Building a Better Stock Market: New Solutions to Old Problems

Abstract

In just the past few years, the U.S. equity markets have experienced, among other things, the growth of electronic communications networks (ECNs), the breathtaking expansion of internet trading, and the NASD's acquisition of the American Stock Exchange. Around the world, we have also witnessed the disappearance of trading floors. The astonishing pace of change is attributable to the convergence of three powerful forces: advances in computer technology, intensified competition, and regulatory intervention in market structure. What should be the competitive responses of Nasdaq and the New York Stock Exchange? What effect will these profound changes have on the provision of dealer services and on the quality of our markets? This paper surveys the current scene and addresses these questions. In so doing, we give particular attention to issues concerning the price discovery function of a market place, and to problems concerning liquidity, volatility, and order flow consolidation that have not been resolved after a quarter of a century of extensive analysis and public debate. We also consider the role of a call auction in a hybrid market structure. A call auction is a form of trading that died out in the pre-computer age but is making its reentrance today as an electronic marketplace. In contrast with a continuous market where a transaction is made any time a buy and sell order meet in price, in call auctions orders are batched together and executed in multilateral trades at specific points in time. We suggest that the problems we are facing concerning liquidity, volatility and price discovery are largely endemic to the continuous market, and that the introduction of electronic call auction trading in the U.S. would be the most important innovation in market structure that can be made.