 in 6 percent "stock" of the United States. (7)

      More formal organization arrived in that year with the creation of what is now the Philadelphia Stock Exchange by ten merchants calling themselves the Philadelphia "Board of Brokers." They operated out of a coffee house and traded bank stocks and government securities. (8) Within a year, express coaches were speeding to Philadelphia from New York bearing news from ships docking in the New York port that might affect security prices on the Philadelphia exchange. (9)

      In New York, coffee house merchants were also dealing in securities, mostly government obligations, after the Revolution. (10) In 1791, daily auctions of government "stock" were being held on Wall Street under a set of rules agreed to by the auctioneers. (11) More formal trading arrangements developed after concern arose that the auctions had fueled the speculation that touched off a market panic. (12) A meeting at Corre's Hotel in March 1792 (13) resulted in the so--called "Buttonwood Agreement" in which a group of traders agreed to fix their commissions on sales of public stock and to give preference to each other in their dealings. (14) This was an effort to centralize and monopolize trading--the model for exchange trading that would dominate American trading markets until the advent of the ECNs. (15)

      The Buttonwood Agreement was the forerunner of the NYSE. (16) That exchange was given a more formal structure in 1817 when the Buttonwood brokers sent a delegation to examine the constitution of the Philadelphia Stock Exchange. That document became a model for the NYSE (it was then called the New York Stock and Exchange Board). (17) The NYSE was a "call" market where trading was conducted by rotation, which involved reading out the list of stocks trading on the exchange and requesting bids or offers. (18) Members were assigned chairs (hence the reference to exchange "seats") and were required to be present for each session. (19)

      The NYSE was not an immediate success. Average trading volume in 1821 was 300 shares, rising to 1,300 shares a day in 1824 and then declining to an average of 100 shares per day in 1827. (20) However, by 1835, average daily trading volume was over 8,000 shares. (21) The price of NYSE seats reached a high of $4,000 before falling to $500 in 1861. (22) In order to restore the value of its seats, the NYSE then amended its constitution to prohibit its members from trading in listed securities outside the exchange's trading room and continued to restrict the number of its seats. (23)

      The NYSE was already facing competition from the curb market (the precursor to Nasdaq) that was conducted on William Street in New York. (24) Competition heightened with the outbreak of war from a number of new exchanges, including some rather shady operations like the "Coal Hole" and more serious operations like the Open Board of Stock Brokers that introduced the modern concept of continuous market--making that would replace the rotation system theretofore employed by the NYSE. (25) Several "evening" exchanges were also operating that traded after the NYSE closed for the day, (26) foreshadowing the demand for 24--hour trading in the next century that paved the way for electronic trading systems. Technology also made inroads at the NYSE during the Civil War. The telegraph replaced the express companies as the means for communicating market information rapidly, (27) and was in return replaced by the stock ticker and telephone by the end of the nineteenth century. (28)

      One other change occurred in that century that would complete the NYSE model that lasted throughout the next 100 years. (29) This was the introduction of the "specialist" who makes a continuous "two--sided" market on the NYSE floor and holds the book of customer limit orders. (30) This change was necessary in order to compete with the curb markets operating in the street outside the NYSE. (31) The specialists first competed with each other in particular stocks, but over time a single specialist emerged to monopolize market making in each stock, allowing them to reap vast benefits from that powerful position until electronic trading arrived late in the last century. (32)

   2. Development of Futures Trading on Exchange Floors

      American futures exchanges trace their history to the development of centralized trading on the Chicago Board of Trade (CBOT) before the Civil War in standardized contracts calling for the delivery of grain in Chicago area warehouses. (33) The standardization of the contract terms allowed them to be offset with other contracts, giving rise to a trading market that could be used for hedging and speculation. (34) The clearinghouse was another important contribution to finance by the commodity exchanges. The clearinghouse acts as an intermediary in each futures transaction. The clearinghouse's primary function is to guarantee the performance of all parties to a contract. (35)

      The primary purpose of the commodity exchanges in their infancy was to permit hedgers to purchase and sell cash commodities and offset risks associated with operating businesses in the underlying cash commodities, (36) but speculators operated in the markets as well. During these early stages, a contract's success was based upon its ability to replicate trading in the spot market. (37) Today, the success of a contract is largely dependent on its liquidity, i.e., the volume and open interest it attracts. (38) These measures are proxies for the contract's...