CFA Institute
Which Road to an Efficient Stock Market: Free Competition or Regulated Monopoly?
Author(s): Seymour Smidt
Source: Financial Analysts Journal, Vol. 27, No. 5 (Sep. - Oct., 1971), pp. 18-20+64-69
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4470841
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NE of the primary objectives of the SEC's
O Institutional Investor Study, completed December 31, 1970, was to assess the impact
of institutional investors on the securities markets.
Implications of the SEC
A central question, addressed here, is the adequacy
Institutional Investor Study
of the existing arrangements to perform the market-
making function. In the writer's opinion there are
important inadequacies in the present arrangements; significant structural changes in the secu-
0~~~~~~~~~~~~~~~~~~~
rities business are necessary to overcome these
Which Road
to an
Efficient
Stock
Market
inadequacies, and are likely to take place.
The main economic criterion relevant to evaluating the performance of a market-making system
is the extent to which it supplies liquidity in depth
to offset temporary imbalances in supply and demand. The primary source of liquidity in depth in
NYSE stocks is the NYSE specialist system. Its
performance in supplying liquidity is spotty. Some
specialist firms turn in excellent performances;
others perform in a wholly inadequate manner.
When there is inadequate liquidity in depth, the
individual investor is hurt the most. The greater
expertise and the greater range of alternatives
available to institutional investors enable them to
escape the consequences of inadequate liquidity
more successfully than can individuals. The regulatory processes of the NYSE have not been used
effectively to encourage specialists to supply more
fvee competition or
regulated monopoly90
liquidity in depth. Exposing NYSE specialists to
effective competition would increase the supply of
liquidity. At present NYSE specialists are shielded
from competition by a complex of anti-competitive
devices that could not be maintained without the
tacit or explicit support of the government.
by SEYMOUR SMIDT
1. CRITERIA FOR EVALUATING
MARKET MAKING
A market-making service is performed when a
broker-dealer is willing to put its capital at risk to
facilitate the completion of trades by others. Three
main criteria have been suggested for evaluating
market-making performance of dealers who, like
DR. SEYMOUR SMIDT, who was Associate Director of
NYSE specialists, regularly make two-sided mar-
the SEC's Institutional Investor Study, is Professor
kets. These are the bid-asked spread, continuity
of Managerial Economics at Cornell University. With
Harold Bierman, he is co-author of The Ccapital
and liquidity in depth. The bid-asked spread is the
Budgeting Decision.
difference between the best (highest) bid price and
The views expressed in this article are the author's
alone, and do not represent the views of the Securi-
ties and Exchange Commission, its regular staff, the
the best (lowest) offer price. Continuity is the
change in price from one transaction to the next.
Financial Analysts Federation, which publishes the
A market has liquidity in depth if a large quantity
Financial Analysts Journal, or its officers or staff.
of stock can be bought or sold at a unit price
18 FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1971
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not too different from the price at which a small
If supply and demand are in balance, then a
quantity could be traded. Other tests that have
spread will tend to produce small changes in price
been applied are primarily designed to discourage
from one transaction to the next. A market with
supposedly undesirable activities-the tick test is
adequate liquidity in depth will tend to produce
a prime example.' This paper considers only eco-
small changes in price from one transaction to
nomic criteria.
another, even if there is an imbalance between
Undesirable actions can often be controlled rela-
supply and demand. Thus markets with narrow
tively effectively by regulation; but regulations are
bid-asked spreads and adequate liquidity in depth
less effective in encouraging desirable activities.
will tend to be continuous. However, the converse
The choice between a system in which market-
is not necessarily true. In particular, a market that
making activities in a stock are restricted to a
has inadequate liquidity in depth may also have
single firm, and a system in which these activities
small price changes from one transaction to anare freely open to as many firms as desire to par-
other. Thus, although depth tends to produce
ticipate, will depend mainly on which system is
continuity, a market can be continuous when there
likely to be most effective in promoting the desir-
is inadequate depth. Even when markets have ade-
able types of activities.
