Innovative technology holds great promise for the financial markets, where it makes lighter work of raising capital. With new means of communications and new uses for existing technologies such as the Internet, companies can disseminate information about stock offerings more efficiently, easily, cheaply, quickly, and with greater interactivity than ever before. Several companies have already conducted offerings entirely over the Internet. Many other issuers use advanced communications to help investors receive information.
Improvements in technology are also fostering novel approaches to trading securities in the secondary markets. Technology can lower the cost of transactions and increase the liquidity of previously thinly traded stocks. It can provide greater transparency in pricing and reduce error rates. Some companies have recently set up Internet sites where interest in acquiring shares from existing shareholders may be expressed by potential investors without recourse to traditional markets. Perhaps more importantly, technology permits qualitatively different types of trading structures to emerge.
Since all these developments can improve the way capital markets work, they are good news for investors, issuers, and the economy. They also change the way these markets work, affecting the activities of customers, brokers, regulators, and even those persons intent on committing fraud. In the future, more changes will occur if technology fosters integration of the diverse U.S. marketplaces into a truly national market system--a possibility foreseen 20 years ago, in amendments to the Securities Exchange Act of 1934. Eventually, an international market system will evolve.
Stock trading status quo
Trading starts with an investor's decision to take part in a transaction--a determination based on information in the marketplace, the official filings of issuers, the advice of brokers, and so forth. Advances in communications technology have obviously facilitated this process. Eventually, paper disclosure documents will largely be supplanted by electronic versions, since they enable issuers to reach possible investors at a lower marginal cost and with interactive and better disclosure.
Technology has also smoothed the primary offering process, in which securities are offered to investors directly by an issuer or through an underwriter. The Internet, for example, allows issuers to distribute the required information directly to possible investors at less time and cost than paper delivery requires. In October 1995, the U.S. Securities and Exchange Commission (SEC) issued a release discussing the issues raised by the Internet and other technologies in this context; few difficult technical or regulatory concerns were presented.
How customer orders are executed in today's secondary markets depends on many factors, such as the type of order and the market where it is sent for execution. Despite many permutations, there are basically just market orders and limit orders. By entering a market order, the customer expresses an intent to buy (or sell) the security at the prevailing market price. A limit order is a notice of intent to buy (or sell) at a specified price for a specified time.
By and large, limit orders are executed whenever the market price reaches the limit order price. For example, if a customer places a one-day limit order to purchase stock at $49, and the stock currently trades at an asking price of $50, the order will remain unexecuted unless someone is willing to sell the stock for $49. If the order is not executed on that day, it expires.
Technological advances offer the possibility of a new type of order, which might be called a dynamic order. This would be similar to traditional contingent orders--orders that have parameters, conditions, or constraints that determine whether a transaction will occur and at what price. But they would be dynamic in that the conditions for a series of orders would have to be satisfied simultaneously. For example, an investor might enter into a system a "dynamic" order to sell 1000 shares of a stock within a certain price range, but only if at the same time another order to buy 1000 shares of a different stock occurs at a price no greater than a set price, and provided moreover that a certain market index stays within a specified range.
With available computing power, many orders like this can be entered into a system that would proceed through a series of algorithms and iterations to determine if an order can be matched with others. If it could, all the matchable orders would be executed. This type of order would allow portfolio managers and others to engage in sophisticated trading strategies, to hedge risk exposure on a portfolio-wide basis, and to take into account co-variances among stocks or other assets and ensure appropriate portfolio-wide management. Systems of this sort may soon be in operation.
Currently, an order can be executed in many different marketplaces. A customer can designate an order-execution method, either by instructing the broker how to execute the trade or by directly inputting orders in certain proprietary trading systems. In the absence of instructions from the customer--the norm for retail accounts--the executing broker may determine where and how to execute the order by using algorithms or simply checking for the best price in selected marketplaces.
In the United States and many other countries, one traditional kind of marketplace for securities has been an exchange. A traditional exchange has members, detailed trading rules, and listing requirements for stocks traded on it. Besides the primary U.S. stock exchanges (the New York Stock Exchange [NYSE] and the American Stock Exchange [AMEX], also in New York City) there are five regional stock exchanges in the United States: the Boston, Chicago, Cincinnati, Pacific, and Philadelphia exchanges. Also, there are exchanges for trading other investment instruments, such as options, as well as many exchanges elsewhere in the world.
