RESEARCH OUTPUT AND CAPITAL MARKET EFFICIENCY UNDER ALTERNATIVE COMMISSION RATE STRUCTURES

• Published date: 01 December 1978
• Author: Nancy Jacob,Rich Pettit
• Date: 01 December 1978
• DOI: http://doi.org/10.1111/j.1475-6803.1978.tb00005.x

The Journal of Financial Research • Vol. I,

No.1'

Winter, 1978

RESEARCH

OUTPUT

AND

CAPITAL

MARKET

EFFICIENCY

UNDER

ALTERNATIVE

COMMISSION

RATE

STRUCTURES

Nancy Jacob and Rich

Pettit"

Standard economic theory asserts that the existence

of

a competitive secondary

market for financial claims enhances the efficiency with which real resources are allocated

in an economy. Similarly, the notion that asecondary securities market characterized by

high trading costs, a small number of participants, and/or substantial institutional and

regulatory constraints tends to encourage allocational inefficiency, is also widely

accepted. Because

of

this, it is not surprising that economists have devoted so much

attention to studies concerning the efficiency

of

the stock market.

Most research on market efficiency has concentrated on martingale or "fair-game"

properties

of

the stock market and, more specifically, on the potential existence

of

prices

which do not "fully reflect" the "intrinsic" values implied by publically-available

information.

While

these investigations are clearly relevant to the assessment of market

efficiency, they are not sufficient.

It

is possible for a market to be fair-gameefficient, in

the sense that its prices fully reflect information, but yet be allocationally inefficient.

This would be the case if, for example, entrance to the market were controlled by a

monopolist who charged investors transactions fees in excess

of

the marginal costs

of

providing those transactions services. By encouraging less frequent trading on the part of

individual investors, industry output would be reduced below a competitive level and

social welfare would be adversely affected. Thus, it is important that studies purporting

to examine the market's efficiency consider not only the behavior

of

its prices, but also

the implications

of

its organizational and regulatory structure for transactions costs.

Our investigation is concerned with one such aspect

of

the structure of the brokerage

industry on the allocative efficiency

of

the market for New York Stock Exchange

(NYSE) stocks. In particular, we assess the impact

of

competitive commission rates on

allocational efficiency.

It

would seem apparent from the above that any departure

of

brokerage fees from a competitively-determined level, as was the case under the fixed-

minimum rates which prevailed prior to May 1, 1975, would, ceteris paribus introduce

inefficiencies. However, the NYSE and others have argued that the brokerage commission

structure has a direct effect on the pricing and output

of

investment research by broker-

age houses. To the extent this is true, changes in the quantity and/or nature

of

investment

information disseminated to investors by brokers would accompany changes in the

commission structure. The policy implications

of

this are apparent. Since enhancement of

both

fair-game and allocational efficiency requires that relevant information be widely

and cheaply available, the most desirable commission structure from society's point of

view would be the one which had the most salutory effect on the production and

dissemination of "useful" information to investors.

In order to assess the impact

of

competitive commissions on the pricing and output of

research, this paper is organized into four sections. Section I briefly examines the history

of the NYSE's commission rate structure and reviews previous economic analyses

of

it. In

*The authors are, respectively, Associate Professor

of

Finance, University

of

Washington, and

Associate Professor

of

Finance, University of Houston.

45

46 TheJournal

of

Financial Research

Section II, we create a micro-economic model

of

the brokerage industry as it existed prior

to May 1, 1975. In Section III, we use this model to assess the impact

of

the change in

rate structure on the price and output of research. Finally, Section IV considers the

possibility of changes in the nature, or quality, of the research produced by the industry

and its implications for efficiency.

I. Background

A. History

of

the

NYSE

Commission Rate Structure

The forerunner

of

the present New York Stock Exchange was founded in 1792 by

twenty-four securities brokers, who signed an agreement then known as the Corte's Hotel

Pact. Their intent was to charge outsiders a fixed, noncompetitive commission for trans-

actions and to treat each other preferentially. Amazingly, this exclusionary and non-

competitive stance was not seriously challenged until the 1960's, over 150 years later. By

that time, a growing number of institutional investors were sufficiently encouraged by the

fixed commission structure to trade in NYSE securities

"off

the board" at reduced

commission charges. Many reciprocal fee-splitting arrangements were also invented as a

means of effectively avoiding the fixed fees on institutional trades.

In response to these institutional pressures on the fixed rate structure, the NYSE

introduced aquantity discount for the portion of orders exceeding 1,000 shares in

December, 1968. At the same time, the NYSE and other national exchanges offered to

negotiate rates for that portion

of

commissions which exceeded $100,000 on a single

order. Then, under heavy pressure from the Securities &Exchange Commission, the

NYSE initiated a system

of

freely competitive rates on the portion

of

trades exceeding

$500,000. This change, which took effect in April, 1971, was followed by a reduction in

the breakpoint to $300,000 one year later. The SEC then ordered the NYSE to remove

fixed commissions entirely, making the charges for all traders subject to competitive

forces by May 1, 1975 [8] .

The general consensus within the industry prior to the change in May, 1975, was that

the price

of

executions would fall somewhat on medium and large trades, rise somewhat

on small trades, and overall rates would drop enough to force some brokerage firms out

of business. Moreover, for reasons that as yet escape us, there was a widespread feeling

that it would not necessarily be the least efficient firms that would fail. What seems to

have actually happened after the change is that rates have fallen markedly on large trades

and stayed about the same or risen slightly on small trades. Estimated figures for 1976,

based on actual business transacted, show that commission revenue was $485 million

below the revenue that would have been generated if the pre May, 1975, commission rate

structure had been in force

[9].

This difference, which approaches 15 percent, results

entirely from transactions exceeding $2,000. Apparently, the effect

of

these price

changes on research output remains an issue. The responses to a recent query

of

brokers

indicated that institutional brokerage business was unprofitable, but that corporate

finance operations were profitable enough to persuade many to increase their commit-

ment to institutional research as a means

of

increasing institutional demand for corporate

finance services

[10].

Moreover, there is some evidence that certain types of unbundling

of prices

of

transactions from research services is taking place. In fact, the ambiguities

relating to the effect

of

introducing a competitive market on the price and output

of

transactions and research have not been resolved.