Alternative Trading Systems: Will Computers Replace Stock Exchanges?

Alternative Trading Systems: Will Computers Replace Stock Exchanges?

Order Code RL30195
CRS Report for Congress
Received through the CRS Web
Alternative Trading Systems:
Will Computers Replace Stock Exchanges?
May 27, 1999
(name redacted)
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

ABSTRACT
Computer systems that perform all the transaction functions of a traditional stock
exchange, called “alternative trading systems” (ATSs), now account for about 15% of U.S.
stock volume and are growing rapidly. Benefits to ATS investors include lower trading costs
and better information about market conditions. However, traditional exchanges are not just
trading mechanisms; they are regulators. There are concerns of a “regulatory gap” — the
ATS may not provide the same level of investor protection and market integrity. In December
1998, the SEC issued rules for ATSs: they may now choose to register as exchanges or to be
regulated by a new Regulation ATS. This report presents background information on the
ATS markets and on the new SEC rules. It will not be updated regularly barring significant
legislative or marketplace developments.

Alternative Trading Systems:
Will Computers Replace Stock Exchanges?
Summary
Recently, the retired head of a large investment bank reflected on the great
changes he had seen on Wall Street over his long career. The deregulation of
commissions and the shift from partnerships to public ownership were key events, but
the changes brought by electronic technology were “a revolution” that, although still
in the early stages, “superseded the others infinitely.”
Perhaps the most visible aspect of this electronic transformation has been the rise
of Internet trading by small investors. Another change, however, although less
publicized, may have a much greater impact on the way stocks are traded. This is the
development of “alternative trading systems” (ATSs), computer systems that match
buyers and sellers of stocks and execute transactions without the services of
traditional brokers or exchanges. Benefits to investors of “cutting out the middleman”
include significantly lower trading costs and better information about market
conditions and prices. In the long run, competition between ATSs and traditional
markets may lower the cost of capital for business.
However, the rise of the ATS raises questions for market oversight. The
traditional stock exchange is not just a trading mechanism: under U.S. securities law,
it is also a regulator. Exchanges registered with the Securities and Exchange
Commission (SEC) are required to make and enforce rules against fraud and
manipulation, to treat all participants fairly, and to act in the public interest. Up to
now, ATSs have not been required to register as exchanges — their legal status has
been as broker/dealers. Accordingly, there have been concerns about possible gaps
in investor protection, market integrity and stability, and the absence of regulatory
redress for problems that may arise in ATS trading.
In December 1998, the SEC adopted rules concerning the regulation of ATSs.
An ATS now has the choice of whether to register as an exchange or to continue to
be regulated as a broker/dealer subject to a new Regulation ATS, which subjects an
ATS to an increasing level of exchange-like regulation as its trading volume rises.
One of the largest ATSs, Island ECN, has indicated that it will apply for registration
as an exchange. Many of the largest securities firms, computer companies, and
financial data providers have announced plans to launch an ATS.
The House Banking Committee’s Subcommittee on Capital Markets, Securities,
and Government-Sponsored Enterprises held a hearing on March 25, 1999 on
technology and the financial markets. Several witnesses addressed ATS-related
issues. No current legislation is pending, but the subject is an important one for
congressional and regulatory oversight.
This report presents background information on the ATS markets and on the
new SEC rules. It will not be updated regularly barring significant legislative or
marketplace developments.

