Equity markets must meet the changing needs of different classes of market partici- pants. We consider the equity marketplace primarily through the lens of buy-side institutions and their intermediation needs. We are not ignoring the small partici- pants since many retail customers rely on buy-side institutions for their equity investments.
Size is the overriding distinction between institutional orders and retail orders.
For large institutional orders, we refer to the size of an order for a single name (a 1,000,000 share order for a liquid stock is not unusual), and to the size of a basket
3 We should also note that there are substantial differences in the regulatory environment and market structures of the NYSE and German equity markets. Thus, our analysis does not represent a direct, apples-to-apples comparison and should be interpreted with appropriate caution.
order (there can be 1,000 names in a basket with an average order size of 1,000 shares.) Equity market structure must facilitate the efficient execution of both single name orders and basket orders. There is an important distinction between a 1,000 share retail order for a stock and a 1,000 share institutional order that is part of a basket trade – the basket order will likely be laced with contingencies (e.g., a maxi- mum net dollar difference between purchases and sales may be stipulated).
Electronic trading is essential for the efficient handling of basket orders; this is not necessarily the case for large, single stock trades.
Recognizing the complexities of order handling, the enormous differences between a 1,000 share retail order, a 1,000,000 single share institutional order, and a 1,000,000 share basket order, and given the varying trader needs for speed, anonymity and control, the challenges facing market architects and government regulators who oversee the markets are enormous. To achieve desired answers, two fundamental goals for the broad market must be kept in focus: sufficiently accurate price discovery and reasonably complete quantity discovery.
Price discovery refers to finding the price that best reflects the underlying desire of participants to buy and sell shares. A well-discovered price could be considered an equilibrium (or consensus) value. Because equilibrium prices are not observable before trades are made, and given that all orders are not submit- ted simultaneously, finding an equilibrium value is a complex, dynamic process. 4 The prices that we actually see in a market reflect the orders that participants submit, the structure of the market that determines how orders are handled and translated into trades, and the size of the market (e.g., the number of participants and/or market cap). The market’s structure and size establish the network.
Taking a market’s structure as given, larger markets are expected to deliver better price discovery.
Quantity discovery involves participants disclosing their orders so that they can meet each other and transact the total number of shares that they wish to buy or to sell. Ideally, price and quantity discovery should go hand-in-hand, much as in any microeconomics course the simultaneous solution for price and quantity is given by the intersection of a demand curve and a supply curve. In real world equity markets, however, quantity discovery is rarely simultaneously achieved with price discovery, nor is it generally complete. 5 That is, contra-side orders that could in principle meet and trade with each other are commonly held in partici- pants’ pockets and not disclosed to the market. This is true especially for big orders that are not fully revealed because participants fear market impact. For a given market structure, larger markets are expected to deliver more complete quantity discovery.
4 For further discussion of the dynamics of price discovery, see Paroush et al., Schwartz, and Wolf (2006).
5 See Moulton (2005) for further discussion of investors’ desire to trade at specific quantities and the increased price impact of trading at precise quantities, particularly by institutional investors at the end of a calendar quarter.
102 P. Davis et al.
To date, the Big Board continues to receive a bit more than 70% of the order flow for its listed stocks. 6 The NYSE’s architecture consists of both a “fast” com- ponent (the SuperDot system and Direct+) and a “slow” component (the floor trad- ers and specialists on the floor of the exchange). The new Hybrid Market restructuring will change many of the features of the NYSE, but it will hopefully preserve a vibrant network that offers both fast and slow trade execution.
Why not go to a fast market only? A purely electronic order driven platform is certainly compelling. It is cheaper to operate, and it offers speed, anonymity, and control. 7 Perhaps the reason it does not dominate is that a slow market, in some situations, actually is not slow. That is, matching a large buy and sell order in a single trade may accelerate the execution of the entire package. “Slicing and dic- ing” (the usual characterization of large orders being executed in smaller pieces over an extended period of time) is highly prevalent in today’s marketplace. Each tranche of a large order can receive a fast execution, but the procedure may never- theless be slow for the entire order.
The bottom line is, for a market to be an effective network, a fast electronic component cannot do it all. For large orders in particular, improper order handling can lead to sizable market impact costs and, by offering more intelligent direction, the human tortoise can outpace the electronic hare. 8 And so intermediation will retain its importance irrespective of the existence of an electronic platform. But the form that it might take is not easily foretold. At this time, just how the introduction of the NYSE’s fast market will change the balance between order book trading, floor trading, and the upstairs market is not very predictable. If the floor survives, the distribution of the order flow will be determined by competitive forces but, if the profitability of floor trader operations erodes to the point where the floor trader firms cease their operations, the floor could collapse. If so, the network efficiency of the Exchange will be profoundly affected.
The reality is that price and quantity discovery have already partially decoupled in the current environment. For the most part, prices of NYSE-listed shares are discovered on the Big Board’s trading floor, an environment where relatively small, retail orders play an important role. As we have noted, larger, hard-to-work orders may be sliced and diced and brought to the floor over extended sequences of trades;
they may also be executed in an NYSE call auction or off-board, either in the upstairs market, in a crossing network, or in a block trading facility. Consequently, while price discovery largely occurs at the Exchange, quantity discovery increasingly does not.
6 The percent received by the NYSE, in December 2005, was 73.25%. See NYSE Facts & Figures web site (formerly known as the NYSE Fact Book) at http://www.nysedata.com/nysedata/Default.
aspx?tabid = 115.
7 In a fast market only environment, the role of the floor broker passes to brokers who work orders electronically. These agents would not necessarily be affiliated with the NYSE.
8 See Boehmer (2005) for further discussion and analysis of the trade-off between differences in the speed and cost of trading on an electronic system versus a floor-based market. Overall, the author finds a positive relation between the speed and execution cost associated with a trade.
It is possible that the bifurcation between order book-provided price discovery and off-book-provided quantity discovery will sharpen. On the other hand, if the NYSE’s new market structure better facilitates the handling of large orders, the two processes may be brought into closer harmony. Before attempting to peer into the future, let us first take a broad look at off-exchange trading and then obtain some perspective on the current importance of fast market, order book trading at one exchange, Germany’s Deutsche Börse, where the primary focus is on electronic trading.