quate depth, large price changes from one trans-
The size of the bid-asked spread is one criterion
action to another may appropriately take place if
for evaluating the market-making system. If the
one of the transactions is exceptionally large, or
price of a stock is such that an equal number of
if important news is published that changes in-
buy and sell market orders are flowing into the
vestors' perceptions of what the stock is worth.
market, then the bid-asked spread reflects the
The amount of stock a single institution wishes
amount that investors must pay to achieve prompt
to buy or sell is often sufficiently large to create a
execution. Under the assumed conditions if the
temporary imbalance if the transactions are carried
market maker's bids and offers are better than
out in a relatively short period of time. But the
those of public investors, the bid-asked spread
consequences of inadequate liquidity in depth fall
measures the gross margin earned by the market
more heavily on individual investors than institu-
maker for providing prompt execution, and has
tions. If institutional position changes were always
been widely used to measure market-maker per-
carried out in a short period of time regardless of
formance. The importance of the bid-asked spread
temporary market conditions institutions would
seems to have been grossly overemphasized, how-
indeed suffer greatly when there was inadequate
ever, in part because the data necessary to measure
liquidity in depith. In practice, institutions are bet-
it are so easy to obtain.2 Temporary imbalances of
ter informed than individuals about temporary
supply or demand are more the rule than the ex-
market conditions and, by using some combination
ception. To an investor selling when there is a
of delaying transactions, "not held" orders, and
temporary excess of supply, the size of the bid-
block trading facilities, or by transferring trades
asked spread is of little relevance. What is im-
to other markets, are usually able to avoid the
portant to him is the extent to which the bid price
extreme costs of inadequate liquidity in depth.3
has declined because of the temporary imbalance.
If the decline is moderate because the marketmaking system is supplying adequate liquidity in
depth, the selling investor will not be penalized
much because substantially his selling happened to
coincide with a temporary excess of supply. On
the other hand, if the market-making system is not
supplying adequate liquidity in depth, an investor
who desires to sell when there is a temporary
excess of supply must choose between accepting a
more or less severe price penalty to gain an inm,
mediate execution, or delaying his transaction.
1. Footnotes appear on page 68.
The conventional mythology is that a large volume of transactions from individual investors is a
primary source of market liquidity. There is an
element of truth in this belief to the extent that
some individuals will be buying while others will
be selling. However, temporary surges of buying
and selling orders from individual investors in a
particular stock seem to occur more frequently
than is generally realized. These surges of orders
from individual investors probably result from re-
ports in newspapers, magazines, wire house sheets
and other widely circulated media. Whether or not
such reports contain genuine news, they are- likely
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1971 19
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to attract attention to an issue and increase the
responsibility can be assigned. Both of these argu-
ments need to be considered.
volume of trading in it. Since individuals frequently
utilize market orders, and since they cannot easily
be aware of how many others of their kind are re-
The Natural Monopoly Argument
acting in the same way, at the same time, to the
An industry is a natural monopoly if in the
same bit of mass media information, they are par-
range of output at which it operates the average
ticularly likely to find that their sell order has been
unit cost for a given firm tends to decrease as the
executed in the midst of a temporary excess of sup-
volume of its output increases. Under these con-
ply, while their buy order was executed while there
ditions the average cost will be lower if output is
"happened" to be a temporary excess of demand.
concentrated in a single firm than if it is divided
Furthermore when a temporary imbalance re-
among a number of firms.
sults from the decisions of a large number of sepa-
In recent years a number of studies by Demsetz,
rate individuals, it is difficult for a market maker
Tinic and by the New York Stock Exchange have
who recognizes the imbalance to determine how
considered the relationship between the average
large it will be or how long it will continue. By
bid-asked spread in a stock and the volume of
contrast, when an imbalance results because of the
trading in that stock. In each case the data used
decision of one or a small number of institutions,
are a cross-section of different stocks traded on
the market maker can frequently determine the
the New York Stock Exchange. All the studies
magnitude of the potential imbalance, and thus
agree that there is an inverse relationship between
make his inventory decision with much more cer-
the size of the bid-asked spread and the volume of
tainty. Because of NYSE Rule 113 specialists on
trading in the stock. That is, stocks with high
that exchange do not ordinarily contact institutions
volumes of trading tend to have small bid-asked
directly. But they may obtain information about
spreads and vice versa.
institutional trading imbalances indirectly from, the
institutions' brokers and from block positioners.
