|
Article Excerpt
THE PAST 25 YEARS HAVE SEEN AN explosion in trading activity and innovation in financial markets. In 1977, trading volume on the New York Stock Exchange averaged about 21 million shares per day; in 2001, volume averaged 1.24 billion shares per day -- a 60-fold increase. In 1977, NASDAQ daily volume averaged 7.7 million shares; in 2001 NASDAQ traded an average of 1.9 billion shares each day. Equity options trading began in 1973, and by 1977 options were traded on 227 stocks with daily average volume totaling 157,000 contracts; by 2001, options were traded on 2,261 different stocks and average daily volume had reached 3.1 million contracts.
In 1977, financial derivatives were a novel concept. Futures contracts on currencies, Treasury Bills, and Treasury Bonds traded on organized exchanges in modest volumes, and the over-the-counter derivatives markets were just developing. In 2002, exchanges trade immense volumes of derivatives on currencies, interest rates, and equities from around the world, and the over-the-counter markets and financial derivatives markets (especially the interest-rate markets) have mushroomed, with tens of billions of notional value traded each day. In 1977, three energy derivatives contracts (propane, fuel oil, and heating oil) were traded on exchanges; in 2002, energy derivatives on oil, gasoline, heating oil, natural gas, and electricity dominate commodity derivatives trading both on exchange and over-the-counter.
Substantial innovation in trading technology and changes in market structure have accompanied the proliferation of financial instruments and the massive increase in trading volume. Electronic trading was a relatively new concept in 1977, and the first experiments in automation of trading were underway in the United States and Canada. In the intervening 25 years, electronic trading platforms for equities, fixed income, and derivative products have proliferated. Moreover, competitive conditions and market structures have evolved markedly over the last 25 years. In particular, the development of over-the-counter derivatives markets and overseas derivatives exchanges has reshaped the competitive landscape.
The sea changes have posed major challenges to financial market regulators in the United States. Ir response, there have been substantial regulatory developments during the last quarter-century. Regulation of derivatives markets has been particularly affected, but securities regulations have undergone substantial changes as well. In essence, the innovations in financial products and trading technologies rendered the regulatory structures erected in the 1920s (in derivatives) and 1930s (in securities) obsolete. The innovations have created new interests and eroded the importance of others. That has changed the regulatory calculus and led to substantial changes in financial market regulation
MARKET STRUCTURE REGULATION
Market structure issues pose serious difficulties to regulators. Securities and derivatives markets exhibit network effects; traders prefer to trade where others trade. The network effects exert a centripetal force that leads to centralization of trading and which makes it difficult for new markets to enter in competition with established exchanges.
As I argue in a forthcoming Journal of Law, Economics, and Organization article, exchanges can exploit entry barriers by adopting inefficient rules and pricing policies. Although market participants can act to mitigate the impact of such exchange efforts to exercise market power, entry barriers can persist for considerable periods of time. As a result, regulators can influence market efficiency by restricting (or not) exchange efforts to exercise market power. Such regulatory actions clearly have distributive as well as efficiency effects, and hence can lead to intense political conflicts. The past 25 years have seen many major regulatory battles over market structure issues, and the regulator scorecard is somewhat mixed.
Fixed commissions Regulation debuted two years after the passage of a major change to the Securities Exchange Act (originally adopted in 1934). The Securities Act Amendments of 1975 banned the longstanding practice of commission fixing on U.S. securities exchanges. The NYSE had operated a brokerage cartel since its founding, and both established the rates of commission its member-brokers could charge and enforced the cartel agreement. The cartel was the subject of substantial academic criticism, as was the Security and Exchange Commission's tolerance of the practice.
It was not academic scribbling that spelled the doom of the brokerage cartel, however. Instead, the development of institutional trading and "off-exchange" trading in so-called "third markets" undermined the power of the NYSE cartel. Institutional investors found that they could circumvent the fixed brokerage commissions by trading off-exchange. Although that imposed some costs on them (they could not take full advantage of the economies of trading on a centralized market), the costs were often smaller than the commission savings inherent in trading on the third market.
The defection of large and increasing volumes of business from the exchange reduced the benefits of maintaining the brokerage cartel, and hence undermined the political support for it. The increasing importance of institutional investors further eroded support for a practice that benefited exchange members. As large players with a large stake in reducing trading costs, institutional investors were a more effective political counterweight to the exchanges and their members than individual investors had ever been. Congress responded to the change in the political landscape by requiring the SEC to take action to eliminate the brokerage cartel.
Although institutional efforts to circumvent the fixed commission rule had eroded the NYSE'S market power, it did not eliminate it prior to the abolition of the brokerage cartel. As a consequence, the elimination of fixed commissions in 1975 resulted in a substantial increase in exchange trading activity; if the brokerage cartel had been completely ineffective, such an increase in volume would not have occurred. It also resulted in substantial consolidation in the brokerage industry; small, inefficient...
|