At Nasdaq [right], a broker-dealer who is a market maker for a stock can execute a trade against its own inventory or else execute a trade with other market makers. Click on image to enlarge.
Exchanges differ significantly. When an order is routed to the NYSE, for example, it is transmitted electronically or physically delivered to the "specialist post" where that stock is traded. Each stock traded on the exchange has one "specialist." (In theory there could be more.) The specialist firm ensures an orderly market for that security and executes all orders received in that stock.
For stocks trading at prices above $1, the specialist reports the current price quote for that security in increments of an eighth of a dollar (12.5 cents). The price quote, ultimately determined by supply and demand, generally consists of the number of shares ordered, the highest bid price (the price at which someone is willing to buy the stock), and the lowest ask price (the price at which someone is willing to sell it). Assuming a quote of "1000 XYZ at $50 1/8 bid and 2000 at $50 3/8 offered," the specialist stands ready to execute an order of as many as 1000 shares of the stock from anyone who wants to sell for 50 1/8 and an order of up to 2000 shares of the stock to anyone who wants to buy for 50 3/8.
The difference between these two prices is termed the spread (which typically ranges from one-eighth to one-half of a dollar--generally, the more liquid the market for the stock and the lower its price, the smaller the spread). The specialist must ensure that trades are executed at prices no worse than the best quote. Transactions may be crossed between them if orders to buy and sell between the quotes arrive reasonably contemporaneously "on the floor." (For instance, if someone is willing to sell 1000 shares for 50 1/4, and someone else is willing to buy 1000 shares for 50 1/4, a trade would be executed at 50 1/4.)
On the NYSE, part of the trading process has been automated. Certain small orders can be transmitted electronically over data communication lines from a member firm's trading desk (located anywhere in the world) to the NYSE SuperDot system, which routes them directly to the specialist's display book. Only odd-lot orders (orders smaller than 100 shares) are executed automatically by the system [Fig. 1, left].
Securities not listed on an exchange are traded in the over-the-counter (OTC) market, which has no physical trading center, instead consisting of the network of broker-dealers willing to "make a market" in OTC securities. These "market makers" publish quotes, generally in eighths, for specific securities and stand ready to buy and sell them for their firm's own account with customers or other broker-dealers. Each market maker sets its own quotes. The "best bid and offer" price represents the highest amount any market maker is willing to pay for a stock and the lowest amount at which any market maker (whether the same firm or a different one) is willing to sell. Usually, the more heavily a stock is traded, the more market makers there will be.
Long ago, brokers had to call market makers to obtain theirquotes, but in 1971, Nasdaq changed this process for many OTC stocks. Nasdaq is an electronic network that displays the quotes at which market makers are willing to trade [Fig. 1, right]. It does not automate the trading process or execute trades, except for small retail orders executed automatically at the best price through the Small Order Execution System. Generally, trades must still be negotiated by phone, although in some cases they may be negotiated electronicsally through the SelectNet system of the National Association of Securities Dealers Inc. (NASD), Washington, D.C.
Besides exchanges and the OTC market, there have traditionally been two more broad categories of markets. One consists of OTC market makers that make markets in exchange-listed securities. The other is now substantial, consisting of directly negotiated customer-to-customer trades, typically between institutions.
In a crossing system [center], unpriced or priced orders (depending on the system) are entered by customers on terminals or by phone at the operator's trading desk. At a given time, the system algorithm crosses unpriced orders at a price determined from another market--the midpoint of the bid/ask spread on an exchange--or by performing a "call auction" if the orders are priced.
At an electronic brokerage [bottom}, customers route orders and receive confirmation through an Internet connection, for instance. Their broker then routes the orders to an exchange or market maker to be executed. Click on image to enlarge.
Electronic broker-dealer trading
Thanks to technology, trading can be facilitated by electronic proprietary trading systems operated by registered broker-dealers. Currently, there are two types: matching services and crossing services [Fig. 2].
Matching service systems like Instinet are designed to allow participants to use an electronic communications network to enter orders for stocks listed on an exchange or in the OTC market. Most systems display orders anonymously; participants can view orders but do not know who entered them. Orders are firm, so that when another participant enters an executable contra order, a trade occurs and the participants are bound by it.
