Participants in a pure order-driven market are referred to as "naturals" (the natural buyers and sellers). No intermediary participates as a trader in a pure order-driven market. Rather, the investors supply the liquidity themselves. That is, the natural buyers are the source of liquidity for the natural sellers, and vice versa. The naturals can be either buyers or sellers, each using market or limit orders.

Order-driven markets can be structured in two very different ways: a continuous market and a call auction at a specific point of time. In the continuous market, a trade can be made at any moment in continuous time during which a buy order and a sell order meet at a specific time. In this case, trading is a series of bilateral matches. In the call auction, orders are batched together for a simultaneous execution in a multilateral trade at a specific point in time. At the time of the call, a market-clearing price is determined; buy orders at this price and higher and sell orders at this price and lower are executed.

Continuous trading is better for customers who need immediacy. However, for markets with very low trading volume, an intraday call may focus liquidity at one (or a few) times of the day and permit the trades to occur. In addition, very large orders—block trades that will be described later—may be advantaged by the feasibility of continuous trading.

Nonintermediated markets involve only naturals; that is, such markets do not require a third party. A market may not, however, have sufficient liquidity to function without the participation of intermediaries, who are third parties in addition to the natural buyers and sellers. This leads to the need for intermediaries and quote-driven markets.

Quote-driven markets permit intermediaries to provide liquidity. Intermediaries may be brokers (who are agents for the naturals); dealers or market makers (who are principals in the trade); or specialists, as on the New York Stock Exchange (who act as both agents and principals). Dealers are independent, profit-making participants in the process.

Dealers operate as principals, not agents. Dealers continually provide bid and offer quotes to buy for or sell from their own accounts and profit from the spread between their bid and offer quotes.

Dealers compete with each other in their bids and offers. Obviously, from the customer's perspective, the "best" market is highest bid and lowest offer among the dealers. This highest bid/lowest offer combination is referred to as the "inside market" or the "top of the book." For example, assume that dealers A, B, and C have the bids and offers (also called asking prices) for stock Alpha as shown in Figure 11.1.

Figure 11.1. Quote-Driven/Dealer Market

The best (highest) bid is by dealer A of 40.50; the best (lowest) offer is by dealer C of 41.00. Thus, the inside market is 40.50 bid (by A) and 41.00 offer (by C). Note that A's spread is 40.50 bid and 41.20 offer for a spread (or profit margin) of 0.70. A has the highest bid but not the lowest offer. C has the lowest offer but not the highest bid. B has neither the highest bid nor the lowest offer.

For a stock in the U.S. market, the highest bid and lowest offer across all markets is called the national best bid and offer (NBBO).

Dealers provide value to the transaction process by providing capital for trading and facilitating order handling. With respect to providing capital for trading, they buy and sell for their own accounts at their bid and offer prices, respectively, thereby providing liquidity. With respect to order handling, they provide value in two ways. First, they assist in the price improvement of customer orders, that is, the order is executed within the bid/offer spread. Second, they facilitate the market timing of customer orders to achieve price discovery. Price discovery is a dynamic process that involves customer orders being translated into trades and transaction prices. Because price discovery is not instantaneous, individual participants have an incentive to "market-time" the placement of their orders. Intermediaries may understand the order flow and may assist the customer in this regard. The intermediary may be a person or an electronic system.

The over-the-counter (OTC) markets are quote-driven markets. The OTC markets began during a time when stocks were bought and sold in banks and the physical certificates were passed over the counter.

A customer may choose to buy or sell to a specific market maker to whom they wish to direct an order. Directing an order to a specific market is referred to as "preferencing."

Overall, nonintermediated, order-driven markets may be less costly due to the absence of profit-seeking dealers. But the markets for many stocks are not inherently sufficiently liquid to operate in this way. For this reason, intermediated, dealer markets are often necessary for inherently less liquid markets. The dealers provide dealer capital, participate in price discovery and facilitate market timing, as discussed above.

Because of the different advantages of these two approaches, many equity markets are now hybrid markets. For example, the NYSE is primarily a continuous auction order-driven system based on customer orders but the specialists enhance the liquidity by their market making to maintain a fair and orderly market. Overall, the NYSE is primarily an auction, order-driven market which has specialists (who often engage in market making), other floor traders, call markets at the open and close, and upstairs dealers who provide proprietary capital to facilitate block transactions. Thus, the NYSE is a hybrid combination of these two models. Another hybrid aspect of the NYSE is that it opens and closes trading with a call auction. The continuous market and call auction market are combined. Thus, the NYSE is a continuous market during the trading day and a call auction market to open and close the market and to reopen after a stop in trading. Thus, the NYSE is a hybrid market.

Nasdaq began as a descendent of the OTC dealer network, and is a dealer quote-driven market. It remains primarily a quote-driven market, but has added some order-driven aspects such as its limit order book, called SuperMontage (discussed below), which made it a hybrid market.

An overview of the nonintermediated, auction, order-driven market and the intermediated, dealer, quote driven markets is provided in Figure 11.2.

Another structural change that has occurred in exchanges is their evolution from membership-owned, floor-traded, organizations to publicly owned electronically traded (that is, no trading floor) organizations. The nature of this evolution (or revolution) is discussed in the next section.

As of the first quarter of 2008, the U.S. stock markets are dominated by the NYSE and Nasdaq, the two largest exchanges (as discussed below, until June 2006 Nasdaq was not technically an exchange).

New York Stock Exchange

The beginning of the NYSE is identified as May 17, 1792, when the Buttonwood Agreement was signed by 24 brokers outside of 68 Wall Street in New York under a button-wood tree. The current NYSE building opened at 18 Broad Street on April 22,1903 (the "main room"). In 1922, a new trading floor (the "garage") was opened at 11 Broad Street.

Figure 11.4. The "Big Picture" of the U.S. Stock Market

Additional trading floor space was opened in 1969 and in 1988 (the "blue room"). Finally, another trading floor was opened at 30 Broad Street in 2000. Notably, for reasons discussed below, during early 2006, the NYSE closed the trading room at 30 Broad Street with the beginning of the NYSE Hybrid Market and a greater proportion of the trading being executed electronically. The NYSE is referred to as the "Big Board."

The NYSE trading mechanism has been based on the specialist system. This system, as discussed above, is a hybrid of primarily an order-driven market with some quote-driven features. According to this mechanism, each stock is assigned to an individual specialists. Each specialist "specializes" in many stocks but each stock is assigned to only one specialist. Each specialist is located at a "booth" or "post." All orders for a stock are received at this post, and the specialist conducts an auction based on these orders to determine the execution price. The orders arrive at the specialists' posts either physically, delivered via firm brokers, or electronically via the Designated Order Turnaround (DOT) system or its successors. In conducting the auction, typically the specialist is an agent, simply matching orders. At times, however, the specialist becomes a principal and trades for itself in the interest of maintaining an "orderly market."

Limit orders, as opposed to market orders, are kept by the specialist in their "book," originally a physical paper book but now an electronic book. These limit orders are executed by the specialist when the market price moves to the limit. At one time, the book could be seen only by the specialist, which was judged to be a significant advantage for the specialist, but now the book is open to all the traders on the exchange floor. Overall, the NYSE trading mechanism is an auction-based, order-driven market.

This type of mechanism is often judged to provide the best price but, on a time basis, often a less rapid execution. There is, thus, a trade-off between price and speed.

The need for "space" for trading floors for the NYSE derives from its trading mechanism, a floor-based specialist system. The amount of space necessary depends not only on overall trading volume, but also the fraction of this volume that is handled by the specialist.

The NYSE lists stocks throughout the United States (as well as some international stocks) and, thus, is a "national exchange."

Trading Mechanism—The Specialist System Fundamentally, the NYSE is an auction-type market based on orders (order driven). As indicated above, the traditional trading mechanism for the NYSE is the specialist system. However, the volume of trading that has occurred electronically has increased continually. In 2006, with the advent of NYSE Hybrid Market, the degree of electronic trading has increased significantly, as discussed below.

Here, we discuss the traditional NYSE specialist system in more detail. Trading in stocks listed on the NYSE is conducted as a centralized continuous auction market at a designated physical location on the trading floor, called a post, with brokers representing their customers' buy and sell orders. A single specialist is the market maker for each stock. A member firm may be designated as a specialist for the common stock of more than one company; that is, several stocks can trade at the same post. But only one specialist is designated for the common stock of each listed company.

The NYSE began its DOT (Designated Order Turnaround) system during 1976. This system, now called SuperDOT, is an electronic order routing and reporting system that links member firms worldwide electronically directly to the specialist's post on the trading floor of the NYSE.

The NYSE SuperDOT system routes NYSE listed stock orders electronically directly to a specialist on the exchange trading floor, rather than through a broker. The specialist then executes the orders. This system was initially introduced as the DOT system but is now referred to as the SuperDOT system. The SuperDOT system is used for small market orders, limit orders, and basket (or portfolio) trades and program trades.

The SuperDOT system can be used for under 100,000 shares with priority given to orders of 2,100 shares or less. After the order has been executed, the report of the transaction is sent back through the SuperDOT system.

According to the NYSE, as of 2007, over 99% of the orders executed through the NYSE were done through SuperDOT, which meets the continually increasing demand, which stood at 20 million quotes, 50 million orders, and 10 million reports daily.

In addition to the single specialist market maker on the exchange, other firms that are members of an exchange can trade for themselves or on behalf of their customers. NYSE member firms, which are broker-dealer organizations that serve the investing public, are represented on the trading floor by brokers who serve as fiduciaries in the execution of customer orders.

The largest membership category on the NYSE is that of the commission broker. A commission broker is an employee of one of the securities houses (stockbrokers or wire houses) devoted to handling business on the exchange. Commission brokers execute orders for their firm on behalf of their customers at agreed commission rates. These houses may deal for their own account as well as on behalf of their clients.

Other transactors on the exchange floor include the following categories. Independent floor brokers (nicknamed "$2 brokers") work on the exchange floor and execute orders for other exchange members who have more orders than they can handle alone or who require assistance in carrying out large orders. Floor brokers take a share in the commission received by the firm they are assisting. Another category, registered traders, are individual members who buy and sell for their own account. Alternatively, they may be trustees who maintain memberships for the convenience of dealing and to save fees.