Contents
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Regulatory and Oversight Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Two-Tiered Market: Instinet and Nasdaq . . . . . . . . . . . . . . . . . . . . . . 4
The ATS and Price Manipulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Market Fragmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Gaps in Regulation: Exchange Vs. ATS . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The SEC’s New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Redefining “Exchange” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Regulation ATS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
What Next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
List of Figures
Figure 1. Stock Trading Volume, 1970-98 . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Alternative Trading Systems:
Will Computers Replace Stock Exchanges?
The computerization of stock trading is not a new phenomenon. Trade
execution, order handling, transaction processing, record keeping, and price
dissemination have all become increasingly automated over the past few decades.
What is new is that the availability of vast amounts of cheap computing power has
enabled these automated systems to take a leap forward. Instead of merely increasing
the speed and capacity of existing markets, it is now feasible for privately-owned
computer systems to replicate all the trading mechanisms that stock markets provide.
They have become, in the jargon, alternative trading systems. Such systems, which
match buyers and sellers and execute transactions without the services of traditional
intermediaries, now account for almost 30% of trading volume in Nasdaq stocks and
may soon handle significant fractions of New York Stock Exchange volume as well.
Alternative trading systems (ATSs) can provide improved
1
access to markets and
information, longer trading hours, and lower brokerage costs. Competition among
markets is beneficial to both traders and the corporations who use the stock market
to raise capital. However, the rise of ATSs raises questions for market oversight.
The traditional stock exchange is not just a trading mechanism; under the Securities
Exchange Act of 1934, it is also a regulator. Stock exchanges registered with the
Securities and Exchange Commission (SEC) are required to make and enforce rules
against fraud and manipulation, to treat all participants fairly, and to act in the public
interest.
Up to now, ATSs have not been required to register as exchanges — their legal
status has been as broker/dealers. Accordingly, there have been concerns about
possible gaps in investor protection, market integrity and stability, and the absence of
regulatory redress for problems that may arise in ATS trading.
In December 1998, the SEC adopted rules concerning the regulation of ATSs.2
An ATS now has the choice of whether to register as an exchange or to continue to
be regulated as a broker/dealer under a new Regulation ATS, which subjects an ATS
to an rising level of exchange-like regulation as its trading volume rises. One of the
largest ATSs, Island ECN, has indicated that it will apply for registration as an
1Other terms used, often interchangeably, are “proprietary trading system” (PTS) and
“electronic communications network” (ECN).
2 U.S. Securities and Exchange Commission. Regulation of Exchanges and Alternative
Trading Systems. (Release No. 34-40760) Federal Register, v. 63, December 22, 1998.
p. 70844.

CRS-2
exchange.
3
Many of the largest securities firms, computer companies, and financial
data providers have announced plans to launch an ATS. Some observers believe that
the eventual impact on the stock market will be revolutionary, comparable to May
Day in 1975, when fixed commissions were abolished. The effects on the market
4
,
and the implementation of the SEC’s new regulations will be important subjects for
regulatory and congressional oversight in the years ahead.
Background
In the late 1960s, Wall Street was nearly paralyzed by a paperwork crisis.
Brokerages’ back offices were unable to process the growing volume of trades
generated by the “go-go”
market of the time. As Figure 1. Annual Stock Trading Volume, 1970-98
figure 1 suggests, a whole
year’s trading then would
fit in a slow week in 1999.
The rapid and continuous
growth in capacity reflects
massive investments in
automation.
The effect of
information processing
technology on the market
has not been simply to
make the existing trading
systems faster and more
efficient. The stock market
has been altered in
fundamental ways by
several technology-
dependent innovations, including derivatives markets, program trading and other
computer-driven investment strategies, and global investing.
Similarly, the vast increase in trading volume does not just reflect more (or more
active) traders. The rise of institutional investors — pension funds, mutual funds, and
others — has had a transforming effect on Wall Street. When institutional investors
wished to reallocate their portfolios, the resulting trades were often so large that the
traditional NYSE auction market, with a specialist post for each stock, surrounded
by a crowd of brokers and traders, was not always satisfactory. Transaction costs
were high; in addition to brokerage commissions and specialist fees, institutional
orders were often too large for the system to handle smoothly. An order would have
3Schonfeld, Erick. Why Island Wants to Be an Exchange. Fortune, March 15, 1999. p.
207-208.
4 See, e.g., Lux, Hal and Jack Willoughby. May Day II. Institutional Investor, v. 33,
February 1999. p. 45-56.

