Merging Markets

• Date: 01 June 1999
• Author: Philip Hersch,Tom Arnold,J. Harold Mulherin,Jeffry Netter
• Published date: 01 June 1999
• DOI: http://doi.org/10.1111/0022-1082.00137

Merging Markets

TOM ARNOLD, PHILIP HERSCH, J. HAROLD MULHERIN,

and JEFFRY NETTER*

ABSTRACT

We study the causes and effects of the competition for order flow by U.S. regional

stock exchanges. We trace the origins of competition for order flow to a change in

the role of regional exchanges from being venues for listing local securities to

being more direct competitors for the order flow of NYSE listings. We study the

way regionals competed for order f low, concentrating on a series of stock-exchange

mergers that occurred in the midst of this transition of the regional exchanges.

The merging exchanges attracted market share and experienced narrower bid-ask

spreads.

STOCK EXCHANGES CAN BE VIEWED as firms that compete on a number of inter-

related dimensions including liquidity provision and price discovery. As part

of this competitive process, exchanges attempt to exploit scope and scale

economies in securities trading by listing new firms and by attracting vol-

ume in existing securities. The second objective is known in modern par-

lance as “competition for order f low” and has received increasing attention

in recent years, both within the U.S. securities market and across inter-

national borders ~see, e.g., SEC ~1994!.!The questions of interest include the

extent to which competition for order f low is affected by information costs

and regulatory barriers ~Gordon and Bovenberg ~1996!, Smith ~1991!!, the

manner in which exchanges compete for order f low ~Battalio, Greene, and

Jennings ~1997!, Easley, Kiefer, and O’Hara ~1996!, Battalio, Greene, and

Jennings ~1998!!, and the effect that such competition has on execution costs

~Lee ~1993!, Blume and Goldstein ~1997!!.

In this paper, we contribute to such queries by analyzing historical as-

pects of the competition for order f low by regional stock exchanges in the

United States. We first document how regulatory and technological changes

altered the role of the regional exchanges from being the listing location of

local firms to being an alternative venue for trading NYSE-listed securities.

*The authors are from Indiana University, Wichita State University, Penn State University,

and the University of Georgia, respectively. We thank session participants at the 1995 South-

ern Finance Association meetings, the 1996 Financial Management Association meetings, and

the 1997 American Finance Association meetings, and seminar participants at the University of

Notre Dame, Penn State University, and Wichita State University, as well as Charles Cao,

Laura Field, Gordon Hanka, Larry Harris, Ananth Madhavan, David Malmquist, Robert Jen-

nings, Deon Strickland, and Robert Weiner for helpful comments. We also thank the editor,

René Stulz, and an anonymous referee for valuable suggestions.

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We then analyze the manner in which the regionals competed for order f low,

concentrating on the effects of a series of exchange mergers on trading vol-

ume and execution costs. We find that the merging exchanges attracted or-

der flow and exper ienced narrower bid-ask spreads.

The organization of the paper is as follows: Section I describes the chang-

ing role of regional stock exchanges over time. Section II presents the em-

pirical evidence on the competitive effects of the stock exchange mergers.

Section III concludes, and includes some remarks about the implications of

our results for pending exchange mergers.

I. The Changing Role of Regional Stock Exchanges

Perhaps the fundamental issue underlying our analysis is whether com-

petition between stock exchanges is viable. Stigler ~1961, 1964!is among the

first to model the fact that the trading of a par ticular security tends to

cluster in a single location. He attributes this phenomenon to the presence of

economies of scale in information production and, therefore, in the price

discovery process. Subsequent empirical analysis by Doede ~1967!and Dem-

setz ~1968!elaborates on the scale economies present in securities markets.

Doede reports that the average operating costs of stock exchanges are a

declining function of trading volume, indicating evidence of economies of

scale in exchange operations. Demsetz finds that bid-ask spreads are a de-

clining function of the rate of transaction volume, indicating economies of

scale in the market making of a particular security.

In the presence of such scale economies, intuition as well as formal theory

~Chowdry and Nanda ~1991!! suggest that order flow will g ravitate to the

market with the lowest execution costs. Of course, execution costs have many

dimensions ~see, e.g., Ahn, Cao, and Choe ~1997!, de Jong, Nijman, and Roell

~1995!!. Moreover, a substantial body of analysis, much in the context of the

home-market-bias in international investing, suggests that information costs

and regulatory barriers can impede the ability of stock exchanges to compete

for order f low simply by offering lower execution costs ~see, e.g., Kang and

Stulz ~1997!, Gordon and Bovenberg ~1996!, Smith ~1991!!.

A. The Initial Role of Regional Exchanges

The history of regional stock exchanges in the United States demonstrates

that information costs and regulatory barriers can signif icantly affect the

competition for order f low.

1

In the nineteenth century United States securi-

ties financing, ownership, and trading all tended to occur on a localized

basis, indicated by the fact there were more than 100 regional exchanges

~SEC ~1963!,p.928!. For example, Dilts ~1941, p. 67!notes that for a secu-

1

A good source of information on the development of regional stock exchanges is Cole ~1944!.

See also Greenwood ~1921!, Kamm ~1942!, Merrill ~1937!, Smith ~1936!, and Walter ~1957!,as

well as media articles such as Business Week ~1947!.

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