Generally, a participant can also execute a trade by "hitting" a bid or offer displayed on screen. Some services let participants post indications of interest, as opposed to firm orders, so that they can use the system to negotiate a transaction directly. New rules, put into effect by the SEC at the start of 1997, are meant to ensure that participants in public markets who do not subscribe to a private matching service will, in many cases, know the best bid/ask entered into the private system.
Crossing service systems generally "cross" customer orders at a single price determined by the system. Those prices can be established by derivation from the prevailing price for the security in other markets through a procedure termed a call auction, or otherwise. One example of the first type of system, Posit, automatically crosses all executable orders, usually at the midpoint of the public bid/ask price for the security, at predetermined occasions (several times daily, either while the markets are open, or after hours).
The second type of system crosses executable orders at a so-called auction price: the single price at which the greatest number of buy and sell orders can be executed at a price equal to or better than the limit price entered by each participant. (This price for buyers would be a price equal to or lower than their limit order, while for sellers it would be equal to or higher than their limit order.) Once that price has been determined, all eligible orders are executed at the auction price. Participants can view limit orders posted on the system and add or delete them as the cutoff time for the call auction approaches. The Arizona Stock Exchange (run by AZX Inc, Phoenix) is a single-price call auction system.
In addition, registered broker-dealers, primarily discount brokerages, allow customers to route orders electronically, rather than having to call or visit a live broker. While this is a beneficial development for investors, lowering costs and providing real-time information and other benefits, it does not materially change the way these trades are executed. Essentially, such systems merely make entry to the trading mechanism more efficient. The electronic brokerage determines where to route the orders [Fig. 2, bottom].
The equity market of the future [right] may be ruled by investor-to-investor trading (no intermediaries) and may embrace investor-to-investor smart agent technology and multiple competing marketplaces offering a variety of functions. Technology will interconnect all the players and enable each to execute orders differently, while orders will be settled in real time. Click on image to enlarge.
Post-trade clear and settle
If a trade occurs, the specialist or executing broker-dealer reports the trade information to be displayed on the "consolidated tape," designed to report publicly trades in securities listed on the exchanges and on Nasdaq, even if the trade occurred in a matching or crossing system. Once a trade is executed, it must clear and settle. Clearance involves confirming the security, the number of shares, their price, the time, and the buyer and the seller in a transaction. Settlement is the fulfillment, by each party, of the obligations of the trade.
A clearinghouse compares records of the trade to ensure that all its aspects (price, quantity, buyer, and seller) agree, determining the net amount of securities and cash due from its participating broker-dealers. Next, the settlement process ensures that the trade is paid for, frequently by the wire transfer of funds. Finally, the process ensures that stock ownership records reflect the name of the new owner.
Technology should change the clearance and settlement process. In 1995, the standard settlement time was reduced from five business days (trade+5, or T+5) to three business days (T+3). Eventually, technology should allow for same-day (T+0), and even real-time settlement, which will improve the stability of the markets and the economy by further removing the risk of default on trades. In addition, at T+0, the risk of counterparty failure should be limited, which would reduce the level of capital needed to operate in the markets.
If investors do not insist on negotiable paper stock certificates, all transfers of ownership can be reflected with a simple change to a depository's computer records, thereby facilitating the shift to T+0. Improved fund transfer technology, electronic banking, and "electronic cash" could make payment almost instantaneous. Moreover, even now investors can use credit or debit cards to purchase many securities, and credit card companies or their successors may become more heavily involved in the securities guarantee function in the future. Rethinking regulation
The U.S. stock trading system is quite complex [Fig. 3, left], with vast numbers of market players and many marketplaces. All of them must carry out their assigned tasks involving millions of transactions a week.
Many components of the U.S. market structure have been in place since the early 20th century. The Securities Exchange Act of 1934 (the Exchange Act) regulates markets, brokers, and dealers and generally requires companies whose stocks are traded on an exchange or on Nasdaq, as well as other companies if they satisfy certain conditions, to provide periodic disclosure. The act established a system for regulating market participants that in part reflects the nature of the securities markets in the 1930s.