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a “market impact” — the share price would have to rise or fall significantly before
the entire order could be absorbed.
Institutional investors had the incentive, the market power, and the financial
resources to demand or create alternatives to the NYSE floor. One response was the
emergence of the “upstairs” market. Specialized brokers known as block positioners
emerged to match institutional buyers and sellers. The transaction would be sent to
the floor for final execution, but only after buyers and sellers had agreed on a price.
In some cases, large transactions would never go to the floor at all, but would take
place directly between the principals: such deals make up what is called the “fourth
market.”
The ATS is the product of two factors: (1) the desire of institutional investors
to cut trade execution costs and avoid the market impact of their trades, and (2)
advances in data processing and electronic technology. The first ATS to have a
significant impact on stock trading was Instinet, a system developed in the early 1970s
and still owned by Reuters. Instinet became a force in the 1980s, as it developed into
a kind of parallel Nasdaq market. Access to Instinet is restricted to members, who
are institutional investors and the large securities firms who served as dealers, or
market-makers, on the public Nasdaq market. Instinet participants enter their buy and
sell price quotations and execute transactions automatically through the computer
system. Instinet also offers after hours trading and a market for foreign securities.
Instinet is the largest ATS, with about 20% of Nasdaq volume. Island ECN, the
ATS that has applied to the SEC for exchange status, accounts for about 6% of
Nasdaq volume. The other dozen or so ATSs in operation today have only a bit more
than 2% of Nasdaq volume, but that could change dramatically. ATSs have the
potential to attract volume because their transaction costs are very low: Island, for
instance, charges a flat fee of 0.015 cents per share traded. In addition, strong
competitors to the existing ATSs are likely to emerge. Over the past year or so,
announcements of plans for a new ATS have become almost a weekly event, and
many of these are joint ventures or investments involving the largest firms in the
securities, computer, and telecommunications industries. At the same time, numerous
existing exchanges and ATSs, both in the United States and abroad, have announced
mergers, linkages, and alliances, all seemingly driven by the new competitive
environment created by technology and market forces.
Regulatory and Oversight Issues
The technological revolution that has brought forth the ATS has had obvious
benefits for the stock market. Access to the market and market data has improved
greatly. Institutional investors have a greater number of investment and execution
choices as a result of competition, which has also lowered trading costs and made the
market more efficient. Electronic linkages among various markets may advance the
5
Market
5
efficiency increases as trading costs are reduced because investors are more likely to
react to new information by buying or selling stock — making stock prices more reflective
(continued...)

CRS-4
goal, established by Congress in the Securities Acts Amendments of 1975 (P.L. 89-
29), of a national securities market.
However, the new markets also have the potential to undermine several
fundamental goals of securities regulation, including fair and equitable treatment of
all market participants and investor protection. Will the rise of the ATS result in a
two-tiered market, divided between those with access to private markets and those
who can only trade on the public markets? Are the electronic markets susceptible to
new forms of fraud and manipulation, and will the ATSs be able to maintain the level
of surveillance provided by the traditional markets? In publishing its 1998 ATS rules,6
the SEC noted two examples that indicate the seriousness of these concerns.
The Two-Tiered Market: Instinet and Nasdaq
In 1994, a price-fixing scheme on the Nasdaq market came to light. Nasda
7
q
market makers had adopted the convention of not using prices that ended in odd-
eighths. This meant that the minimum bid/ask spread8 was artificially maintained at
25 cents per share. As part of the investigation that followed, the SEC turned its
attention to the function of the Instinet, the ATS used by institutions and securities
firms to trade Nasdaq stocks.
9
The SEC found that 90% of transactions on Instinet involved Nasdaq market
makers, or dealers, and that 85% of the prices quoted over Instinet were better than
the prices offered by those same market makers to investors who traded the same
stocks on Nasdaq. The “pricing convention” was not followed on Instinet; odd-eighth
prices were common. The disparity in pricing could exist because Instinet prices were
not reported to the public. In effect, there were two markets: a private one limited
to dealers and institutions and a second market where public investors traded at
inferior prices. The SEC concluded that the existence of Instinet supported the price-
fixing arrangement, because the availability of a private market removed the incentive
for dealers to compete on price (by narrowing spreads) on the public market.
(...continued)
5
of the true economic prospects of firms and industries. In the long run, increased market
efficiency improves economic efficiency, as the market better allocates capital to its best uses.
6Summarized beginning on page 7 below.
7See CRS Report 96-214E, Nasdaq: Investigations and Reform, by (name redacted),
8The spread is the difference between the highest price a dealer is willing to pay for a share
of stock (the “bid” price) and the lowest price at which he is prepared to sell (the “ask”).
Other things being equal, the wider the spread, the greater the dealer’s profit, and the higher
the customer’s transaction cost.
U.S.
9
Securities and Exchange Commission. Report Pursuant to Section 21(a) of the
Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market. August 6,
1996. p. 21-22.