The major type of exchange participant is the specialist.

NYSE Specialist As indicated, specialists are dealers or market makers assigned by the NYSE to conduct the auction process and maintain an orderly market in one or more designated stocks. Specialists may act as both a broker (agent) and a dealer (principal). In their role as a broker or agent, specialists represent customer orders in their assigned stocks, which arrive at their post electronically or are entrusted to them by a floor broker to be executed if and when a stock reaches a price specified by a customer (limit or stop order). As a dealer or principal, specialists buy and sell shares in their assigned stocks for their own account as necessary to maintain an "orderly market." Specialists must always give precedence to public orders over trading for their own account.

In general, public orders for stocks traded on the NYSE, if they are not sent to the specialist's post via SuperDOT, are sent from the member firm's office to its representative on the exchange floor, who attempts to execute the order in the trading crowd. There are certain types of orders where the order will not be executed immediately on the trading floors. These are limit orders and stop orders. If the order is at a limit order or a stop order and the member firm's floor broker cannot transact the order immediately, the floor broker can wait in the trading crowd or give the order to the specialist in the stock, who will enter the order in that specialist's limit order book (or simply, the book) for later execution based on the relationship between the market price and the price specified in the limit or stop order. The book is the list on which specialists keep the limit and stop orders that are given to them, arranged with size, from near the current market price to farther away from it. Whereas the book used to be an actual physical paper book, it is now electronic. While for many years only the specialist could see the orders in the limit order book, with the NYSE's introduction of OpenBook in January 2002, the book was electronically made available to the traders on the exchange floor.

A significant advantage of the NYSE market is its diversity of participants. At the exchange, public orders meet each other often with minimal dealer intervention, contributing to an efficient mechanism for achieving fair securities prices. The liquidity provided in the NYSE market stems from the active involvement of the following principal groups: the individual investor; the institutional investor; the member firm acting as both agent and dealer; the member-firm broker on the trading floor acting as agent, representing the firm's customer orders; the independent broker on the trading floor acting as agent and handling customer orders on behalf of other member firms; and the specialist, with assigned responsibility in individual securities on the trading floor. Together, these groups provide depth and diversity to the market.

NYSE-assigned specialists have four major roles:

In carrying out their duties, specialists may, as indicated, act as either agents or principals. When acting as an agent, the specialist simply fills customer market orders or limit or stop orders (either new orders or orders from their book) by opposite orders (buy or sell). While acting as a principal, the specialist is charged with the responsibility of maintaining a "fair and orderly market." Specialists are prohibited from engaging in transactions in securities in which they are registered unless such transactions are necessary to maintain a fair and orderly market. Specialists profit only from those trades in which they are involved; that is, they realize no revenue for trades in which they are an agent.

The term "fair and orderly market" means a market in which there is price continuity and reasonable depth. Thus, specialists are required to maintain a reasonable spread between bids and offers and small changes in price between transactions. Specialists are expected to bid and offer for their own account if necessary to promote such a fair and orderly market. They cannot put their own interests ahead of public orders and are obliged to trade on their own accounts against the market trend to help maintain liquidity and continuity as the price of a stock goes up or down. They may purchase stock for their investment account only if such purchases are necessary to create a fair and orderly market.

Specialists are also responsible for balancing buy and sell orders at the opening of the trading day in order to arrange an equitable opening price for the stock. Specialists are expected to participate in the opening of the market only to the extent necessary to balance supply and demand for the security to affect a reasonable opening price. While trading throughout the day is via a continuous auction-based system, the opening is conducted via a single-priced call auction system. The specialists conduct the call and determine the single price.

If there is an imbalance between buy and sell orders either at the opening of or during the trading day and the specialists cannot maintain a fair and orderly market, then they may, under restricted conditions, close the market in that stock (that is, discontinue trading) until they are able to determine a price at which there is a balance of buy and sell orders. Such closes of trading can occur either during the trading day or at the opening, which is more common, and can last for minutes or days. Closings of a day or more may occur when, for example, there is an acquisition of one corporation by another or when there is an extreme announcement by the corporation. For this reason, many announcements are made after the close of trading.

NYSE trading officials oversee the activities of the specialists and trading-floor brokers. Approval from these officials must be sought for a delay in trading at the opening or to halt trading during the trading day when unusual trading situations or price disparities develop.

Because of their critical public role and the necessity of capital in performing their function as a market-maker, capital requirements are imposed by the exchanges for specialists.

American Stock Exchange

The American Stock Exchange (Amex) dates from colonial times when brokers conducted outdoor markets to trade new government securities. Amex began trading at the curbstone on Broad Street near Exchange Place. Until 1929, it was called the New York Curb Exchange. In 1921, the Amex moved inside into the building where it still resides at 86 Trinity Place in New York City. In 1998, Amex merged with the National Association of Securities Dealers (NASD), which then operated Nasdaq, to create the Nasdaq-Amex Market Group wherein Amex was an independent member of the NASD parent. After conflicts between the NASD and Amex members, the Amex members bought Amex from NASD and acquired control in 2004. Amex continued to be owned by its members until its acquisition by the NYSE in early 2008.

Amex, like the NYSE, lists stocks from throughout the United States and also international stocks. Amex is therefore a national exchange. Amex is also an auction-type market based on orders. Its specialist system is similar to that of the NYSE.

Amex developed exchange-traded funds (ETFs). The first ETF, the SPY ETF, based on the S&P 500 index, was listed on the Amex on January 29, 1993. Although ETFs have proved to be a very successful product and most of the listings remain on the Amex, most of the trading volume has migrated to other exchanges, including the NYSE and Nasdaq.

The number of listings on and the trading volume of stocks on the Amex have continued to decline in recent years, and as of early 2008, the Amex is regarded as a minor market in U.S. stocks, although it continues to trade some small to mid-sized stocks.

Amex is the now highly dependent on trading in stock options.

Regional Exchanges

Regional exchanges developed to trade stocks of local firms that listed their shares on the regional exchanges and also to provide alternatives to the national stock exchanges for their listed stocks. Regional stock exchanges now exist in Chicago, Philadelphia, and Boston and have existed in many other U.S. cities. These exchanges have also been specialist-type, auction-based systems. Some of the regional stock exchanges, including Philadelphia and Boston, as well as the Amex, have been driven by trading in stock options and index options rather than stock in recent years.

Chicago Stock Exchange The Chicago Stock Exchange (CHX) was founded on March 21, 1882. In 1949, it merged with the St. Louis, Cleveland, and Minneapolis/St. Paul Stock Exchanges and changed its name to the Midwest Stock Exchange. In 1993, it changed its name back to the Chicago Stock Exchange and is the most active regional exchange.

Philadelphia Stock Exchange The Philadelphia Stock Exchange (PHLX) is the oldest stock exchange in the United States, founded in 1790. In 2005, a number of large financial firms purchased stakes in the PHLX as a hedge against growing consolidation of stock trading by the NYSE and Nasdaq. These firms—Morgan Stanley, Citigroup, Credit Suisse First Boston, UBS AG, Merrill Lynch, and Citadel Investment Group—collectively own about 45% of the PHLX.

During October 2007, PHLX announced that it was for sale by a group of its shareholders. On November 7, 2007 Nasdaq announced a "definitive agreement" to purchase PHLX for $652 million, with the transaction expected to close in early 2008.

The Philadelphia Stock Exchange handles trades for approximately 2,000 stocks, 1,700 equity options, 25 index options, and a number of currency options. As of 2007, it had a 14% U.S. market share in exchange-listed stock options trading.

Boston Stock Exchange The Boston Stock Exchange (BSE) was founded in 1834, the third-oldest stock exchange in the United States. The Boston Options Exchange (BCX), a facility of the BSE, is a fully automated options market. On October 2, 2007, Nasdaq agreed to acquire BSE for $61 million.

National Stock Exchange The National Stock Exchange (NSX), now in Chicago, was founded in 1885 in Cincinnati, Ohio as the Cincinnati Stock Exchange. In 1976, it closed its physical trading floor and became the first all-electronic stock market in the United States. The Cincinnati Stock Exchange moved its headquarters to Chicago in 1995 and changed its name to the National Stock Exchange during November 2003. The NSX handles a significant share, approximately 20%, of all Nasdaq-listed securities.

Pacific Exchange The Pacific Exchange began in 1957 when the San Francisco Stock and Bond Exchange (founded in 1882 with a trading floor in San Francisco) and the Los Angeles Oil Exchange (founded in 1889 with a trading floor in Los Angeles) merged to form the Pacific Coast Stock Exchange (the trading floors were kept in both places). The name was changed to the Pacific Stock Exchange in 1973, and options trading began in 1976. In 1997, its name was changed to the Pacific Exchange. In 1999, the Pacific Exchange (PCX) was the first U.S. stock exchange to demutualize. In 2001, the Los Angeles trading floor was closed and the next year the San Francisco trading floor was closed (the options trading floor still operates in San Francisco.)

On September 27, 2005, the Pacific Exchange was bought by the ECN Archipelago, which was in turn bought by the NYSE in 2006. No business is conducted under the name Pacific Exchange, thus ending its separate identity. All formerly PCX stock and options trading takes place through NYSE Arca.

Overall, as indicated by these brief descriptions of regional exchanges, some of the regional exchanges have diversified into options trading to remain viable. Some have made the transformation from membership-owned, trading floor organizations to publicly owned electronic organizations, and others have remained in their original forms. Finally, the regional exchanges have become attractive acquisition targets for larger exchanges, with some having already been acquired and others remaining potential merger targets.

A significant change in the U.S. stock market occurred during 1971 when the National Association of Securities Dealers Automated Quotations System, now often referred to as NASDAQ (or Nasdaq, as referred to in this chapter), was founded. When it began trading on February 8, 1971, Nasdaq was the world's first electronic stock market. Nasdaq was founded by the NASD. Fundamentally, Nasdaq is a dealer-type system based on quotes (quote driven).

The NASD divested itself of Nasdaq in a series of sales in 2000 and 2001 to form a publicly traded company, the Nasdaq Stock Market, Inc. The Nasdaq Stock Market is a public corporation, the stock of which was listed on its own stock exchange at its IPO on July 1, 2002 (ticker: NDAQ).