Whatever the reasons, the facts are that for a
given decline (rise) in price, there is a fairly consistent tendency for NYSE specialists to be willing
to accumulate (dispose of) a larger amount of
inventory when institutions account for a larger
proportion of the trading.4 Furthermore, large dayto-day price changes occur less frequently when
institutions account for a high proportion of the
trading in a particular stock than when they account for a more moderate proportion.'
Thus the provision of adequate liquidity in
If the size of the spread reflected the market
maker's costs, and if the volume of trading in a
stock measured the "output" of the miarket maker,
then the fact that the spread is inversely related to
volume would be good evidence of economies of
scale in market making. This seems to be Demsetz's
position. For example, he writes that "Competition of several types will keep the observed spread
close to cost".6 If competition were sufficiently
effective to keep the observed spread close to cost,
specialists should earn no more than a competitive
return. However, data collected by the Institutional Investor Study effectively demonstrates that
many specialists earn rates of return far in excess
depth is the most important criterion for evaluating
of any conceivably competitive level. For examt
the economic effectiveness of a market-making
ple, the average gross monthly rate of return, be-
system.
fore taxes, in active stocks, ranged from 88 to
II. ARGUMENTS FOR MONOPOLY
Two main lines of argument have commonly
been advanced in support of the proposition that
market making is best provided by a single firm.
One line claims that market making is a natural
monopoly. The second claims that certain kinds
of socially desirable behavior would not be forthcoming under competition, and that to make regulation effective in calling forth such behavior it is
necessary to have a single market maker to whom
190 per cent, depending on the type of specialist.
Furthermore, this does not seem to be a recent
phenomenon. Data in Special Study, conducted
nearly ten years earlier, confirms this finding."
Rates of return as high as these might be attributable to risk. But in fact the specialists who bear
less risk generally earn higher rates of return than
those who bear more risk.
The fact that some New York Stock Exchange
specialists earn monopolistic profits is direct and
CONTINUED ON PAGE 64
20
FINANCIAL
ANALYSTS
JOURNAL
/
SEPTEMBER-OCTOBER
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1971
Which road to an efficient market
CONTINUED FROM PAGE 20
doubt that by providing depth in both good markets
and bad, a specialist is more likely to accumulate
an inventory and thus increa.se his risk. However,
convincing evidence that the competition they face
the business of the specialist is not an unrewarding
is not sufficient to keep the. observed spread close
one. A responsibility to provide continuity with
to costs. Under these conditions the fact that the
depth is a reasonable concomitant to the many
size of the spread is inversely related to the volume
privileges specialists enjoy." 13 Implicit in this stateof trading does not necessarily imply that market
ment is the assumption that in the absence of the
making is a natural monopoly.9
special privileges that specialists enjoy as a result
The empirical fact that high volume issues on
of their monopoly position, adequate liquidity in
the NYSE tend to have lower spreads is consistent
depth would not be forthcoming. We will argue
with at least two other hypotheses that do not
later in this paper that competition can be relied
imply that market making is a natural monopoly.
on to provide adequate liquidity in depth.
One hypothesis is that specialists face more comIn any case, it seems clear that the current regupetition in high volume issues than in low volume
latory
practices of the New York Stock Exchange
issues, and that they therefore quote more nearly
competitive bid-asked spreads in those issues. A
second hypothesis is that it is less risky to make a
market in a high volume issue, and that spreads in
such issues would be lower for this reason even if
there were, competing market makers.'0
Market making may or may not be a natural
monopoly. There is no empirical evidence to sup-
port the proposition that it is, in fact, a natural
monopoly. However, if there are no barriers to
effective competition, and if market making is a
natural monopoly, then competition will result in a
cialists to provide adequate liquidity in depth.