CRS-5
In response to the scandal, the SEC approved a package of new trading rules in
January 1997. One of these was a requirement that price quotations placed with
10
an ATS also be available to the public. This could be accomplished either by a market
maker displaying its ATS quote together with its public quote, or by linking the
ATS’s bid display to the public quotation system. When the rules went into effect,
four ATSs, including Island and Instinet, began to display their bid and ask prices
alongside the market makers’ quotes on the public Nasdaq trading screens.
The ATS and Price Manipulation
The new trading rules took effect on January 20, 1997. In June 1998, the SEC
filed a cease and desist order against two traders for illegal manipulation of stock
prices on January 27 and 28, 1997. The manipulation exploited one of the ne
11
w
trading rules, which required that limit orders for at least 100 shares placed by
customers be displayed on market makers’ screens if the prices were better than the
market makers’ own quotes.12
The technique of the manipulation was as follows. One of the traders would
enter a limit order to sell 100 shares at a price below the best available current quote
(the “National Best Bid/Offer,” or NBBO). Since limit orders of this size were now
required to be displayed to the public, this would effectively lower the NBBO. Then
the other trader would place a buy order in the same stock, which would be executed
at the lower NBBO price. That done, the first trader would cancel the limit order
13
to sell, and enter a limit order to buy 100 shares at a price above the current NBBO
price, again causing the NBBO to rise. Finally, the second trader would sell the
shares he had just purchased, and the first trader would immediately cancel the limit
order to buy.
The traders were successful in manipulating prices profitably four times,
according to the SEC. A fifth attempt failed when the second limit order was filled
before it could be canceled, with the result that the newly-acquired shares were sold
at the pre-limit price, at a loss.
This particular case involved relatively small amounts of money. (The profits
disgorged under the cease and desist order were only $662.50.) However, this type
of trading, which has been described elsewhere as “ECN price manipulation,” could
14
10U.S. Securities and Exchange Commission. Release No. 34-38156. January 10, 1997.
(Collectively referred to as the “order handling rules.”)
U.S.
11
Securities and Exchange Commission. Administrative Proceeding in the Matter of
Ian Fishman and Lawrence Fishman. Securities Exchange Act Release No. 40115. June
24, 1998.
12A limit order is an order to buy or sell only at a particular price, as opposed to a market
order, which directs the broker to buy or sell immediately at the current price.
Many
13
brokerages guarantee that orders of up to 5,000 shares will be executed at the NBBO
price or better.
14See letter from Walter Raquet of Knight/Optimark Group to Nasdaq, the SEC, et al.,
(continued...)