Initially, the Nasdaq was simply a computer bulletin board system that did not connect buyers and sellers. The Nasdaq helped lower the spread (the difference between the bid price and the ask price of the stock) and so was unpopular among brokerage firms because they profited on the spread. Since then, the Nasdaq has become more of a stock market, adding automated trading systems and trade and volume reporting.

The Nasdaq, as an electronic exchange, has no physical trading floor, but makes all its trades through a computer and telecommunications system. Since there is no trading floor where the Nasdaq operates, the stock exchange built a site in New York City's Times Square to create a physical presence. The exchange is a dealers' market, meaning brokers buy and sell stocks through a market maker rather than from each other. A market maker deals in a particular stock and holds a certain number of stocks on its own books so that when a broker wants to purchase shares, the broker can purchase them directly from the market maker.

Nasdaq is a dealer system or OTC system where multiple dealers provide quotes (bids and offers) and make trades. There is no specialist system, and therefore there is no single place where an auction takes place. Nasdaq is essentially a telecommunication network that links thousands of geographically dispersed, market-making participants. Nasdaq is an electronic quotation system that provides price quotations to market participants on Nasdaq listed stocks. Nasdaq is essentially an electronic communications network (ECN) structure that allows multiple market participants to trade through it, increasing competition, as discussed below.

Since Nasdaq dealers provide their quotes independently, the market has been called "fragmented." So while the NYSE market is an auction/agency, order-based market, the Nasdaq is a competitive dealer quote-based system.

Until 1987, most trading occurred via telephone. During the October 9, 1987, crash, however, dealers did not respond to telephone calls. As a result, the Nasdaq developed the Small Order Execution System (SOES), which provides an electronic method for dealers to enter their trades. The Nasdaq requires that the market makers honor their trades over the SOES. The purpose of the SOES is to ensure that during turbulent market conditions small market orders are not forgotten but are automatically processed.

Over the years, the Nasdaq became more of a stock market by adding trade and volume reporting and automated trading systems. In October 2002, the Nasdaq started a system, called SuperMontage, which has led to a change in the Nasdaq from a quote-driven market to a market that provides both quote-driven and order-driven aspects; that is, it has become a hybrid market. This system permits dealers to enter quotes and orders at multiple prices and then displays these aggregate submissions at five different prices on both the bid and offer sides of the market. Su-perMontage also provides full anonymity, permits dealers to specify a reserve size (that is, they do not have to display their full order), offers price and time priority, allows market makers to internalize orders, and includes pref-erenced orders. In effect, SuperMontage is the Nasdaq's order display and execution system.

The advent of SuperMontage continues completing Nasdaq's transformation from a quote-driven market to a hybrid market that contains both quote- and order-driven features. The Nasdaq added a third component to the hybrid, which is a call auction that both opens and closes the market. Currently, SuperMontage competes with the alternative display facility (ADF) that is operated by the Financial Industry Regulatory Authority (FINRA). Super-Montage is a key feature in Nasdaq's development.

There are two sections of the Nasdaq stock market: the Nasdaq National Market (NNM) and the Small Cap Market (also known as the Nasdaq Capital Market Issues). For a stock to be listed on the NNM, the company must meet certain strict financial criteria. For example, a company must maintain a stock price of at least $1, and the total value of outstanding stocks must be at least $1.1 million and must meet lower requirements for assets and capital.

To qualify for listing on the exchange, a company must be registered with the SEC and have at least three market makers. However, the Nasdaq also has a market for smaller companies unable to meet these and other requirements, called the Nasdaq Small Cap Market. Nasdaq will move companies from one market to the other as their eligibility changes.

During December 2005, Nasdaq acquired Instinet, the largest ECN and a large trader of Nasdaq-listed stocks.

On June 30, 2006, the SEC approved Nasdaq to begin operating as an exchange in Nasdaq-listed securities. Prior to this, as indicated above, Nasdaq had been an OTC stock market but not formally an exchange. This change is more technical then substantive.

Nasdaq was very acquisitive during 2007. During September 2007, Nasdaq agreed to buy the Middle East's Borse Dubai for approximately $4.9 billion. During August 2007 Nasdaq, after failing to acquire the LSE, partnered with Borse Dubai in the Middle East to gain control of Stockholm's OMX, which operates eight Nordic and Baltic exchanges. As part of the deal, Nasdaq sold its 28% position in the LSE to Borse Dubai, which ended up with nearly a 20% stake in Nasdaq. This acquisition made the Middle East's Borse Dubai a minority owner of the combined Nasdaq/OMX. With the purchase of OMX following its agreement with Borse Dubai, Nasdaq captured 47% of the controlling stake in OMX, thereby going closer to taking over the company and becoming a trans-Atlantic exchange.

During October 2007, Nasdaq also announced plans to buy the Boston Stock Exchange (for $61 million).

During November 2007, the Nasdaq Stock Market announced that it would buy the Philadelphia Stock Exchange for approximately $650 million, mainly to trade stock options. This was Nasdaq's first effort in stock options. Nasdaq, a purely electronic exchange, was expected to maintain Philadelphia trading floor.

The NYSE versus Nasdaq

Fundamentally, the NYSE has been an auction-type market based on orders (order driven), while Nasdaq has been a dealer-type market based on quotes (quote driven).

For decades, debates continued about which system—the NYSE or Nasdaq system—was most competitive and efficient. Those who think the Nasdaq OTC market is superior to the specialist-based NYSE often cite the greater competition from numerous dealers and the greater amount of capital they bring to the trading system. They also argue that specialists are conflicted in balancing their obligation to conduct a fair and orderly market and their need to make a profit.

Proponents of the specialist NYSE market structure argue that the commitment of the dealers in the OTC market to provide a market for shares is weaker than the obligation of the specialists on the exchanges. On the NYSE, specialists are obligated to maintain fair and orderly markets. Failure to fulfill this obligation may result in a loss of specialist status. A dealer in the OTC market is under no such obligation to continue its market-making activity during volatile and uncertain market conditions. Supporters of the specialist system also assert that without a single location for an auction, the OTC markets are fragmented and do not achieve the best trade price.

Another difference of opinion comes from traders who say that the specialist system may arrive at the better price, but take a longer period of time, during which the market price may move against the trader, or at least expose the trader to the risk that it will do so. The OTC market may, on the other hand, lead to a faster execution but not arrive at a better, market-clearing price. Professional traders, in this case, often prefer higher speed over better pricing. Retail investors on the other hand may prefer a better price.

While the NYSE has been an auction type/order driven market, it has adopted many dealer-type features. Similarly, while the Nasdaq has been a dealer type/quote-driven market, it has adopted many auction-type features. Thus, while distinct differences continue between these two markets, they have converged considerably and are both currently hybrid markets, although with different mixes of order-driven and quote-driven features.

Exchange Volume Data

This section illustrates the fragmentation of the trading of the stocks listed on an exchange among different trading markets.

During the 1980s, an exchange actually traded all stocks listed by the exchanges and only those stocks. Currently, however, stocks listed on one exchange can be traded by other exchanges, including regional exchanges, by nonex-change markets such as ECN, or via internalization markets, which are discussed below. For example, during the first week of January 2008, based on exchange data, of the 13,222,716 shares of NYSE-listed stocks traded during this week, 41.7% were traded by the NYSE Euronext and 12.3% by NYSE Arca. The remainder were traded by markets not related to the NYSE, including the regional markets, Nasdaq markets, and new stock markets such as the International Securities Exchange and Chicago Board Options Exchange, discussed below.

To generalize this dispersion (or "fragmentation") of trading of an exchange's listed stocks across multiple trading venues on a day in January 2008, according to exchange data, consider that:

As indicated in the discussion on Regulation NMS later in this chapter, this increase in the fragmentation of trading among venues is likely to continue or even increase due to Regulation NMS.

The OTC market is often called a market for "unlisted" stocks. As described previously, there are listing requirements for exchanges. And while, technically, the Nasdaq has not been an exchange—it was an OTC market—there are also listing requirements for the Nasdaq National Market and the Small Capitalization OTC markets. Nevertheless, exchange-traded stocks are called "listed," and stocks traded on the OTC markets, including Nasdaq, are called "unlisted."

There are three parts to the OTC market: the two under Nasdaq and a third market for truly unlisted stocks, which are therefore non-Nasdaq OTC markets. The third non-Nasdaq OTC market is composed of two parts: the OTC Bulletin Board (OTCBB) and the Pink Sheets.

Thus, technically, both exchanges and the Nasdaq have listing requirements and only the non-Nasdaq OTC markets are nonlisted. However, in common parlance, the exchanges are often called the "listed market," and Nasdaq, by default, referred to as the "unlisted market." As a result, a more useful and practical categorization of the U.S. stock trading mechanisms is as follows:

The OTCBB, also called simply the Bulletin Board or Bulletin (often just the "Bullies"), is a regulated electronic quotation service that displays real-time quotes, last sale prices, and volume information in the OTC equity securities. These equity securities are generally securities that are not listed or traded on the Nasdaq or the national stock exchanges. The OTCBB is not part of or related to the Nasdaq Stock Market.

The OTCBB provides access to more than 3,300 securities and includes more than 230 participating market makers. The traded companies do not have any filing or reporting requirements with Nasdaq or FINRA, which is discussed later in the chapter. However, issues of all securities quoted on the OTCBB are subject to periodic filing requirements with the SEC or other regulatory authorities. Companies quoted on the OTCBB must be fully reporting (that is, current with all required SEC fillings) but have no market capitalization, minimum share price, corporate governance, or other requirements. Companies that have been "delisted" from stock exchanges for falling below minimum capitalization, minimum share price, or other requirements often end up being quoted on the OTCBB.

The Pink Sheets is an electronic quotation system that displays quotes from broker-dealers for many OTC securities. Market markers and other brokers who buy and sell OTC securities can use the Pink Sheets to publish their bid and ask quotation prices. The name "Pink Sheets" comes from the color of paper on which the quotes were historically printed prior to the electronic system. They are currently published today by Pink Sheets LLC, a privately owned company. Pink Sheets LLC is neither a NASD broker-dealer nor registered with the SEC; it is also not a stock exchange.