The New York Stock Exchange does not regularly
collect any data that enables it to determine
whether individual specialists in particular stocks
are providing adequate liquidity in depth. At best
subjective judgments are made occasionally on. an
ad hoc basis about particular situations in which,
in the opinion of the regulators, inadequate liquidity has been provided. The Institutional Investor
Study found substantial differences among special-
single market maker for each stock. If there. are no
ists in the extent to which they provide liquidity in
barniers to competition, however, a single market
depth.14 It also found no evidence that the Ex-
maker under these conditions will not be able to
change has used its most effective positive sanction,
earn monopoly profits. As soon as he attempts to
the allocation of stocks to, specialist units, to en-
do so, other competitors will take over the market-
courage those specialists who are doing an excep-
making function." Thus the possibility that market making may be a natural monopoly is no
tional job of providing liquidity in depth.'5
A second kind of socially desirable result that
justification for maintaining barriers that prevent
regulation, conceivably obtains from monopolistic
effective competition.
market makers is better markets for low volume
stocks. Whether present market-making monopo-
Making Regulation Effective
64
are not being effectively used to encourage spe-
lies improve the markets for such stocks I do not
The second line of argument in favor of mo-
know. However, it is hard to see why this result
nopoly is that artificial barriers to competition are
would be socially desirable. Why should certain
socially desirable because they enable regulation to
stocks that happen to be listed on the New York
force market makers to behave in ways that might
Stock Exchange benefit from having their market-
not be profitable for them under conditions of
making activities subsidized while other low vol-
competition.12
ume stocks trading in other markets, for example,
What types of behavior do those who, take this
on the American Stock Exchange or the OTC
position hope to encourage? Some appear to be-
markets can not be so subsidized? It might be
lieve that specialists who are regulated monopolists
possible to, justify this sort of arrangement from
can be induced to provide more liquidity in depth
the point of view of the private interests of the
than would be achieved under conditions of com-
members of the New York Stock Exchange. How-
petition. For example, consider the following
ever, it seems almost im.possible to justify it from
quotation from the Special Study: "There is no
the point of view of the public interest.
FINANCIAL
ANALYSTS
JOURNAL
/
SEPTEMBER-OCTOBER
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1971
It is sometimes claimed that the. market maker
However, as we have argued above, there is no
who is a regulated monopolist will perform better
empirical evidence to suggest that market making
under occasional chaotic conditions such as those
is subject to economies of scale of a sort that would
that occurred on the day Eisenhower's heart attack
lead to a single market maker in a particular stock.
was announced.'6 Here too, the evidence is, at
1-t is impoirtant to know how the existence of com-
best, mixed. Even if one grants the point, the cost
peting market makers might affect the supply of
of achieving this result far exceeds any conceivable
liquidity in depth which is a most important cri-
benefits. The market conditions referred to pre-
terion for judging a market-making system.
sumably result when an event of transcendent im-
Suppose two market makers are both competing
portance occurs and investors do not have time
to make a market in a particular stock, but that
to evaluate its importance. Under those condi-
one of them has a greater willingness to provide
ditions, full time investors have a tremendous
liquidity in depth than the other. If an excess of
comparative advantage over the great majority of
supply develops, both market makers would tend
small investors whose primary occupations prevent
to accumulate stock. Both will reduce their bids as
their devoting full time to the market. If public
their inventories accumulate. However, the market
policy makers feel that the disadvantage inherent
maker who is more willing to provide liquidity in
in the position of most small investors under these
depth will have a larger increase in inventory for a
circumstances is so great, the appropriate remedy
given reduction in the bid price than the other.
would be to temporarily close the market. Trading
This is what is meant by a greater willingness to
halts for individual stocks are not infrequent. Sub-
provide liquidity in depth. The result is that his
sidizing monopolistic market makers, perhaps for
bid will usually be deeper, and often more com-
years, in the hope that their performance under
petitive than the bid of the other firm. If the
those conditions will in some sense be superior
competing bids are known to all potential sellers,
seems, at best, a costly remedy with highly un-
most transactions will take place between the
certain consequences.