CRS-6
possibly occur on a larger scale. Moreover, it illustrates a recurring problem in
market design and regulation: mechanisms or rules intended to prevent one problem
can create new loopholes for other kinds of abuse.
Market Fragmentation
Another ATS-related regulatory concern is market fragmentation. Are there
15
disadvantages to having buying and selling interest dispersed among many markets,
as opposed to concentrated in a single exchange? There may be a primary market
where prices are set, and a set of satellite ATS markets that generally rely on the
primary markets for price quotations. If the secondary markets siphon off volume
from the primary market, prices in the primary market may become more volatile, as
there are fewer buyers and sellers to absorb large orders. Another way to put this is
to say that the primary market suffers a loss of liquidity as trading moves to ATSs,
which means that transactions of a given size will have a greater price impact, perhaps
reducing the efficiency of the price-setting mechanism.
At present, the SEC does not view market fragmentation as a pressing problem,
although it foresees that “over time, an ATS may become the primary market for
some securities.”16 Competition among markets brings offsetting benefits, and the
effects of fragmentation are tempered by the trend towards linkages among
exchanges17 and by rules requiring that the best prices be available to all investors.
Moreover, moves to prevent fragmentation by regulation would be criticized as
attempts to defend those with entrenched interests in the status quo.
A related concern is how the ATS markets would fare in a market crisis such as
the October 1987 crash. Since 1987, the NYSE and Nasdaq have been spurred by the
SEC to develop their capacity to handle periods of unexpected and unprecedented
trading volume. If an ATS which could not afford (or lacked the incentive) to build
such excess capacity into its system were to break down in a market crisis, the
solvency of ATS customers or market makers might become uncertain. In crisis,
uncertainty leads to panic: other market participants might withdraw credit or refuse
to deal with such firms, and the perceived problems could become real.
The soaring prices and trading volumes of the current bull market are perhaps
the ideal environment for the growth of ATSs. Whether they will prove to be the
(...continued)
14
February 7, 1997. On the Internet at <www.knight-sec.com/knight/regulatory/2797.html>.
For
15
a general discussion, see U.S. Securities and Exchange Commission. Market 2000: An
Examination of Current Equity Market Developments. Washington, U.S. GPO, 1994. Study
III.

16 U.S. Securities and Exchange Commission. Regulation of Exchanges and Alternative
Trading Systems. (Release No. 34-40760) Federal Register, v. 63, December 22, 1998.
p. 70845.
In
17
other words, because market participants value the liquidity provided by a centralized
marketplace, there is a centripetal force in securities markets that tends to offset the
centrifugal force caused by the search for lower transaction costs, etc.

CRS-7
weak links in the next market plunge, or wither away in a prolonged market slump,
is impossible to predict.
Gaps in Regulation: Exchange Vs. ATS
Although ATS markets now offer virtually all the trading services that exchanges
provide, they have not been regulated or legally classified as exchanges. Instead, as
noted above, they have been registered with the SEC as broker/dealers. Under the
securities laws, an exchange has many responsibilities that a broker/dealer does not.
For example, a registered exchange must consider the public interest in its dealings,
its fees must be reasonable and reasonably allocated, it must establish rules to admit
members on a nondiscriminatory basis, it must conduct market surveillance, and its
rules must not be anti-competitive. An exchange has governmental powers — it can
apply sanctions to its members — therefore its structure of governance is also
controlled by SEC regulation. Members of an ATS regulated as a broker/dealer do
not have the same regulatory redress available to them. Investors who trade on an
ATS may not have the degree of regulatory protection that applies to exchange
customers, even though the two trading venues handle transactions in exactly the
same securities.
On the other hand, some features of broker/dealer regulation are clearly
inappropriate to an ATS: for instance, broker/dealers must join the Securities Investor
Protection Corporation, which insures customer funds against broker failure, even
though most ATSs never hold customer funds, but simply match buyers and sellers.
The primary intent of the SEC rules issued in December 1998 was to resolve
these disparities and inconsistencies.
The SEC’s New Rules
The new SEC rules give an ATS a choice: to register as an exchange, and take
on all the regulatory responsibilities that apply to the NYSE and other stock
exchanges, or to remain regulated as a broker/dealer subject to a new set of
regulations. The SEC offers the choice rather than a “one-size-fits-all” regulation “to
avoid jeopardizing the commercial viability of these markets.”18
Redefining “Exchange”
The first option requires a reinterpretation of the statutory definition of
“exchange.” Under the old definition, an exchange was “a marketplace or facility for
bringing together buyers and sellers of securities.” The new definition is somewhat
more complex: “an organization that (1) brings together the orders of multiple buyers
and sellers and (2) uses established, nondiscriminatory methods under which such
orders interact with each other.”
18U.S. Securities and Exchange Commission. Regulation of Exchanges and Alternative
Trading Systems. (Release No. 34-40760) Federal Register, v. 63, December 22, 1998.
p. 70846.

