The Importance of Institutional Design: Evidence from the New York Stock Exchange IPO and Reg. NMS

Abstract

For more than two hundred years, the New York Stock Exchange (NYSE) provided the dominant national platform upon which firms could list, and investors could trade, securities. Until 2006, the NYSE was organized as a private mutual non-profit firm whose membership, dominated by investment banks, maintained tight control over floor brokers, specialists and issuing firms. Even when over-the-counter markets such as the NASDAQ and alternative platforms such as “electronic communications networks” (ECN’s) offered faster execution of trades, NYSE floor quotes were protected against “trading through” to such competing venues (the so-called “trade-through” rule). The NYSE long argued that this framework provided highly liquid and continuous markets that lowered the cost of capital for, and incentivized good quality governance of, issuing firms. As a private monopoly the NYSE’s self-regulation periodically generated controversy, and the NYSE was finally subjected to serious government oversight in the 1930’s. In part based on that original Congressional mandate, in 2005, the Securities and Exchange Commission (SEC) began a two-year process of implementing Regulation NMS (for “national market system”). Most significantly, Reg. NMS, among other features, eliminated the protective “trade-through” rule thus enabling customers to trade off price quality for faster trade execution of trades on ECN’s. In 2006, in order to defend its place in the new post-“trade-through” world enabled by Reg. NMS, the NYSE demutualized and went public via a merger with Archipelago Holdings Inc., a large publicly listed ECN. We examine stock market data around the implementation of Reg. NMS and the NYSE IPO to show that eviscerating the “trade-through” rule triggered an explosion of new trading on alternative venues but also increased volatility in the pricing for formerly staid NYSE-listed shares. The end of the NYSE’s monopoly reduces choices for issuing firms as the NYSE no longer offers an “orderly market” for their listed shares. This increases the cost of capital for stable, well-managed firms and contributes to the reluctance of promising firms to go public thus eliminating a source of high-end customers for underwriters and undermining liquidity for investors. Reg. NMS and the NYSE IPO also likely encourage the formation of “dark pools” (transactions that take place outside of the regulated markets) and the spread of risky “high frequency” trading.