To be quoted in the Pink Sheets, companies do not need to fulfill any requirements (e.g., filing statements with the SEC). With the exception of a few foreign issuers (mostly represented by American Depositary Receipts, or ADRs), the companies quoted in the Pink Sheets tend to be closely held, extremely small, and/or thinly traded. Most do not meet the minimum listing requirements for trading on a stock exchange such as the NYSE. Many of these companies do not file periodic reports or audited financial statements with the SEC, making it very difficult for investors to find reliable, unbiased information about those companies.

For these reasons, the SEC views companies listed on Pink Sheets as "among the most risky investments" and advises potential investors to heavily research the companies in which they plan to invest. Buying Pink Sheets stocks is intended to be difficult. Broker-dealers are enjoined to weed out unsophisticated investors who may get an e-mail or word-of-mouth tip about a small stock.

Most OTCBB companies are dually quoted, meaning they are quoted on both the OTCBB and Pink Sheets. Stocks traded on the OTCBB or Pink Sheets are usually thinly traded microcap or penny stocks and are avoided by many investors due to a well-founded fear that share prices are easily manipulated. The SEC issues a stern warning to investors to beware of common fraud and manipulation schemes.

In general, options trading is composed of two components: (1) options on individual stocks (stock options) and options an indexes (index options).

Options exchanges are a combination of exchanges of two different origins. The first group began as options exchanges (and, as discussed elsewhere, diversified into stock exchanges). They are the Chicago Board Options Exchange (CBOE) and the International Securities Exchange (ISE). The second group consists of stock exchanges that diversified into options exchanges. They are the American Stock Exchange, the Philadelphia Stock Exchange, the Boston Options Exchange (a subsidiary of the Boston Stock Exchange), and the New York Stock Exchange through its Archipelago holding, which had bought the Pacific Stock Exchange, which had added options to its original stock business.

With the acquisition of the Philadelphia Stock Exchange, Nasdaq will join the NYSE as a newcomer in the options market.

A significant difference between stock and options trading is that stock trading is predominantly institutional, but stock options trading has a larger retail component, as shown below:

Since options exchanges are registered with the SEC, they, too, can initiate and operate stock exchanges. During 2007, the ISE and CBOE began stock exchanges, called the ISE Stock Exchange and the Chicago Board Options Stock Exchange, respectively.

The ISE Stock Market has two components, the first of which began during September 2006. The first component, called the MidPoint Match, is a nondisplayed market or "dark pool" (discussed below), where users can trade in a continuous, anonymous pool in which trades are executed at the midpoint of the national best bid and offer. The second component is a fully displayed continuous and anonymous electronic market wherein quotes are integrated in an auction market. Thus, investors can benefit from the interaction between a nondisplayed dark pool, the MidPoint Match, and the displayed liquidity pool. In this combination of systems, orders will have the opportunity for price improvement from the MidPoint Match system, or be executed or be displayed on the market's order book; or be routed out to other exchanges as required by the SEC's Regulation NMS.

Interestingly, the CBOE and ISE were options-only exchanges that subsequently developed stock exchanges. Some of the regional stock exchanges—Philadelphia, Boston, and Pacific—later developed options exchanges. In addition, the NYSE is in the stock options business through its purchase of Archipelago, which had previously bought the Pacific Stock Exchange. And Nasdaq entered the stock options business through its purchase of the Philadelphia Stock Exchange.

Electronic communications networks (ECNs) are essentially off-exchange exchanges. They are direct descendants of (and part of) Nasdaq, not the NYSE. ECNs are privately owned broker-dealers that operate as market participants, initially within the Nasdaq system. They display bids and offers; that is, they provide an open display. They provide institutions and market makers with an anonymous way to enter orders. Essentially, an ECN is a limit order book that is widely disseminated and open for continuous trading to subscribers, who may enter and access orders displayed on the ECN. ECNs offer transparency, anonymity, automated service, and reduced costs, and are therefore effective for handling small orders. ECNs may also be linked into the Nasdaq marketplace via a quotation representing the ECN's best buy and sell quote. In general, ECNs use the Internet to link buyers and sellers, bypassing brokers and trading floors. ECNs are informationally linked, even though they are distinct businesses. ECNs are subject to some best execution responsibilities including the SEC's Regulation NMS, which is discussed later.

Consider the background of ECNs. Instinet, the first ECN, began operating in 1969 before Nasdaq was founded in 1971. Instinet was designed to be a trading system for institutional investors (hence its name, which stands for "institutional network"). Instinet was viewed as an alternative to and competitor of the traditional Nasdaq dealer market. Instinet was intended to be a trading system for institutional investors, which allowed them to meet in an anonymous, disintermediated market.

Instinet seemed very similar to an exchange but was registered with the SEC, not as an exchange, but initially as a broker-dealer and subsequently as an ECN. Instinet took the position that they were just a broker-dealer that operated in the off-exchange ("upstairs") market as does any other broker-dealer that puts trades together for large customers. The only difference, according to Instinet, was that it operated electronically. This view emphasized the difficulty of distinguishing an exchange from a broker-dealer in a technological environment. The SEC acknowledged this difficulty by using a new category to apply to Instinet, that is, electronic communications Network, as discussed below when we explain order handling rules.

The number of ECNs increased considerably after the SEC imposed the order handling rules in 1997, as discussed below. As a result, ECNs significantly affected Nasdaq during the late 1990s after the SEC adopted its new order-handling rules in 1997. ECNs such as Archipelago, Brut, Island, and Instinet captured a majority of Nasdaq volume in about two years. Instinet acquired Island in September 2002.

Archipelago, which began operating in 1997, handles both institutional and retail order flow. Another ECN, Island, was primarily retail. Prior to these developments, all the off-exchange systems were designed for institutional customers.

As many as a dozen ECNs existed by early 2000. Then a wave of consolidations and acquisitions began that within only two years whittled that number down to a handful.

Some of the large ECNs were acquired—Instinet by Nasdaq during December 2005, and Archipelago by the NYSE during March 2006. Prior to its acquisition, Archipelago, an ECN at the time, acquired the Pacific Stock Exchange, to form a fully electronic stock exchange.

Figure 11.5. ECN Highlights

As of early 2008, there were a few ECNs operating; the largest is BATS, which provides trades to Nasdaq, the NYSE, the ISE, and some regional exchanges. BATS began in January 2006 and applied to the SEC to become a fully licensed securities exchange during 2007. Among the others are Direct Edge, Bloomberg, LavaFlow, and Track Data.

Prior to 2000, ECNs could not penetrate the NYSE-listed stocks as they did the Nasdaq market. The main reason was the impediment imposed by the NYSE's Rule 390, also called the order consolidation or order concentration rule. According to Rule 390, dealers who traded NYSE-listed stocks in the OTC could not be members of the NYSE. For this reason, only a few dealers actively participated in the OTC market for NYSE-listed stocks, and NYSE-listed stocks were traded mainly on the NYSE.

All central markets have incentives to impose order consolidation rules on their members. However, the SEC, to open up the NYSE market, pressured the NYSE to eliminate Rule 390. The NYSE eliminated Rule 390 in December 1999. This elimination exposed the NYSE to the same type of fragmentation to which Nasdaq had been exposed. But in the years immediately after the elimination of Rule 390, the NYSE continued to conduct most of the trading in its stocks; that is, the NYSE market did not experience nearly as much fragmentation as the Nasdaq markets. Subsequently, however, the NYSE has lost considerable market share to ECNs and other exchanges.

Some of the key events for ECNs are summarized in Figure 11.5.

In addition to ECNs, other alternative trading systems (ATSs) developed as alternatives to exchanges.

It is not necessary for two natural parties conducting a transaction to use an intermediary. That is, the services of a broker or a dealer are not required to execute a trade. The direct trading of stocks between two customers without the use of a broker or an exchange is called an ATS.

A number of proprietary ATSs have been developed. These ATSs are for-profit "broker's brokers" that match investor orders and report trading activity to the marketplace via the Nasdaq or the NYSE. More recently, such trades have been reported through Trade Reporting Facilities, as discussed later. In a sense, ATSs are similar to exchanges because they are designed to allow two participants to meet directly on the system and are maintained by a third party, who also serves a limited regulatory function by imposing requirements on each subscriber.

Broadly, there are two types of ATSs: crossing networks, which have functioned since the 1980s; and dark pools, which are much more recent.

Crossing Networks

Crossing networks are electronic venues that do not display quotes but anonymously match large orders. Crossing networks are systems developed to allow institutional investors to cross trades—that is, match buyers and sellers directly—typically via computer. These networks are batch processors that aggregate orders for execution at prespecified times. Crossing networks provide anonymity and reduce cost, and are specifically designed to minimize market impact trading costs. They vary considerably in their approach, including the type of order information that can be entered by the subscriber and the amount of pretrade transparency that is available to participants.

A crossing network matches buy and sell orders in a multinational trade at a price that is set elsewhere. The price used at the cross can be the midpoint of a bid-ask spread (such as the national bid and offer, as discussed below) or the last transaction price at a major market (such as the NYSE or Nasdaq) or linkage of markets. Thus, no price discovery results from a crossing network.

The major drawbacks of the crossing networks are (1) that their execution rates tend to be low and (2) that if they draw too much order flow away from the main market, they can, to their own detriment, undermine the quality of the very prices on which they are basing their trades. These limitations can be overcome in a call auction environment that includes price discovery.

ATS began developing during October 1987 when Investment Technologies Group's (ITG) Posit began. Posit is a crossing network that matches customer buy and sell orders that meet or cross each other in price (this is the way crossing networks were named) at a price established by the NYSE or the Nasdaq markets or the overall national market.

Another crossing network, LiquidNet, started operation in 2001. LiquidNet is an ATS that enables institutional customers to meet anonymously, negotiate a price, and trade in large sizes (average trade size is nearly 50,000 shares). Part of LiquidNet's ability to attract order flow is attributable to its customers' being able to negotiate their trades with reference to quotes prevailing in the major market centers. In other words, LiquidNet's customers do not have to participate in significant price discovery. Further, LiquidNet customers' anonymity and knowledge that counterparties in the system also wish to trade in size offers them some assurance that their orders will not have undue market impact. A key feature of the LiquidNet system is that customer matches are found electronically, and negotiations are also conducted electronically by the natural buyer and seller. LiquidNet has also developed in Europe.