In the '60s and '70s, amendments to the Exchange Act modernized the securities laws and provided a blueprint for a national market system for traded securities. More than 20 years ago, the U.S. Congress stated that "new data processing and communications techniques create the opportunity for more efficient and effective market operations" and called for electronically linking together various marketplaces for securities trading. Some progress has been made toward that goal, but more work remains to be done. Many other countries have replicated elements of the U.S. regulatory scheme, and as stock transactions are becoming increasingly globalized, these issues have worldwide impact.
At the Federal level, the United States currently regulates the securities markets through a partnership between government and industry. Although the SEC oversees the markets, it does so in part through a system of "self-regulation" that grants the exchanges and the NASD responsibility for regulating their members and trading practices. Now that technology has opened up more opportunities for investors to deal with each other directly, without much mediation by a broker-dealer, more and deeper thought must be given to the current regulatory scheme.
If trading moves away from so-called fully intermediated markets, the SEC will have less ability to leverage scarce governmental resources with those of the self-regulating organizations. If transactions can occur without a broker or organized exchange as an intermediary, the SEC loses some of its eyes and ears and private sector compliance staff.
The United States also must think about how it will oversee the regulated players in its markets. For one thing, the Exchange Act contains a broad definition of "exchange," although the SEC has interpreted the term more narrowly. Many other market centers have developed over time but are not regulated as exchanges. Specifically, Nasdaq is not regulated as an exchange, but is subject, by statute, to many of the same types of requirements. Most proprietary trading systems are regulated under the broker-dealer regulations. The only call auction exchange in existence, the AZX, is exempt from most requirements of the Exchange Act by virtue of AZX's classification as a "limited-volume" exchange.
As technology progresses, the line between alternative markets and traditional exchanges will continue to blur. Moreover, technology has created linkages between domestic and offshore markets, thereby raising the issue of what regulations apply if those offshore facilities become easily accessible to U.S. investors.
Since no end is in sight to the emergence of novel types of markets, the country should ask why various markets should be regulated so differently under U.S. laws. The eventual solution will be to move to goal-oriented, flexible regulations that make sense in a world of rapid technological change. Goal-oriented regulation would focus on the functions performed by the market center and regulate with respect to those functions, not the entire center itself.
Consequently, a market center that engaged in some but not all activities of an exchange would be regulated with respect to those activities, rather than (as at present) being subject either to all or to none of the regulations applicable to an exchange, depending on how the market center was defined. For example, market centers that only discovered prices might be subject to surveillance, audit trail, and public reporting requirements, but not to governance or capital requirements.
Regulators also must ensure that innovations do not create greater potential for fraud or systemic risk. Clearly, technology makes possible more complex frauds or circumvention of rules. There is also great concern about computer failures and systemwide failures.
The next step
Technology's continued revolution of the securities trading process should, of course, be encouraged. Ultimately, technology will turn U.S. markets into a reflection (although a rather updated one) of the "national market system" that was envisioned by Congress in 1975.
For that process to be complete, a number of things will have to happen. All market participants and market centers will need to be interconnected or accessible; that is, any participant in one market should be able to see and access the orders and quotes of any other participant, who could be anonymous, in another. Markets will eliminate artificial constraints on price competition. Finally, market-wide time priority, as well as any other factors participants like to add through algorithms they select, could help promote the competition.
Some of today's market intermediaries will survive, although they may have to adapt their operations. For example, intermediaries will still provide the valuable role of ensuring "immediacy" for investors who seek it: when an investor wants to sell a company's stock, an intermediary frequently buys it because a purchaser may not be available at that time. At some point, there will be enough liquidity from buyers and sellers, or enough investors who will not want immediacy, to eliminate the need for this intermediary function for some stocks. But someone would still have to ensure that trades clear and settle, that the books are kept, and that the issuer of the stock is told who now owns it.
Trading in tenths
Existing technology holds hope of another development that would benefit investors by improving prices: decimalization. Generally, U.S. markets have traded in minimum increments of an eighth of a dollar, which makes it harder for investors to obtain better prices, because, for many stocks, eighths are likely to be too large. With a more flexible pricing structure, market makers or specialists could reduce the quoted spread more easily, and investors placing limit orders would be better able to compete. It now costs 12.5 cents to place a better limit order; decimalization would allow investors to do this in finer increments.
Decimalization is inevitable. Although technology is obviously not a necessary condition for decimalization, it does make decimalization more likely to occur sooner by permitting more market centers--including those based outside the United States that trade in finer increments like decimals--to compete more easily with those in the United States, thereby placing pressure on U.S. markets to be more competitive.