selling investors and the market maker providing
greater liquidity in depth. Thus, under compe-
Ill. ARGUMENTS FOR COMPETITION
tition, the market maker who provides greater
liquidity in depth will participate in a larger frac-
The conditions necessary for competition will be
tion volume of the business than the other market
spelled out in more detail later in this paper. How-
maker. Furthermore, this market maker, since he
ever, the essential condition is that there be no
has acquired inventory when there was a tempo-
artificial barriers to prevent a broker-dealer from
rary excess of supply, will be in a better position to
performing a market-making function in a par-
make competitive offers when a temporary excess
ticular stock if it considers that such performance
of demand develops. With competition, therefore,
would be in its own interests. As indicated above
market makers who supply more liquidity in depth
we do not prejudge whether the outcome of this
will gain a larger share of the total volume.
freedom would in fact be more than one market
maker at a time. Under conditions of competition,
IV. REQUIREMENTS FOR COMPETITION
there would be a reduction in the level of profits
There are many active New York Stock Ex-
earned by market makers. Any firm that generated
change listed securities in which markets are made
monopoly profits would be inviting potential competitors to enter its market, and take over all or
by more than one broker-dealer. In addition to the
part of the market-making function. If there are
New York specialist, several regional exchange
economies of scale, so that typically only one
specialists and third market makers may be at-
market maker is active in a particular stock at a
tempting to compete with each other. However,
particular time, this reduction in monopoly profits the existing state of affairs cannot, in any real
will occur either because the average bid-asked
sense, be described as one of effective competition.
spread is narrower or because the firm provides
The primary requirement for effective competition
more liquidity in depth. It is difficult to know al
for small transactions is that each market maker
piriori which of the two will account for the lion's
must be able to expose his bids or offers to all of
share of the reduction.
the available volume. This requires an effective
FINANCIAL
ANALYSTS
JOURNAL
/
SEPTEMBER-OCTOBER
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1971
65
communication system to link geographically sepa-
necessity and efficacy of the regulatory framework
rated market makers and investors. The NASDAQ
itself is likely to be viewed with scepticism or
system appears to be one reasonably effective de-
worse by those who suffer from the resulting lack
vice capable of achieving the required exposure if
of competition.
it is enlarged to include the bids and offers of all
exchange specialists in all listed stocks.
A second requirement is that any market par-
A third requirement for effective competition is
that there be no unnecessary barriers to freedom
of entry and exit for market makers. Specifically,
ticipant be free of anti-competitive regulation that
qualified broker-dealers should be free to compete
restricts his ability to seek the most favorable
by making markets in a particular stock whenever
execution. Specifically this requires the elimination
they want to. They should also be free to cease
of such patently anti-competitive devices as NYSE
making such markets whenever they want to. The
Rules 394 and 113 and the elimination of non-
more cumbersome the administrative procedures
competitive brokerage commission rates.
for entry and exit, the more freedom existing
NYSE Rule 394 serves to discourage exchange
market makers have to avoid competition. The
members and member firms from conducting trans- fear that no one might be interested in makina a
actions in listed stocks in the third market. Part
market for some of the less active listed stocks
(a) of the rule requires obtaining permission from
seems unwarranted for the type of company listed
the exchange in advance before conducting such
on the NYSE, when one considers that even very
a transaction. Part (b) specifies procedures and
much smaller companies traded in the over-the-
conditions that must be met before permission can
counter market are able to attract some interest
be granted. The rule is discriminatory in that non-
from market makers.
member institutions can deal directly with third-
Another requirement for a qualified market
market dealers, while individual investors as a
maker is his financial integrity. In addition, if he
practical matter cannot. The rule, insofar as it is
also acts as a broker, he should be subject to
effective, tends to provide for pronmpt public re-
regulations to insure that he gives priority and
porting of transactions. The same objective could,
precedence to brokerage orders left in his care.
and should be accomplished by providing for
The type of market making we have been de-
prompt public reporting, over a common com-
scribing is primarily designed to serve individual
munications system, of trades in all markets.