Instinet, in addition to its continuous ECN, also developed an after-hours crossing, the Instinet Crossing Network. Instinet's after-hours cross was the first crossing network.

The Burlington Capital Markets, Burlington Large Order Cross (BLOX) also provides crossing systems. These systems enable institutions to trade with no price impact in a batched environment; the crosses are made at prices set in other stock market places. In addition, Harborside, which started operations in 2002, provides crossing services. These systems assist institutional customers to meet anonymously and negotiate their trades in an anonymous manner in an electronic environment that uses current quotes from external stock markets as benchmarks.

These crossing system are designed exclusively for institutional order flow. Among the major current crossing networks and their area of specializations are:

Crossing networks have provided attractive alternatives to institutions to trade without their orders having any impact on the prices. However, due to lack of liquidity, their execution rates tend to be low, and if they draw too much order flow from the established markets, they could undermine the quality of the prices, which are the bases for the trades. In effect, crossing networks that use prices from the central stock markets to price their crosses are "free riding" on the price discovery of the central markets. These limitations could be resolved in a call-auction environment, which does provide price discovery.

In a call auction, sometimes called a period call, orders from customers are batched together for a simultaneous trade at a specific point in time. At the time of the call (in a "timed call") a market clearing price is determined—that is, there is a price discovery—and buy orders at this price and higher and sell orders at this price and lower are executed.

But the two systems based on call auction methods have not developed liquidity. The two ATSs based on call auction principles were the Arizona Stock Exchange (which started operations in 1991 and has been inactive since 2001) and Optimark (which started in 1999 and has been inactive since 2000). Neither of these systems succeeded in attracting critical mass order flow. Their experiences point up the difficulty of implementing an innovative new trading system that has to compete with an established market center, especially when the new system provides independent price discovery. These call auction systems provided price discovery and, thus, competed with established market centers and had difficulty attracting order flow.

Crossing markets are offered by some of the major broker-dealers who may also use such systems to "internalize" their order flow, that is match or cross bids and offers "upstairs," that is in their own organization. These orders may both be customer orders, or one may be a customer order that they cross with their own proprietary orders. A selection of the firms involved in internalization is Citigroup, Credit Suisse, Goldman Sachs, Lehman Bros., Merrill Lynch, Morgan Stanley, and UBS.

Dark Pools

Another step in the evolution of nonexchange trading is the use of dark pools. Dark pools fulfill the need for a neutral gathering place and fulfill the traditional role of an exchange in the new paradigm. Dark pools are private crossing networks in which participants submit orders to cross trades at externally specified prices and, thus, provide anonymous sources of liquidity (hence the name "dark"). No quotes are involved—only orders at the externally determined price—and, thus, there is no price discovery.

Dark pools are electronic execution systems that do not display quotes but provide transactions at externally provided prices. Both the buyer and seller must submit a willingness to transact at this externally provided price—often the midpoint of the NBBO—to complete a trade. Dark pools are designed to prevent information leakage and offer access to undisclosed liquidity. Unlike open or displayed quotes, dark pools are anonymous and leave no "footprints." The advent of pricing in pennies led to less transparent markets and was, thus, instrumental in the initiation of dark pools.

Dark pools, as well as crossing networks, are creating very fragmented markets for large trades and block trades. Customers are also using algorithmic trading (discussed later) to respond to such hidden liquidity.

Among the advantages of dark pools are:

Among the disadvantages are:

The sponsors of dark pools can be:

Figure 11.6. Structure of Equity Transactions

Summary of the Structure of the Mechanisms for Equity Transactions

In this section, several mechanisms for transacting equities, both conceptual and actual, have been discussed. Figure 11.6 summarizes the structure of the mechanisms for equity transactions. While the exchange markets continue to evolve, the off-exchange markets also continue to grow, diversify, and add advantages to the overall market. ECNs are used for either institutional or retail order flow, while crossing networks and dark pools are used mainly for institutional order flow.

Another difference between sectors of the off-exchange market is that ECNs are quote driven, while crossing networks and dark pools are order driven. One disadvantage of these off-exchange markets is that they tend to fragment the overall market, that is, remove quotes and trades from the central exchange markets.

Some analysts observe that there is a hierarchy in the quality of execution, with ATS being the highest, ECN being next, and exchanges being the lowest. Some analysts say that the exchanges are getting the so-called "exhaust" of executions.

For years, even decades, the NYSE gradually increased the use of electronic trading to supplement it specialist-based, human-touch trading. Then, during 2006 and early 2007, this evolution turned into a revolution.

During the previous years, the functionality and capacity of DOT and SuperDOT, discussed earlier, continually increased, reducing the need for specialist intervention for a larger number of trades. A significant indication of the rapid change in the need for specialist-oriented NYSE floor space was that a new NYSE trading room that was opened at 30 Broad Street during October 2000 was closed in February 2007.

There were several components of this revolution. The two major components were as follows. First, in December 2005, the NYSE initiated its NYSE Hybrid Market, which gave customers the choice of the traditional auction-based specialists system or new electronic trading. The basis for the electronic component of the NYSE Hybrid Market was NYSE Direct+, an automatic execution service, the pilot of which was launched in October 2000 and which was expanded in August 2004.

Second, the crescendo of this revolution occurred in March 2006. On March 7, the NYSE merged with Archipelago Holding Inc. (commonly called "Arca") and, as a result, became a for-profit, publicly owned company. On the following day, the shares of the newly formed NYSE Group began trading on an exchange—the NYSE, of course. As a result, there were no more NYSE memberships or "seats" (which reached a high of $4 million in December 2005). These seats were replaced by NYX shares as a measure of value and "access" rights for floor trading privileges became available separately.

The period 2006–2007 was exceptionally active for the NYSE. Specifically, the major events during this period were as follows:

Thus, during a brief period from 2006 to 2007, the NYSE went public, initiated a hybrid market, and became global.

While the NYSE Hybrid was introduced in the period from October 2006 to January 2007, it was based on systems initiated and developed previously. Some of these are described below:

A summary of the key dates and activities is summarized in Table 11.1.

The remainder of this section provides additional information on these elements of the NYSE Hybrid Market and the overall Hybrid market.

Designated Order Turnaround Systems (DOT or SuperDOT)

Traditionally, the NYSE has conducted its execution via the specialist system wherein the specialists execute orders presented by floor brokers. However, as explained earlier, the use of electronic trading has continually increased. The key mechanism for electronic trading has been the DOT or SuperDOT.

DOT is an electronic system that increases order efficiency by routing orders for listed securities directly to a specialist on the trading floor, instead of through a broker to the specialist. The DOT system is used by the NYSE for small orders, limit orders, basket trades, and program trades.

Electronic trading on the NYSE began in 1976 with the DOT for market orders of 100 shares. DOT's capabilities were expanded over time to accommodate limit orders and larger sizes. DOT was renamed SuperDOT in 1984. The system can be used for orders up to 100,000 shares, and it has the capacity to handle in excess of 2 billion shares daily. Orders that come in through SuperDOT are referred to as system orders. Floor brokers provide the main alternative delivery method.

To some extent, however, separate order handling may be unavoidable. Namely, whereas small retail orders are typically sent electronically by SuperDOT to specialist posts, large orders are commonly worked by floor brokers on a not-held basis or are negotiated in the upstairs institutional market. These procedures, however, are coordinated and the exchange's order flow is reasonably well integrated. This coordination is of critical importance because price discovery should reflect the desires of the broad market to hold shares of stock.

Data on the participation of specialists, floor brokers, and the entire floor (specialists plus floor broker) by Hendershott and Moulton (2007) found that since 1999 there has been a continual decline in the floor volume, both floor broker and specialist. The data indicate that floor trading volume began to decline significantly during 2002, the time of the introduction of OpenBook, which provides limit order book data to traders off the exchange floor. By June 2006, floor trading had declined to slightly more than 20% of the total volume from in excess of 50% in January 1999. The specialist share was less than 10% in May 2006. The data by Hendershott and Moulton also show that these shares continued to decline during June 2006 through May 2007 with the total flow volume approximately 10% and the specialists' share approximately 5% during May 2007.

According to the NYSE, during 2007, 99% of all orders pass through SuperDOT.

Anonymous SuperDOT (ADOT) enables institutional investors sponsored by a member firm to submit orders directly to the NYSE without the exchange, member firm, specialist or floor brokers knowing their identity. Institutions that have been sponsored by member firms can use ADOT to send orders directly and anonymously to the point of sale on the NYSE trading floor. With ADOT, the institution will receive transaction reports as they occur, and the member firm will receive a copy only at the end of the day or after an agreed-upon time has elapsed, for clearing purposes.

Direct+

Automatic execution was introduced on the NYSE in October 2000 when Direct+ was launched. Initially, Direct+ provided an automatic execution service only on limit orders of up to 1,099 shares at the published NYSE quote. There was also a 30-second rule for repeat executions belonging to the same beneficial owner. The only option for market orders was the standard auction method.

In 2003, the NYSE began automatically updating the best bid and offer quotes that reflected changes in the limit order book. Prior to this, the best bid and offer quotes were updated manually by the specialist. Also during 2003, the NYSE launched LiquidityQuote, which disseminated executable, sizable quotes outside the best bid and offer so that users could find greater market size and depth.

After filing during August 2004, the NYSE expanded the NYSE Direct+ automatic trading system, by eliminating the limits on the size, trading, and types of orders that could be submitted via Direct+, thus significantly increasing electronic trading at the NYSE.

NYSE Direct+ is the foundation upon which the electronic component of the Hybrid Market is built. NYSE Direct+ enables users to opt for an immediate execution at the best bid or offer, without a fee and with anonymity and speed. The average execution time is 0.36 seconds. This trade volume represents approximately 17% of NYSE's average daily volume. Direct+ has had two main restrictions: (1) a maximum order size of 1,099 shares; and (2) a minimum reload time of 30 seconds. Within the Hybrid Market, these two restrictions have been removed, allowing customers automatic execution up to 1 million shares, sweep the best bid/offer, and to trade without time restrictions.

An important distinction between SuperDOT and Direct+ is that SuperDOT routes the quote or order directly to the specialist and then the specialist actually provides the execution whereas with Direct+ the system, not the specialist, provides the execution automatically.

