Why Some Dealers and Exchanges Have Been Slow to Automate

Prepared in November 2002 for hearings sponsored by the U.S. SEC on market structure issues, this article outlines structural problems in the listed stock and option markets and explains why many exchanges have resisted automation. The authors conclude that various market structure rules, including order-handling rules, have made it hard for specialists/market makers to profit in the decimalized environment so some have resorted to improperly exploiting the time and place advantages of manual-execution floor markets. The authors recommend restoring economic incentives for professional liquidity providers and eliminating customer priority rules, eliminating the Intermarket Trading System, and replacing trade-through rules with broker/dealer “smart-routing” systems. They also urge regulators to encourage the development of new electronic markets that provide incentives for existing players to use them. A “Postscript” provides further information on aspects of the original presentation and describes how some of the issues have evolved. This article is primarily the text of a paper presented in November 2002 at hearings sponsored by the U.S. SEC on market structure. The paper addresses the anomaly that, although many aspects of the securities and futures business have been automated over the past 20–30 years, the central function of handling and executing orders is still surprisingly manual. This situation is unfortunate, in that handling and executing securities and futures orders is essentially a recordkeeping process that is ideally suited to being done by computers, which are cheaper, faster, and less susceptible to mistakes and fraud than people are.We point out that a variety of market structure rules, including order-handling rules and customer priority rules, have made it hard for specialists/market makers to profit in the decimalized environment. Designated liquidity providers, therefore, have had to rely on their inherent time and place advantage in the manual marketplace—specifically, that they can see orders before others can see them and can take their time (sometimes up to 90 seconds) to decide whether to interact with those orders or not—to reap a reward for the services they provide. Complete automation of order handling and execution, by eliminating latency and creating a perfectly clear time sequence of trading events, would negate this advantage.Even if such change would ultimately be in the public interest, however, the exchanges and their professional member constituents are reluctant to invest heavily in technology that may reduce specialists' trading advantages and eliminate certain market participants altogether.We also address the fact that some market mechanisms, such as the Intermarket Trading System (ITS) and the trade-through rule for listed stocks, have outlived their usefulness and now act as further disincentives to the development of automated trading.The paper suggests several ways to break the logjam preventing automation of order handling and execution. First, the industry must develop innovative ways to make automation palatable by ensuring the economic incentives for existing exchanges and their professional traders to provide liquidity to the marketplace while nevertheless automating. One way would be to enhance liquidity payments and specialist participation rights in electronic trades. In addition, the industry should reverse or eliminate customer priority rules, which create only an illusion of customer benefit. ITS and the trade-through rule also should be eliminated, and best execution of customer orders should be achieved through improved disclosure of realized spreads and by broker/dealer use of “smart” order-routing systems (systems connected to all-electronic markets). Finally, regulators must not impede the development of new electronic markets that will force existing players to automate in order to compete with the speed, certainty, and lower trade-processing costs that these new markets offer.A postscript to the article describes recent developments at the NYSE and the SEC and how they relate to the themes of the original paper.