Rule 113 prevents exchange specialists from
accepting orders directly from non-member insti-
investors or small institutions. It seems likely that
large institutional portfolios will continue to rely
heavily, as they do now, on the services of special-
tutions. In effect the rule forces such non-member
ized block trading firms. Those firms themselves
institutions to interposition a broker between them-
occasionally trade in the regular small-order mar-
selves and the specialist. The rule restricts the
ket, particularly when laying off positions. The
ability of the specialist to compete, since no such
block trading market as it currently exists is com-
interpositioning is required when institutions deal
petitive, at least in the sense that there are no
with third-market firms, or with member firm block
artificial barriers to entry or exit.
positioners. Insofar as the rule is designed to help
If NYSE Rule 113 were to be eliminated, as we
maintain fixed minimum commissions on institu-
have suggested it should be, some additional regu-
tional trades, it is rapidly becoming obsolete.
latory changes would be needed. At present, Rule
Both Rule 394 and the fixed minimum commis-
113 tends to discourage mergers between special-
sion structure are sometimes justified as being
ists and block trading firms, since that rule would
necessary to encourage brokerage firms to subject
prohibit the merged firm from engaging in block
themselves to the more expensive type of regula-
positioning activities in its specialty stocks. If Rule
tion associated with exchange membership. A full
113 were eliminated, some mergers of this sort
discussion of equality of regulation is beyond the
might take place. Such mergers are not necessarily
scope of this paper. But, at best, this argument
anti-competitive, but the potential for anti-com-
suggests using inappropriate means to achieve a
petitive mergers can be eliminated only by certain
desirable enld. When unnecessarily anti-competi-additional regulatory changes.
tive devices are used to promote regulation, the
The consequences of failing to recognize this
66 FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1971
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problem could be serious. Suppose, for example,
tory alternative would be to discourage mergers of
that a firm making ordinary two-sided markets in
block traders and other market makers.
a group of stocks merges with a block trading firm.
Large and well capitalized market-making firms
The merged firm will have a strong incentive to
might also want to escape from a competitive
provide liquidity in depth to purchasers while it is
regime by engaging in periodic episodes of de-
working off positions acquired as a result of block
structive competition in order to discourage other
trades. However, if a block trading competitor
dealers from entering the markets for particular
acquired a position in one of the stocks in which
stocks and providing effective competition. Such
the merged firm was making a two-sided market,
behavior in principle would be illegal under exist-
the merged firm might be tempted to refrain from
ing anti-trust laws. However, peculiar enforcement
providing adequate liquidity in depth while the
problems might arise. The routine collection and
block trading competitor was laying off his posi-
analysis by regulatory authorities of information
tion. Such behavior would be difficult to regulate.
on market makers' trading patterns and rates of
It might rather quickly lead to a situation in which
return will be necessary if the relevant anti-trust
mergers between market makers and block trading
provisions are to be effectively enforced.
firms took place, with each such merged firm mo-
nopolizing the block trading market in the stocks
for which it was making effective public markets.
At present, a block trading firm, that has ac-
quired a position is peculiarly dependent on the
V. FUTURE CHANGES IN MARKET MAKING
Providing for effective competition in the mar-
ket-making function will not automatically solve
the problem of meeting the ,market-making needs
major market makers in the stock in which it is
of the future. One of the main advantages of com,
holding a position. If the market maker is unwill-
petition is that it will change the way in which such
ing to provide adequate liquidity in depth, the
questions are answered. Instead of emerging from
block positioner m.ay see the quoted market value
legislative or administrative rule making, or from
of its holdings decline substantially because of a
negotiation and bargaining between interested par-
relatively small imbalance of public orders. The
ties, the answers, under a competitive regime, will
block positioner may have a stronger interest in
providing adequate liquidity in depth during the
period in which he is gradually working out of his
position than does the regular specialist. Data
collected by the Institutional Investors Study su.g-
emerge from experimentation under realistic conditions.