OpenBook

In January 2002, the NYSE introduced OpenBook, which provides limit order book information to traders off the exchange floor. Immediately after its introduction, Open-Book information was released every 10 seconds. As of May 1, 2006, this information was released continuously (as fast as the NYSE system would permit). OpenBook does not include floor trader interest, and there are lags in floor executions.

The changes identified above, and others, led to the launch of the NYSE Hybrid Market during late 2006; actually, the NYSE Hybrid Market was introduced across the various stocks listed on the NYSE from October 2006 through January 2007. As of January 2007, all NYSE stocks were traded via its electronic Hybrid Market (except for a small group of very high-priced stocks). Customers could send orders for immediate electronic execution, or route orders to the floor for trade in the auction market. In excess of 50% of all order flow is now delivered to the floor electronically. The NYSE Hybrid Market offers customers the choice between the auction system with the opportunity for price improvement provided by the specialist system and very fast automated trade execution provided by the electronic system. Thus, the NYSE Hybrid Market provides investors with a blend of market models, from completely automated to the value-added auction market.

Among the reasons for the NYSE to launch the Hybrid Market were that (1) it wanted to give users the choice of the existing auction mechanism to attain better prices or the new electronic mechanism for faster executions; (2) higher trading volumes could be executed more efficiently; and (3) the SEC Regulation NMS order protection rule affords protection for better-priced quotes from being traded only in markets that offer automatic protection at the posted quotes, defined as "fast" markets. After the Hybrid Market, the NYSE market qualified as fast a very large fraction of the time.

The Hybrid Market involved several changes in the NYSE's systems and rules which enhanced the efficiency of the trading process and increased automatic execution and speed. The intent and effect of the Hybrid Market was to expand automatic execution. The specific changes included: (1) orders were no longer limited to 1,099 shares—the new limit is 1 million shares; (2) the 30-second frequency restriction was eliminated; (3) market orders as well as limit orders are eligible for automatic execution; and (4) market and marketable limit orders are automatically executed by default, rather than requiring a special code.

The Hybrid Market automates much of the specialists' activity, helping them become much more efficient at the point of sale. In order to react to customers, specialists interface with the market through proprietary algorithms that interface with the NYSE Display Book via an NYSE-provided application programming interface (API).

On the trading floor, the NYSE still trades in a continuous auction format. Here, the human interaction and expert judgment with respect to order execution differentiates the NYSE from a fully electronic market. There is still one specific location on the trading floor where each listed stock trades as before. The specialists do on occasion (approximately 10% of the time) facilitate the trades by committing their own capital and, as a matter of course, disseminate information to the crowd that helps to bring buyers and sellers together.

The NYSE Hybrid Market is a NYSE-developed electronic trading system. Archipelago is an NYSE-acquired electronic trading system. The NYSE could have used Archipelago as its only electronic trading system but did not because it believed that its NYSE Hybrid system was better suited to support the diversity of trade-execution choices and information flows that comprise the NYSE Hybrid Market. The NYSE's platform includes a range of technology tools that help specialists and brokers provide value to customers. The NYSE Group's plan has been to retain the distinct value of both the NYSE and NYSE Arca marketplaces. Eventually, the infrastructure supporting the trading platform will be consolidated to provide operating efficiencies while retaining the value-added functionalities of each marketplace.

The NYSE Hybrid Market changes apply only during the continuous trading day, not during the opening and closing call auctions, which are handled manually by the specialist.

A new regulatory requirement, which is part of the SEC's Regulation NMS, is the order-protection rule, which requires market centers to satisfy better-priced quotes in other fast markets before filling orders in their own markets. In order to be a fast market, subsecond automatic execution must be offered, as well as the immediate or cancel capability. The Hybrid Market transformed the NYSE from an auction market with an average trade-execution time of 9.0 seconds to a fast market with sub-second turnaround times.

One expectation of electronic trading is that it will provide faster executions and higher executions costs than the floor trading. This expectation is supported by Hen-dershott and Moulton (2007, p. 23) who state that: "The Hybrid experience suggests that while investors who favor faster execution benefit, investors who are more concerned with lower execution costs or low volatility than speed, may be worse off in a world without floor trading."

In fact, the NYSE Hybrid Market has considerably increased electronic trading at the expense of floor trading. The Hybrid Market expansion of automatic execution has reduced the potential for specialists and floor brokers to participate manually in executions.

In November 2007, NYSE Euronext announced that it would overhaul its Hybrid Market system during 2008, possibly permitting market making firms to act as specialists.

As of February 2001, there were 18 specialist firms on the NYSE. Traditionally, NYSE specialist firms were small, private family-owned businesses. However, recently, NYSE specialist firms have consolidated, been acquired by public companies, or have gone public themselves. The increased capital requirements for specialists have been one factor that has led to a consolidation of the specialist firms. These specialists have continued to face increasing competition from other sources such as ECNs. The increase in electronic trading has reduced the volume of trading through the specialists and, as a result, the number of specialists.

In 2007, the number of specialist firms continued to decline. In November 2007, two specialists firms (Van Der Moolen Specialist USA and Susquehanna International Group LLP) stopped trading on the NYSE floor. These departures left only five specialists firms. These five are units at Bank of America Corp., Goldman Sachs Group Inc., Labranche & Co., Kellog Specialists Group, and Bear Wagner Securities (a unit of Bear Stearns Cos.). Some analysts regarded these departures as a natural move toward more sophisticated electronic trading systems. There had been over 40 specialist firms in the early 1990s.

In addition, the fraction of shares that required human/ specialist intervention decreased as the share executed electronically increased. During 2007, on normal trading days, only 15% of trading required human intervention. On high-volume, volatile days, however, this share increases to 25% because some traders continue to want the service of a specialist on these days (Lucchetti, 2007).

U.S. stock exchanges no longer enjoy a monopoly on trading in their own listed stock. They have lost share to competing exchanges and alternative electronic systems. For example, over the period from 2005 to October 2007, the NYSE lost market share, which declined to approximately 40% of the trading on its listed shares versus over 80% in earlier years (Lucchetti, 2007).

Thus, overall, the NYSE has lost market share in its listed stocks to alternative electronic systems such as ECNs, crossing networks, and dark pools. In addition, the market share it has kept has gone primarily electronic via the NYSE Hybrid Market, which has lessened the need for NYSE's traditional specialist franchises. As a result, some question whether an NYSE listing is worth as much if a large share of the listed companies shares trade away from the NYSE and even the NYSE-traded segment is traded electronically, which is more common across the markets, rather than electronically, which is unique to the NYSE.

Euronext NV was a pan-European stock exchange based in Paris with subsidiaries in Belgium, France, Netherlands, Portugal, and the United Kingdom. In addition to equities and derivatives markets, the Euronext group provides clearing and information services. As of January 31, 2006, markets run by Euronext had a market capitalization of US$2.9 trillion, making it the fifth-largest exchange in the world before it merged with the NYSE Group to form NYSE Euronext, the first global stock exchange.

Euronext was formed on September 22, 2000, in a merger of the Amsterdam Stock Exchange, Brussels Stock Exchange, and Paris Bourse, in order to take advantage of the harmonization of the European Union financial markets.

In December 2001, Euronext acquired the shares of the London International Financial Futures and Options Exchange (LIFFE) and Euronext.liffe was formed in January 2002.

The derivatives activities of the other constituent exchanges of Euronext (Amsterdam, Brussels, Lisbon, and Paris) were merged into Euronext.liffe. Euronext.liffe continues to operate under its own governance. Trading is done electronically through the LIFFE CONNECT platform. Euronext.liffe offers a wide range of futures and option products on short-term interest rates, bonds, swaps, equities, and commodities.

NYSE Group offered €8 billion (roughly $10.2 billion) in cash and shares for Euronext on May 22, 2006. The merger was completed on April 4, 2007, forming the NYSE Euronext. NYSE Euronext then owned the NYSE Group, Euronext, and Archipelago.

During January 2008, the NYSE announced an agreement to buy the American Stock Exchange. The purchase price was expected to be approximately $260 million (plus the proceeds from the sale of Amex's classic lower Manhattan building, expected to be $50 million to $100 million), considerably less than the Nasdaq paid for the Philadelphia Stock Exchange during November 2007. The Amex will relocate its traders to NYSE's trading floor, which has extra space, as discussed.

The purchase of the Amex will (1) increase the NYSE's relatively new stock options business, (2) increase its Arca stock exchange listings of emerging company shares by several hundred companies, and (3) strengthen NYSE's already large position in the ETF market.

The Amex had been losing market share in almost everything it traded, including stocks, options, and ETFs, a product it had started in 1993. Its business of listing new companies peaked decades ago. For example, on a trading day in early 2008 when both the NYSE and Nasdaq traded between 40% and 50% of the shares in their own listed stocks, the Amex traded less than 5% of the shares it listed (Lucchetti, 2008a).

Many of the key dates referred to previously are summarized in the appendix to this chapter.

During the 1990s, the SEC continued its emphasis on greater quote and price transparency. In this regard, the SEC instituted new order-handling rules in 1997. First, any market maker who held a customer order had to display that order in their quote. Second, a market maker could place a more aggressive quote in an ECN, if the ECN displayed the top of its book in the Nasdaq quote montage. Third, if the ECN's own best quote was not shown in the quote montage, then the market maker had to update its own quote in Nasdaq to match the ECN quote.

While these rules may seem narrow and technical, their effect was significant. They were the basis for ECNs to become major participants in the stock market. Before these rules, Instinet was the only ECN. By 1999, there were nine ECNs.

All a new ECN needed to capture order flow was to be a gateway that attracted some customers to place limit orders on its electronic book. Connectivity with other markets (either directly or through one of Nasdaq's systems) would allow market orders from the customers of other firms to reach its books and become traders. ECNs did not have an impact on NYSE trades until Rule 390 was eliminated in 1999, as discussed earlier.

The Archipelago ECN began in December 1996. Archipelago stated on its web site:

The SEC-enforced consolidation, transparency, and accessibility of price information caused by these SEC changes quickly caused the flow of limit orders to fragment onto multiple books and the ECNs' cheap, fast, and anonymous trading forced the Nasdaq to alter its trading systems and organizational structure.