The glass box
As U.S. market centers become more interconnected through technology with each other and with global markets, the market system will begin to accommodate such demands as around-the-clock trading and may eventually provide for price-time priority across markets.
The market innovations generated by technology to date have been positive because they made markets better suited to their users. Different classes of investors have different needs, and any one investor may have different needs at different times and for different orders.
Some observers have predicted the rise of a consolidated marketplace described as a black box into which all trades will be sent for execution--a single market that will dispose of all trades without market fragmentation and with increased customer-to-customer trading. To date, technology has not led to a consolidation of markets. In fact, new specialized marketplaces have come into being. Moreover, a black box structure, operating under one set of procedures, may not be best for all stocks or all customers. More probably, the market of the future will comprise a global collection of diverse, interconnected marketplaces that permit investors to choose the one that makes the most sense for their needs. Technology also will permit more investor-to-investor trading, without intermediaries.
Specifically, new technologies such as "smart agents" will expand the choice of trading methods that require little intermediation. For example, using smart agents--programs designed to act as agents of their principals--a market participant could enter an order to purchase at a specified price that could change over time according to an algorithm selected by the participant. Sellers could enter similar contra side orders with their smart agents. The smart agents would then seek each other out over the Internet by "visiting" selected Web sites or else through search engine techniques.
When smart agents encounter contra- side agents dealing in the same security (or securities that the principal might say are sufficient substitutes, such as any automobile stock if the principal wants to change its exposure to the auto sector), they would negotiate with each other according to their own algorithms. If a "deal" can be struck, the agents will report back to their principals that a transaction has occurred, and at the same time automatically notify the transfer agent of the stock and funds to be exchanged. With such technology, investors anywhere in the world could engage in transactions with little or no intermediation, and very low marginal costs.
Potentially different types of markets could therefore encourage innovation through competition. Some markets will be full-service marketplaces; others will provide only certain services, and others will be ill-defined--such as smart agents on the Internet. Technology will allow orders to be routed to the most appropriate market.
So the market of the future is likely to be a glass box of markets with different but transparent trading opportunities accessible through technology. The result will be seamless electronic trading, around the clock and around the world, with investors buying and selling individual stocks, currencies, commodities, and mixed portfolios. Trades will be based on a variety of parameters. Liquidity will be provided primarily by investors, as opposed to intermediaries. Settlement will occur in real time. Multiple types of competing markets and market centers will provide multiple services. Transaction costs will fall to competitive levels on a worldwide basis [Fig. 3, right].
Technology will help us achieve this goal, but foresight and thoughtful proactive regulation are also necessary. Let us hope that, if the technical community keeps providing the former, the government will try hard to provide the latter.
About the Author
Steven M.H. Wallman is a commissioner on the U.S. Securities and Exchange Commission (SEC). Earlier, he was a partner in the Washington, D.C., law firm Covington & Burling. As a matter of policy, the SEC disclaims responsibility for private publications or statements by its members or employees.
To Probe Further
Use of Electronic Media for Delivery Purposes, Securities Act Release No. 337233 (Oct. 6, 1995), offers interpretive guidance from the U.S. Securities and Exchange Commission (SEC) on how issuers can satisfy their disclosure-delivery obligations under the U.S. Federal securities laws when relying on electronic media. It also offers guidance to companies considering on-line offerings.
Development of a National Market System, Securities Exchange Act Release No. 3414414 (Jan. 26, 1978), explains the SEC's initial ideas on ways to create a national market system.
Market 2000: An Examination of Current Equity Market Developments (January 1994), from the SEC's Division of Market Regulation, has excellent descriptions of the current U.S. market structure, proprietary trading systems, and regulatory issues. It also looks at possible future developments.
The U.S. Office of Technology Assessment's Electronic Bulls and Bears (1990) is a report to the U.S. Congress on automation, the use of technology in the U.S. securities markets, and regulatory issues. Valuable background information on how the markets operate is included. The report is available on a CD ROM, "OTA-Legacy," from the Superintendent of Documents, Box 371954, Pittsburgh, PA 152507974; 202-512-1800; fax, 202-512-2250; price, $23.
Further information from the SEC can be found on the Web at www.sec.gov.