It hardly seems possible that one firm will
succeed in satisfying the enormous diversity of
market-making needs of the many different types
gests that informal and somewhat questionable
of investors in the thousands of publicly traded
arrangements between block trading firms and
issues. It is to be expiected that individual securi-
specialists sometimes exist now to help overcome
ties firms, rather, will concentrate on satisfying, a
this problem.'
particular subset of the market-making needs, by
A block trading firm could overcome the prob-
developing the facilities and capabilities appro-
lem directly if it were allowed to purchase addi-
priate for that subset. There would appear to be
tional stock on the open market in order to stabilize
at least three, main dimensions in terms of which a
the price. If such activity were undertaken by a
firm defines its market-making subset: the classes
block trading firm, the activity might be interpreted
of securities to be positioned, the kinds of investors
as price manipulative and subject the firm to legal
to be served, and the types of market-making re-
action.'" It would seem desirable to modify the
quirements to be handled - for example, quick
regulatory framework to, explicitly recognize that
low-cost highly-automated executions of simple
block traders, and more specifically, block posi-
transactions at one extreme. versus the servicing
tioners are performing a market-making function
of large, complex transactions at the other. The
and should be allowed under appropriate safe-
optimum combination of market-making services
guards to stabilize the market while they are
disposing of their positions. While desirable at
present, such regulatory changes would become
for a particular firm will undoubtedly change over
vital if Rule 11 13 were eliminated. A less satisfac-
the proportion of trading done by ins,titutions and
time in response to changes in comm,unications
technology, the r.elative costs of lablor and capital.,
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1971 67
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by individuals, and the exigencies of competition.
by the ellipses reinforce the train of thought de-
The present institutional and regulatory environ-
veloped in the section quoted, while others could
ment has not wholly discouraged experimentation
be interpreted as providing qualifications, or even
and adaptation, as is indicated by the growing im-
escape routes. This article will have served one of
portance of the third market and the regional
its important objectives if it motivates the reader
exchanges, the explosive growth in block trading,
to consult the original source of the quotation, and
and the approaches to trading automation repre-
even better, the accompanying Study. *
sented by BAS, Autex, Instinet and NASDAQ.
FOOTNOTES
On the other hand, many features of the present
environment are in the writer's judgment unnecessary barriers to competition and change. In this
context it is appropriate to close by quoting at
length from the position expressed by the Securi-
ties and Exchange Commission in the Letter of
Transmittal it submitted to the Congress with the
report of its Institutional Investor Study.
"The evolution of the securities markets
has been, and may continue to be, affected
and distorted by barriers to competition.
Among the most significant of these are mini-
mum commission rates and rules that insulate
markets, market-makers and broker-dealers
from each other. . . the Commission and
other regulatory authorities should endeavor
to prevent the evolution of the market-place
from being distorted by unnecessary restraints
on competition.... To provide for dealer
functions, all responsible market-makers
should have access to the central market....
Given present technology, it is neither necessary nor desirable that all such dealers be
present in any one geographical location....
The participation of competing dealers in the
central market will also reduce the element
of monopoly power which has accompanied
past effort to establish a central market and
will make it possible for potential abuses of
such monopoly power to be controlled not
only by regulation, but to an increasing degree by competition. In summary, our objec-
tive is to see a strong central market system
created to which all investors have access, in
which all qualified broker-dealers and existing market institutions may participate in
accordance with their respective; capabilities,
and which is controlled not only by appro-
priate regulation but also by the forces of
rompnetitinn ." 1 9
In the interests of full disclosure it should ble
stated that some of the omitted passages indicated
1. The tick test, as presently applied, is almost
totally useless as a measure of the extent to
which a specialist is supplying liquidity in depth.
Nearly all NYSE specialists achieve consistently
good scores by this test. At the same time they
are able, and not infrequently do in fact, reduce
their holdings on days when prices are falling,
or increase them on days when prices are rising.
See *IS, Table XII-14, pp. 1873-4.
The Special Study recognized this limitation of
the tick test. It concluded that "The Exchanges'
'tick' test, whatever its other uses, is not by itself significant as an evaluation of the 'stabilizing' of the market by specialists and should not
be so represented." Special Study, Part 2, p. 170.
2. Among the studies that emphasize the bid-asked
spread are those of Demsetz, Tinic, and the
NYSE.
3. For evidence on this point, see IIS (1971), pp.
1407-1411, 1449-1457, 1504-1508, 1517, 1722-35,
and 1880-85.