Then, with the passage of time, consolidation started taking place among the ECNs: Instinet acquired Island, and Archipelago acquired the Pacific Stock Exchange (Archipelago and Instinet/Island accounted for most of the ECN volume). In May 2004, the Nasdaq acquired the Brut ECN, previously owned by Sungard Data Systems.

In concept, it might be expected that most of the trading volume of stocks listed on an exchange would be traded directly with the exchange. This has not, however, been the case. The construct of the Nasdaq as a dealer system has made it easy for ECNs and others to conduct the trades directly and report them to the exchange. And since NYSE Rule 390 was removed in 1999, it has been easier to trade NYSE listed stocks off the exchange. This trading of stock listed on an exchange off the exchange is called fragmentation. While the fragmentation of the NYSE has increased, the Nasdaq remains much more fragmented than the NSYE.

One of the many results of this fragmentation has been the need by customers for some new systems to provide order management, handling, and routing services. These services select a market often on the basis of recent trading activity, resulting in its user's receiving the best executions across the markets by "consolidating" the information across the markets.

One outcome of these smart order routers (also called consolidators) is that customer order flow is "less sticky"; that is, the order flow will switch from one execution service to another quickly based on short-term, quantitative information.

The Securities Act amendments of 1975 mandated a U.S. national market system (NMS). The core of this national market was the Intermarket Trading System (ITS), which began operating in 1978. The ITS electronically linked eight markets (NYSE, Amex, Boston, Cincinnati, Chicago, Pacific, and Philadelphia Stock Exchanges, and the NASD OTC market) via ITS computers. The ITS permitted traders at any of these exchanges to go to the best available price at the other exchanges on which the security could trade. The NMS also included a consolidated electronic tape, as discussed elsewhere, which combined the last sale prices from all the markets onto a single continuous tape. The use of the ITS, however, was voluntary.

Even though ITS evolved, by 2007 it was based on obsolete technology. During 2007, the ITS system was replaced by the new NMS. Regulation NMS was designed by the SEC for electronic exchanges. Regulation NMS requires that orders be executed at the market (exchanges or other execution venues) that offers the best price for the customers. Thus, exchanges must compete with each other on a level playing field. Regulation NMS's impact is attributable to two of its component rules.

The first rule is the Order Protection Rule (Trade-Through Rule). This rule requires that trades be executed at the best displayed prices provided by an electronic trading system and accessible in under one second. This means that markets will have to route out their orders to other markets if the other markets have better prices (bids or offers). That is, a market cannot "trade through" a better price from another market and trade on its own market. As a result of NMS, each exchange has to send its orders to other exchanges if the other exchange has a better price.

The Trade-Through Rule provides price protection to top-of-book orders (best bids or best offers) placed on exchanges that are electronically accessible. Reserve and hidden orders are not protected. Only electronic quotes are protected. All exchanges are required to have capabilities to route orders to the market with the best bid or offer if they are not able to match the price to execute an order on their own exchange. Only the BBO (or top-of-book) is displayed. In this environment, competitive pricing and low-latency systems are essential in attracting order flow.

The second rule is the Access Rule, which requires the use of private linkages among exchanges to facilitate access to quotes and sets a limit on the access fees by the markets. These private linkages replaced the ITS.

Exchanges had to go to electronic trading to offer protection under Regulation NMS. ECNs and broker-dealers are also covered by Regulation NMS.

A common view is that Regulation NMS will fundamentally change U.S. stock trading by creating a virtual centralized market in which all exchanges will be automated and interconnected. The NMS is expected to divert orders from the two major exchanges, NYSE Euronext and Nasdaq, to the regional exchanges and ECNs. Some regional exchanges view Regulation NMS as a great equalizer. The reason for this position is the goal that all investors get the best price when transacting stocks, regardless of which exchange posts these prices.

Internalization refers to off the exchange ("upstairs") trades, mainly of retail trades. As opposed to block trading, internalization involves keeping retail orders within the firm ("internalized") with the broker-dealer buying from its sell orders and selling from its buy orders, generally at the published best bid/offer or a penny better. This practice results in proprietary trading revenue for the broker-dealer. A broker-dealer with a large number of customer orders thereby has a trading opportunity to make a "dealer spread" (buying at the bid and selling at the offer) without interference and will lay off any unwanted positions in the primary market. Brokerage firms internalize through proprietary ATSs. Some believe that this practice reduces transparency, impairs price discovery, and harms investors.

The equity markets permit broker-dealers to internalize retail order flow upstairs. The trades are reported on the trade reporting facility (TRF), as discussed later. While the SEC has approved such internalization in the stock markets, in the stock options markets the orders must be shown to the public market before internalizing them upstairs. Internalization is thus treated differently in the stock and stock options markets.

Off-exchange (internalized) trades as of the end of 2007 account for about 30% of volume in Nasdaq's listed stocks and 16% of the consolidated volume in listed NYSE stocks. Brokers that internalize are reporting 500,000 trades a day in the Nasdaq world and about 350,000 trades a day in NYSE-listed stocks. This volume comes from broker-dealers interacting with their customers' order flow in their upstairs environment and then printing those trades on Nasdaq, as discussed next (Schmerken, 2007).

The NYSE is opposed to internalization. It believes that orders are best represented when they interact with the broader marketplace.

An alternative display facility (ADF) is an entity independent of a registered securities exchange that collects and disseminates securities quotes and trades. It is a display-only facility.

The ADF is an alternative to exchanges for publishing quotations and for comparing and reporting trades. This differs from a trading facility with execution capabilities (a stock exchange) in that the exchange would simply send back to the owner of the displayed order a notice of execution. The NASD has operated an ADF since July 2002. It is now operated by FINRA, as discussed later.

The ADF provides members with a facility for the display of quotations, the reporting of trades, and the comparison of trades. As of March 2007, Consolidated Tape Association (CTA)-listed securities (NYSE, Amex, and the regional exchanges), as well as Nasdaq-listed securities, are eligible for posting quotations through the ADF. ADF best bid and offer and trade reports are included in the consolidated data stream for CTA and Nasdaq-listed securities.

The ADF competes with Nasdaq's SuperMontage system.

These organizations exist to capture some of the values of this information (which has historically been captured by exchanges) for the ADF's information suppliers, usually ECNs.

As indicated above, in the stock market trades can be internalized or arranged upstairs, that is, not traded on an exchange. But if they are traded via internalization they are not reported on the exchange on which the stock is listed. Traditionally, NASD has had a trade-reporting facility (TRF) where these off-exchange trades are printed on NASD's ADF. So, for example, if Merrill Lynch internalized a trade, it would be printed on NASDs TRF through its ADF.

Until recently, broker-dealers that internalized trades—as well as crossing networks and ECNs that matched trades among their subscribers—had to report these trades to their regulator, the NASD via the Nasdaq's Automated Confirmation Transaction System, known as ACT.

The SEC issued an order on June 30, 2006 approving Nasdaq to begin operating as an exchange in Nasdaq-listed securities. The order included approval of the TRF, a new limited liability company operated by Nasdaq and subject to NASD's oversight. In the wake of Nasdaq's receiving SEC approval to become a national stock exchange, NASD and Nasdaq separated, and the SEC allowed Nasdaq to keep its operated TRF, but also opened this up to competition, thereby ending Nasdaq's and NASD's monopoly. Nasdaq's TRF went live August 1, 2006, the same day that it began operating as an exchange in Nasdaq-listed stocks. With the consolidation of the regulatory functions of NASD and NYSE, FINRA has taken over the reporting function. However, FINRA keeps the tape revenue. For this reason, exchanges can set up their own TRFs, report these trades, and keep some of the tape revenues.

The National Exchange (NSX) (the former Cincinnati Stock Exchange) has set up a TRF, so currently such trades can be reported through this exchange as well as the Nasdaq. The NYSE is also considering such an arrangement; if this happens, these trades would be reported by NYSE's TRF as ADF.NYSE.

The ADF NYSE has entered into discussions with the NASD to create a TRF, serving customers reporting off-exchange trades in all listed NMS stocks. If this materializes, stock brokers that internalize trades in NYSE-listed stocks would be able to report those trades to a jointly operated NYSE/NASD TRF. The TRF for NYSE-listed stocks began in 2007.

While the NYSE remains opposed to the internalization of trades, the exchange is developing a TRF for competitive reasons. The NYSE believes that retail orders for individual investors are best represented when they interact with the broader marketplace (Schmerken, 2007).

Regional exchanges, including the Philadelphia Stock Exchange (PHLX), the Boston Equity Exchange (BeX), and the Chicago Stock Exchange (CHX), are also moving forward with plans to create TRFs.

In general, buy-side firms continued to take more control over the way their transactions were executed. Direct market access (DMA) refers to the use of electronic systems to access various liquidity pools and execution venues directly, without the intervention of a sell-side firm trading desk or broker. There are several advantages of DMA to a buy-side firm:

With respect to cost, it is estimated that DMA commissions are about one cent per share; program trades are two cents per share; and block trades cost four to five cents per share. As of 2004, 33% of buy-side equity shares were transmitted by DMA, and it is estimated that by 2008 this share will be 38%. Hedge funds are aggressive users of DMA (Schmerken, 2005).

Initially, the providers of DMA electronic services were independent firms. But increasingly, traditional sell-side firms have either acquired the independent firms or developed their own DMA systems to provide DMA services to sell-side firms. Among the major providers of this type are Goldman Sachs, Morgan Stanley, CSFB, Citigroup (which acquired Lava), and Bank of New York.

Initially, DMA was used only for U.S. equities, but this focus has expanded to U.S. fixed income and derivatives and into the international markets, Europe, and Asia/Pacific.

DMA has become commoditized and its providers now often provide a comprehensive set of services including program trading, block trading, and also the more sophisticated technique, algorithmic trading, which is discussed in the next section.

Traditionally, orders for stock executions have been conducted by traders who execute the trades on a trading desk for a portfolio manager or whomever determines what trades should be executed. Traders are judged to have "market information and savvy," which permits them to conduct the trades themselves at a lower cost and with less market impact than the portfolio manager conducting the trades on a less formal basis.