CRS-8
The first part of the new definition excludes systems that record orders and route
them elsewhere for execution and systems that let investors view the price quotations
of and make transactions with a single market maker or dealer. Such systems are
considered less than full-fledged ATSs and are not subject to the new rules.
The second part of the definition addresses the “two-tiered market” issue: an
ATS registered as an exchange could not simply be a forum where a few securities
dealers and institutional investors traded among themselves on terms more favorable
than those offered to the public. Instead, access must be provided on a
nondiscriminatory basis.
To date, Island ECN is the only ATS to have applied to the SEC to register as
an exchange. The process is expected to take at least a year to complete.
Regulation ATS
Alternative trading systems that wish to continue their legal/regulatory status as
broker/dealers now have to comply with a new Regulation ATS, designed to eliminate
the shortcomings of regulating an exchange-like entity as a brokerage firm. Under
Regulation ATS, an ATS will be subject to an increasing degree of regulation as its
trading volume (measured as a percentage of total volume in any of the securities it
handles) increases. The essential features of Regulation ATS are as follows:
I. An ATS with less than 5% of trading volume in all the securities it lists must:
! file notice of operation and quarterly reports with the SEC;
! maintain various trading records, including an “audit trail;” and
! refrain from using the word “exchange” or “stock market” in its name.
II. In addition to these minimal requirements, an ATS with over 5% of total trading
volume in any National Market System (NMS) security must:
19
! be linked with a registered exchange in order to disseminate its best-priced
orders in NMS securities into the public quote stream; and
! comply with the rules governing execution priorities and obligations that apply
to members of the exchange to which it is linked.
III. In addition, an ATS with over 20% of the total volume in any NMS security
must:
! grant or deny access based on objective standards applied in a
nondiscriminatory manner; and
A
19
security whose last sale price is reported via the Intermarket Trading System (ITS), an
electronic network linking the 8 registered stock exchanges and the Nasdaq. Thus, NMS
securities are all those listed on an exchange or the Nasdaq.

CRS-9
! establish procedures to ensure adequate capacity, market integrity, and
contingency planning.
The new rules do not require an ATS registered as a broker/dealer to perform
market surveillance. However, the SEC noted that it “intends to work with the self-
regulatory organizations [the exchanges and the National Association of Securities
Dealers (NASD)] to ensure that they can operate ongoing, real-time surveillance for
manipulation and fraud and develop surveillance and examination procedures
specifically targeted to alternative trading systems they oversee.”20
The rules provide for a “pilot program,” that is, an exemption from regulation
for new trading systems for two years. Such systems could be put into operation
without prior SEC approval. The exemption, however, does not apply to systems that
exceed the 5% volume threshold: they then become subject to the relevant provisions
of Regulation ATS.
The rules also specify that U.S. securities laws do not prevent an exchange from
reorganizing itself into a for-profit business. (They are now structured as mutual
membership associations, but some observers believe that this reflects the 200-year
old floor-trading model, where access to the market was limited by physical space
constraints.) “Demutualization,” which has been undertaken by several European
exchanges, has the potential to lower the costs of market entry and increase
competition among markets.
Finally, the rules do not address the question of electronic trading of foreign
securities. Technology is available to give U.S. investors direct access to foreign
markets. Instinet is already an international trading system: its screens are available
in many countries, and carry price quotations for many foreign stocks. However,
investors in the United States are not allowed to trade foreign shares that are not
registered with the SEC, which requires compliance with U.S. disclosure, accounting,
and reporting standards. The SEC continues to weigh the risks to investors of
allowing trading of unregistered foreign securities against the competitive interests of
U.S. institutions and traders operating in a global market, and has decided to defer the
issue for now.
What Next?
The hearing on technology and financial markets held by the House Banking
Committee’s Subcommittee on Capital Markets, Securities, and Government-
Sponsored Enterprises on March 25, 1999 provided a first set of reviews for the
SEC’s ATS regulations. Witnesses, who included academics, regulators, an
21
d
exchange and ATS officials, generally agreed that the rules would not impede
Ibid., p. 70848.
20
21Prepared testimony from the hearing is available at the Banking Committee’s web site:
<http://www.house.gov/banking/32599wit.htm>. The hearing covered a range of technology-
related subjects; not all witnesses addressed the ATS issue.