4. See IIS, Table XII-13, pp. 1870-71.
5. See IIS, Table XII-19, p. 1884.
6. Demsetz, p. 43 goes on to describe the main types
of competition as " (1) rivalry for the specialist's
job, (2) competing markets, (3) outsiders who
submit limit orders rather than market orders,
(4) floor traders, who may bypass the specialist
by crossing buy and sell orders themselves, and
(5) other specialists."
7. IIS, pp. 1914-28, and especially Table XII-24,
p. 1925. The rates of return quoted in the text
include income from floor brokerage as well as
trading account income; but they exclude long
term capital gains.
8. In 1959 the annual gross rate of return before
taxes for all NYSE specialist units, for all
listed stocks was 59 per cent. The corresponding
figure for 1960 was 45 per cent. Even when the
market value of their seats was included in capital employed, the percentage of units earning
rates of return of 30 per cent or more was 69 per
cent in 1959 and 48 per cent in 1960. The percentage of units earning less than 10 per cent
per year was only three per cent in 1959 and only
eight per cent in 1960. See Special Study, Part
2, pp. 68-70, and p. 374.
9. The amount of competition specialists face probably increases with the volume of trading in a
security. Under these conditions it would be
profitable for the specialist to quote lower bidasked spreads in high volume stocks, even if his
68 FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1971
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cost were not systematically related to the vol-
shifts in market prices provides a major justification for the specialist's existence." Wolfson
ume of trading.
and Russo (1970), p. 172.
10. I am indebted for this point to Seha Tinic, who
also presents a theoretical argument against the
natural monopoly argument in a forthcoming
paper, "The Economics of Liquidity Services,"
to be published in the Quarterly Journal of Economics. Some empirical evidence from the overthe-counter markets that the size of the spread
in a stock depends on the volume of trading in
the stock, rather than the volume of activity of a
particular dealer is contained in a recent article
17. IIS, pp. 1600-01, 1610-11, 1947.
18. IIS, p. 1611.
19. IIS, pp. xxii-xxv.
REFERENCES
Demsetz, H. "The Cost of Transacting," Quarterly
Journal of Economics, LXXXII (February, 1968)
pp. 33-53.
by Heinze.
11. For a description of how this process actually
worked on the New York Curb Market, before
it moved indoors, see Sobel (1970), 87-88 and
Heinze, D. C., "An Empirical Study of Spread Size
Determinants," North Texas State University
Business Studies, Spring, 1970, pp. 52-62.
159-160.
New York Stock Exchange, Research Department.
The Influence of Regional Exchange Competition
on the NYSE. New York: October, 1969.
12. In reviewing the history of the specialist system,
the Special Study concluded that the elimination
of "competing" specialists followed rather than
preceded the elimination of competition among
them. "Historically, competition o cc u r red in
stocks where the existing specialist's service was
not satisfactory or where the volume was heavy.
At present competition is unsatisfactory for
several reasons. Commission firms are often confused as to who is quoting the market in active
stocks. The commission firms do not shop for the
best service but often give each competitor half
their brokerage business. In addition, neither
competitor accepts full market-making responsibilities, thus adding to the Exchange's regulatory problems." Special Study, Part 2, pp. 62-63.
Sobel, R. The Curbstone Brokers: The Origins of
the American Stock Exchange. New York: The
Macmillan Company, 1970.
Tinic, S. "The Value of Time Preferences and the
Behavior of Liquidity Costs in the New York
Stock Exchange." Unpublished Ph.D. Dissertation. Cornell University, 1970.
U. S. Securities and Exchange Commission. Report
of the Special Study of Securities Markets. Washington, D. C. U. S. Government Printing Office,
1963.
U. S. Securities and Exchange Commission. Institutional Investor Study Report. Washington, D. C.
U. S. Government Printing Office, 1971.
13. Special Study, Part 2, p. 126.
14. IIS, pp. 1880-1891.
Wolfson, N. and Russo, T. A. "The Stock Exchange
Specialists: An Economic and Legal Analysis,"
15. IIS, pp. 1929-1931.
16. For example: "The possibility of sudden large
Duke Law Review (1970, No. 4), pp. 707-746.
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