Life after the Big Board Goes Electronic

The NYSE’s “Hybrid Market” will be a floor-based facility (a “slow” market) combined with an electronic platform (a “fast” market). Technological advances, regulatory pressure, and competition have forced the exchange to introduce an electronic platform, but its success will not be known for some time. This article addresses some of the broad issues involved. The Big Board is considered as a network that provides price and quantity discovery. The article raises several questions about the integration of fast- and slow-market components and presents evidence that in one European electronic exchange, roughly half the euro value of trades does not go through the electronic order book.With portfolio managers under pressure to reduce the costs of trading securities, financial markets are responding in new and creative ways to meet managers’ needs. In the U.S. equity market, technological advances, regulatory pressure, and competition have forced the NYSE to respond by instituting the “Hybrid Market,” a floor-based facility (“slow” market) combined with an electronic platform (“fast” market). The success of the exchange’s electronic platform and its efforts to combine floor-based trading with electronic trading will not be known for some time. We address some of the broad issues involved.We discuss the Big Board as a network that provides both price discovery and quantity discovery to market participants. Price discovery refers to finding the price that best reflects the underlying desire of participants to buy and sell shares. Quantity discovery involves participants disclosing their orders so that they can meet each other and transact the total number of shares they wish to buy or sell. The market’s structure and size establish the network. Given a market’s structure, large markets are expected to deliver better price and quantity discovery. Ideally, price and quantity discovery should go hand in hand, much as in any microeconomics course the simultaneous solution for price and quantity is given by the intersection of a demand curve and a supply curve. In real-world equity markets, however, quantity discovery is rarely simultaneously achieved with price discovery, nor is it generally complete.In addition to the discussion of price and quantity discovery, we raise several questions about the integration of fast- and slow-market components. And we present evidence that in the German electronic exchange–based trading environment, roughly 50 percent of the euro value of trades does not go through the exchange’s electronic order book. Our empirical results reveal a clear size-based difference between on-book and off-book trading percentages. Larger-capitalization stocks trade more heavily off the book (only 41 percent of trades are done on the book), roughly half (48 percent) of midcap volume goes through the book, and a clear majority (65 percent) of small-cap stock trading goes through the book.Our finding that larger stocks experience more off-book trading is reasonable. Large institutional investors, which are typically more active in the larger-cap issues, are less likely to direct their block orders to the book, and retail orders for the larger-cap stocks are more likely to be netted and internalized by German banks and brokers. Furthermore, participants generally have greater confidence in the prices discovered in the larger, more liquid markets, which can result in free riding on exchange-provided price discovery being more prevalent for the large-cap stocks.We do not attempt to foretell merger outcomes or regulatory consequences in the future. We do know that the future will hold fast-market competitors for the 1,000-share orders (whether these orders are retail, part of a basket, or slices of a larger block). And without question, introduction of the Hybrid Market will affect the operations of the NYSE as a network that provides price and quantity discovery. The reassuring news for the exchange is that trading in Germany is split roughly 50–50 between on-book and off-book trades—despite the fact that this national market offers a state-of-the-art electronic trading platform. This finding suggests that demand will exist for both the fast- and slow-market services that the reengineered Big Board will supply.