CRS-10
continued innovation in market design and services. There was no agreement — in
fact, few were willing to predict — what the stock market will look like five years
from now. All agreed, however, that the transformation of markets by technology is
nowhere near complete. Several witnesses mentioned a goal that has yet to be
reached: “straight-through processing,” which means that a trade would be ordered,
executed, recorded, reported, and paid for (which now takes up to 3 days) in the same
instant.
There were few suggestions that innovation had gone too far. Several witnesses
suggested the opposite: that obsolete practices were being maintained for the benefit
of a few. “Established institutions in the securities industry have regularly and
effectively used existing regulation to stifle innovation and competition.” Another
22
witness described the traditional exchange floor/auction trading model as one “which
adds unnecessary layers of intermediaries and creates inefficient marketplaces... [by]
greatly distancing the ultimate buyers and sellers from the point of transaction.”
23
Perhaps the central issue in the “computerization” of the stock market is how
much of the service provided by traditional intermediaries — exchanges and
broker/dealers — adds economic value to the market and the economy. Investors
have long since discovered that new communications media can provide them directly
with much of the market information for which brokers used to charge: hence the rise
of discount brokerage. Other functions, however, are not so easily replaced.
Intermediaries provide assurances that securities sold to the public will be of the
quality advertised by the issuing corporation, they guarantee that purchased securities
will be delivered to the buyer or that payment will be received by sellers, and, finally,
in times of crisis they are expected to keep markets open and trading smoothly, even
when their pure self-interest would lead them to withdraw from the market.
The logical end of present trends may seem to be to reconfigure the stock market
into an Internet auction, where buyer and seller meet directly, and let both beware.
However, one witness at the March 25 hearing pointed out that this E-Bay model is
fine for a flea market, but not an adequate model for U.S. financial markets. A
24
s
investors large and small rush towards cheaper trading and direct market access, and
as ATS and Internet entrepreneurs strive to accommodate them, it is worth
remembering that in the long run the pendulum may swing back the other way.
Demands for liquidity may drive markets to consolidate, and demand for market
integrity may increase demands for regulated intermediaries who are charged with
maintaining fair and orderly markets.
In the meantime, an error or overshooting in either direction can impose real
costs on the economy (not just stock market participants) in terms of higher than
necessary capital costs for business and less efficient allocation of investment, which
22Statement of William Lupien, OptiMark Technologies, Inc., ibid. He describes the ATS
rules as “the most significant and positive piece of regulatory structure promulgated in recent
years.”
Statement of Howard W. Lutnick, Cantor Fitzgerald, ibid.
23
Ibid.
24

CRS-11
translates into slower economic growth. Therefore, it is appropriate for Congress and
the SEC not to stand back and let the chips fall where they may, but to continue
oversight and to intervene with new regulation or legislation when required.

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