Alternative Securities Trading Systems: Tests and Regulatory Implications of the Adoption of Technology

Reasons for the mixed reactions to today's electronic off-exchange trading systems are examined, and regulatory implications are explored. Information technology (IT) could provide more automated markets, which have lower costs. Yet for an electronic trading system to form a liquid and widely used market, a sufficient number of traders would need to make a transition away from established trading venues and to this alternative way of trading. This transition may not actually occur for a variety of reasons. Two tests are performed of the feasibility and the desirability of transitions to new markets. In the first test, traders in a series of economic experiments demonstrate an ability to make a transition and develop a critical mass of trading activity in a newly opened market. In the second test, simulation is used to compare the floor-based specialist auction in place in most U.S. stock exchanges today to a disintermediated alternative employing screen-based order matching. The results indicate that reducing the role of dealer-intermediaries can actually diminish important measures of market quality. Our findings suggest that the low trading volumes on many off-exchange systems do not result from traders' inability to break away from established trading floors. Rather, today's off-exchange trading systems are not uniformly superior to the trading mechanisms of traditional exchanges. Thus, regulatory actions favoring off-exchange trading systems are not warranted; but, improved designs for IT-based trading mechanisms are needed, and when these are available, they are likely to win significant trading volume from established exchanges.