The effectiveness of these traders is often measured by execution evaluation services, and traders are often compensated partially on the basis of their effectiveness. But some observers believe that the traders, in the interest of maximizing their compensation, may have different incentives than the portfolio managers and do not optimize the portfolio manager's objectives—this is referred to as an agency effect. In addition, some think that trades could be conducted more efficiently by electronic systems than by human traders.

As a result, due to improved technology and quantitative techniques, and also regulatory changes, electronic trading systems have been developed to supplement or replace human traders and their trading desks. Such trading is called algorithmic trading, or "algo."

Algorithmic trading is a relatively recent type of trading technique whereby an overall trade (either buy or sell) is conducted electronically in a series of small transactions instead of one large transaction. Such trades are conducted via computers, which make the decision to trade or not trade depending on whether recent price movements indicate whether the market will be receptive to the intended trade at the moment or, on the other hand, will cause the price to move significantly against the intended price. Algorithmic trading also permits the traders to hide their intentions. Trading may involve small trades on a continuous basis rather than a large trade at a point in time. The algo is often said to leave no "footprint" and is a "soft touch" way of trading.

Algos, like dark pools, provide anonymity, which the "visible markets," like exchanges and ECNs, do not. Algos are often described as "hiding in plain view."

The advent and wide use of algos is due primarily to both technology and regulation. The technology element is based on faster and cheaper technological systems to execute via improved quantitative methods. The regulatory element is the adoption of pennies and the approval of the order-handling rules, which provided for the growth of ECNs by the SEC. The adoption of "pennies," which provides for smaller pricing increments, and technological advancements, which provide for low-latency trading, have made algorithmic trading more necessary and feasible (low latency refers to a short period of time to execute an instruction, that is, high speed).

One important result of pennies in conjunction with algorithmic trading has been that the average trade size has been decreased significantly, again increasing the requirements for reporting and systems. There has been a significant reduction of the average trade size at the NYSE, beginning with 2001. Order size on the NYSE has declined significantly from over 2,000 shares in 1998 to slightly over 330 in 2007.

The use of algorithmic trading is significant by large traders such as hedge funds and mutual funds. Some traders maintain their own algorithmic trading facilities and others use the systems provided by another organization. Overall, algorithmic trading has the advantages of being scalable, anonymous, transparent, and very fast.

Price reporting in the U.S. stock markets is conducted by the Consolidated Tape Association (CTA). The CTA oversees the dissemination of real-time trade and quote information (market data) from the NYSE and Amex-listed securities (stocks and bonds). The CTA is an independent, industry-wide organization. The CTA manages two systems to govern the collection, processing, and dissemination of trade and quote data. The two systems are: the Consolidated Tape System (CTS), which governs trades, and the Consolidate Quotation System (CQS), which governs quotes. Since the late 1970, all SEC-registered exchanges and market centers that trade NYSE or Amex-listed securities send their trades and quotes to a central consolidator where the CTS and CQS data streams are produced and distributed worldwide.

The data collected by the CTA are provided on two networks, Network A (or Tape A) for NYSE-listed securities which is administered by the NYSE and Network B (or Tape B) for Amex and regional exchange-listed securities which is administered by the Amex. Nasdaq operates a similar tape for its listed securities, which is called Network C (or Tape C).

CTS is the electronic service that provides last sale and trade data for issues listed on the NYSE, Amex, and U.S. regional stock exchanges and was introduced in April 1976. CTS is the basis for the trade reports from the consolidated tape that run across television screens on financial news programs or on the Internet sites. The "consolidated tape" is a high-speed, electronic system that constantly reports the latest price and volume data on sales of exchange-listed stocks.

CQS is the electronic service that provides quotation information for issues listed on the NYSE, Amex, and U.S. regional stock exchanges.

For every quote message received from a market center, CQS calculates an NBBO based on a price, size, and time priority schema. If the quote is a Nasdaq market-maker quote, CQS also calculates a Nasdaq BBO. CQS disseminates the market center's root quote with an appendage that includes the National and Nasdaq BBOs.

In general, Tapes A and B are referred to as the "CTS Tapes" and Tape C as the "Nasdaq Tapes."

The basis for the federal government regulation of the stock market resides with the SEC. The SEC's authority is primarily based on two important pieces of federal legislation. The first is the Securities Act of 1933 (the "Securities Act"), which covers the primary markets, that is, the new issues of securities. The second is the Securities Act of 1934 (the "Exchange Act"), which covers the secondary markets. The SEC was created by the Exchange Act.

In addition to the SEC regulations, the exchanges also play a role in their own regulation through self-regulating organizations (SROs). The SRO of the NYSE has been responsible for the member regulation, enforcement, and arbitration functions of the NYSE. In addition, the NASD has had the SEC authority to set standards for its member firms and standards of conduct for issuing securities and selling securities to the public. The NASD has also monitored the Nasdaq stock market. There have, however, been some overlapping responsibilities of these two SROs and, thus, some competition between them.

As a result, these two SROs merged and in July 2007 were replaced by the single organization, FINRA, which consolidated the NASD and the member regulation, enforcement, and arbitration functions of NYSE. This consolidation resulted in all firms dealing with only one rule book, one set of examiners, and one enforcement staff, thereby reducing costs and inconsistencies. Thus, FINRA is the single remaining SRO.

After a stock trade is completed, the delivery of the shares by the seller and the payment of cash by the buyer must occur quickly and efficiently. The efficiency of the trade settlement affects the total speed and the overall cost of the transaction. In the United States, there are several execution mechanisms (exchanges and other) for stocks. There is, however, only a single clearance and settlement mechanism for securities, the Depository Trust and Clearing Corporation (DTTC). In stock options, similarly, there is only one clearing mechanism, the Options Clearing Corporation (OCC).

In the futures markets, however, there are several clearing organizations, each typically associated with the related exchange. This control over clearing by futures exchanges makes it easier for them to preserve their monopolies in trading and also gives them a significant source of profitability. During February 2008, however, the U.S. Department of Justice questioned whether futures exchanges should be allowed to own or control clearing businesses that process their trades. The issue is whether futures clearing will become centralized like stock and options clearing (Lucchetti, 2008c).

All clearance and settlement services for U.S. equities market (as well as corporate bonds, municipal bonds, exchange-traded funds, and unit investment trusts trades) are provided by the National Securities Clearance Corporation (NSCC). NSCC is a wholly owned subsidiary of the DTCC. NSCC generally clears and settles trades on a T +3 basis (that is, three business days after the trade date). DTCC is essentially a utility organization for the exchanges.

Other subsidiaries of DTCC provide clearance and settlement for other products and also trust services.

The minimum price variation for a security is referred to as its tick size. The U.S. stock market historically had a tick size of one-eighth of 1 point. The SEC wanted to reduce the bid-offer spread to increase the competition and lower costs. As a result, the NYSE and Nasdaq reduced the tick size first to one-sixteenth and then in 2001 to pennies (1 cent).

This reduction in the tick size narrowed the bid-offer spread considerably, which reduced the costs to customers and the profits of the market makers. In addition, as an unintended consequence, it negatively affected the liquidity of the market. With pennies, there are 100 pricing points per dollar, while with eighths there are only eight. So with pennies, there is less liquidity at each pricing point and therefore less depth at the inside market (the best bid and best offer or the "top of the book"). Since only the top of the book is displayed, the advent of pennies reduced transparency and was one of the reasons for the development of dark pools, as discussed above.

In addition, with pennies, quotes (bids or offers) are changed more frequently, and so the technology must have lower latency. Low latency, that is, a small amount of time necessary to complete an instruction, means high speed. Latency below one millisecond is now common. As indicated above, the advent of pennies is one reason for the development and growth of algorithmic trading.

Subpenny pricing is prohibited except for stocks that trade for less than a dollar.

During and after the 1929 stock market crash, part of the blame for the crash was attributed to "short selling." In short selling, an investor borrows stock and sells the borrowed stock to profit from an expected subsequent decline in the price when the investor buys the stock back at a lower price to repay the borrowed stock. In the short run at least, short selling the stock causes a decline in the market. In the longer run, the stock must be bought back to "cover the short" and causes the stock price to increase. As a result of the stock market crash, Rule 10A-1 was adopted a decade after the 1929 stock market crash to prevent short sellers from adding to the downward pressure on a stock whose price is already declining. This short-selling rule permitted short sales only when the last sales price was higher than the previous price (an "uptick trade") or if there was no change in the last sales price but the previous sales price was higher than the sales price that proceeded it (a "zero uptick trade"). Short sales were not permitted on a downtick.

In June 2007, the SEC eliminated the short-selling rule. The SEC stated that this rule was obsolete due to decimalization, changes in trading strategies, and increased market transparency. These strategies included standard short selling and long-short strategies such as 130/30 strategies which are practiced by hedge funds, mutual funds, and other investors. In addition, the rapid growth of ETFs which were not subjected to the short-sale rule, provided a convenient way of shorting portfolios of stocks, although not individual stocks.

A block is a large holding or transaction of stock, generally 10,000 or more shares or any amount over $200,000. In a block trade (a "block facilitation trade") a broker-dealer commits capital to accommodate a large trade for an institutional customer. These trades are conducted "upstairs" (off the exchange) and "shown to" the market, for potential price improvement. Block trades are reported through the standard price reporting systems. With the growth in algorithmic trading, however, blocks which have traditionally been accomplished "upstairs" via internalization are now accomplished via algorithmic trading.

Before 1975, stock exchanges were allowed to set minimum commissions on transactions. The fixed commission structure did not allow the commission rate to decline as the number of shares in the order increased, thereby ignoring the economies of scale in executing transactions.

Pressure from institutional investors, who transacted large trades, led the SEC to eliminate fixed commission rates in 1975. Since May 1, 1975, popularly referred to as Black Thursday, commissions have been fully negotiable between investors and their brokers. Black Thursday began a period of severe price competition among brokers, with many firms failing, and a consolidation of firms taking place in the brokerage industry. This liberalization of commissions was the U.S. version of the "Big Bang," which was subsequently followed in the United Kingdom in 1986 and Japan in 1996.

Since the introduction of negotiated commissions, the opportunity has arisen for the development of discount brokers. These brokers charge commissions at rates much less than those charged by other brokers, but offer little or no advice or any other service apart from the execution of the transaction. Discount brokers have been particularly effective in inducing retail investors to participate in the market for individual stocks.