Whose Market Is It Anyway? Intermediaries' or Investors' (Reprint 044)

Morris Mendelson and Junius Peake

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The U.S. financial markets have been structurally designed to benefit market intermediaries -- especially market makers -- rather than investors. By limiting the use of technological advancement, these intermediaries have succeeded in perpetuating demand for certain of their services and have thus increased the cost of trade execution. In 1975 Congress charged the SEC with the task of "facilitating" the development of a national market system. What they have created instead is a set of fragmented market centers which are overly costly and technologically obsolescent.

The most critical aspect of fragmentation are the costs that are incurred by the market centers and must be paid by the investor. Some of the associated costs which are inevitable when a number of market centers trade the same securities at the same time include: information system expense; market selection system expense; lobbying and advertising expense; and increased regulatory expense.

To improve the structural soundness of the equity markets we make the following recommendation: First, establish a price/time priority rule in which best bid, first-entered into the trading arena would always have the opportunity to meet the best offer, first-entered. Secondly, issuers would be prohibited from listing their securities on more than one market center at the same time. Instead, all listing contracts would be renegotiable at least every other year. Finally, rules that artificially inflate minimum trading price increments -- such as the NYSE’s Rule 62, which mandates minimum price differentials of 12 1/2 cents -- should be prohibited. Smaller price differentials, such as those as small as one cent, would maximize price competition, reduce trading costs and eliminate pricing artificialities which make such practices as payment for order flow economic.

The result of these simple changes would be a global, low-cost, electronic auction arena for each issue. Such a system would be able to display the entire supply-demand schedule of each issue to all interested participants, regardless of geographic location and encourage competitive market making.

This would increase market transparency, improve the efficiency and fairness of markets and increase liquidity. International trading would be facilitated in a global automated trading arena. Market makers and other intermediaries would pay lower costs because of more efficient, lower-cost operations. Traders would be able to manage their risk in real time and perform more sophisticated transactions. It is important to keep in mind that "best" execution can only be achieved in a system which guarantees that best bid, first-entered, always has the opportunity to meet the best offer, first-entered.

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