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Lecture 17: Brokers, Dealers,
Exchanges & ECNs
Brokers, Dealers Exchanges &
• Brokers deal with public. Example: Merrill Lynch
• Dealers execute trades
• Exchanges are places where dealers operate.
Examples: NYSE, Nasdaq, Arizona Exchange
• Electronic Communications Networks (ECNs)
allow investors to communicate with each other,
and to exchange. Examples: Island, Instinet (now
• Deal with public, know potential buyers and
• Churning versus providing information
• SEC penalizes “rogue brokers” who churn.
• Stockbroker Robert Magnan was convicted of
criminal offense of churning, and barred from
securities industry for life, 1999.
• Magnan’s clients had an annual turnover rate of
11, and investments would have had to earn
annual return of 50% to pay transactions costs.
• Stand ready to buy and sell at posted prices,
bid and asked
• Analogy to antiques dealers
• Why are antiques dealers’ bid-asked spreads
so much wider than stock dealers?
• New York Stock Exchange, established 1792 by
the Buttonwood Agreement among 24 brokers.
• Exchanges provide standards and codes of ethics
for broker members, standards for stocks.
• Regional Exchanges: American Stock Exchange,
Philadelphia Exchange
• Listing requirements for stocks. Delisting too.
• NASDAQ –National Association of Securities
Dealers Automatic Quotation System, 1971, first
electronic exchange, replaced old “pink sheet”
system for over-the-counter stocks.
Markets to Lend (Not Sell) Shares
• “Loan Crowd” on floor of NYSE 1926-33 led
active market
• Wall Street Journal reported “Loan Rate” often
negative (Charles Jones & Owen Lamont)
• J. Edgar Hoover, Crash of 1929
• Equilend was established in 2001
( sponsored by
Barclays Global Investors, Bear Stearns, Goldman
Sachs, JP Morgan, etc.
Equilend Model
New Exchanges
• NASDAQ in 1971 did not require that
stocks have ever made a profit before
listing, listed IPOs immediately.
• Intel, Microsoft refused NYSE switch
• Foreign imitators of NASDAQ: Neuer
Markt, Germany, Mothers, Japan
• Neuer Markt shut down 2002
• Instinet: for professionals. Until 1999, it
was the biggest ECN
• Island: for individuals, became the biggest
ECN. In 1999 it did 4.9% of all Nasdaq
trading volume, compared with 3.0% for
• Other ECNs: Redi-Book, Bloomberg,
Intermarket Trading System
• Securities Act of 1975 called for a national
market system
• In response to this act, the ITS, an
electronic system, was opened in 1978.
Displays quotes on all exchanges where a
stock is listed.
• Today the ITS is a relic, too slow to be of
much use.
Payment for Order Flow
• Brokers drum up orders, deal with customers
• Brokers sell the order flow to crossing networks,
who profit from the order flow.
• November 2000 SEC posted rules that brokers
must post composite statistics on fraction of order
flow going to various places.
• Firms must also report statistics on their orderexecution quality
The Battle of the Platforms
Exchanges merge to try to gain critical mass
Rumors of possible NYSE-Nasdaq merger
Euronext merges European stock exchanges
Instinet buys Island 2002 (to form
Offered automatic trading facilities that Nasdaq
lacked. (Nasdaq responds with Supermontage)
• The Pacific Exchange acquires
2000, then REDIBook. ArcaEx trading system
Shares Traded per Day (Dec. 2003)
New York Stock Exchange 1.3 billion
Nasdaq 886 million
Inet 586 million
Pacific Exchange 526 million
Limit Order Book
• The Island ECN shows its
book on the web from
2002, example of Dell is
at right.
• Color blocks indicate
orders at same price
• Orders are expressed in
dollars and cents
• Island was the first US
exchange to list go to
• Inside spread is 35.625 to
Central Limit Order Book
• Island Exchange shows only its own orders.
• Nasdaq Level 1 shows only inside spread, few
have Level 2
• In January 1997 SEC forced NASDAQ to list
ECNs orders on its order book, among dealers’
Kinds of Orders
• Market Order
• Limit Order
• Stop Loss Order
– Market orders dangerous for thinly-traded
– Island did not allow market orders
The “Book” on NASDAQ
• NASDAQ’s book is visible to everyone
who orders NASDAQ Level 2 service
• NYSE says it has plans to make its
specialist’s book more widely available
Gambler’s Ruin Problem
• Starting with $S, betting $1 on heads on a
coin toss with probability p of coming up
heads, continuing to toss until ruin,
probability of eventual ruin equals 1 if p is
less than or equal to one half, otherwise
1 p
Gambler’s Ruin Derivation
• Call probability of ever failing, playing
forever, given that one has S dollars today
Pr(S). Then,
Pr( S )  p Pr( S  1)  (1  p ) Pr( S  1)
Pr(0)  1
1 p 
 Pr( S )  
 p 
Optimal Bid-Asked Spread
• Dealer must set a bid-asked spread in
consideration of the ultimate probability of ruin
and dealer’s utility weighting of this outcome
• Dealer has inferior information, expects to be
“picked off” by superior traders.
• Must set bid-asked spread so that the amount of
gain from spread offsets the expected loss.
NYSE: The Specialist’s Post,
Book and the Crowd
• NYSE specialist maintains a book like Island’s,
but it is not public, yet.
• NYSE, AMEX, and Montreal are about the only
remaining specialist exchanges
• Specialist has obligation to maintain an orderly
• NYSE Rule 390 (prohibiting members from
trading off exchange) abolished May 5, 2000
The Crowd, NYSE
• Floor brokers cluster around specialist post,
and trade among themselves
• About 50% of NYSE share volume (though
only about 10% of trades) go through floor
brokers, not through specialist’s book
• In addition to the crowd, there are the
“upstairs traders” who handle very large
Myth: Stock trading is going all
• Electronic trading remains a venue for small
• If they close the NYSE floor, the floor traders will
just go upstairs.
• Frankfurt, London, Paris, Toronto electronic
exchanges: between 40% to 60% of trades were
never orders on the book (though trade may be
ultimately reported there.)
• Books have too much transparency, large orders
tip their hand too much by putting it on book.
Criticism of NASDAQ
• William Christie & Paul Schultz , Journal of
Finance, Dec. 1994, pointed out that “odd
eighths” spreads were rare on NASDAQ: dealers
rarely quote prices ending in 1/8, 3/8, 5/8 and 7/8.
• Therefore inside spread is always at least ¼.
• Day after study reported in news, spreads narrow.
• Authors interpret as evidence of tacit collusion.
• Federal class action lawsuit against NASDAQ
won $1.03 billion in 1998.
Disadvantage to Limit Orders
• Placing a limit order is being a sitting duck. If
more in-the-know investors realize stock price is
higher than in your sell order, they will buy from
you at your price. In an expected value sense, your
orders can be filled only in this unfortunate case.
• Problem is enhanced by decimal trading. When a
specialist has the slightest inkling that there is
greater demand for the stock, can pick up shares
selling for just pennies above market. “Getting
pennied by the specialist.”
The CNBC Effect
• Successor of Financial
News Network 1983
• NYSE trades above,
color indicates
direction of trade
• NASDAQ trades
The CNBC Effect
• Rapid Dissemination of financial innovation
• CnnFn, Bloomberg New are the two cable
TV competitors to CNBC
• Claims that because of CNBC, markets
respond much more rapidly to information.
• But viewership on a typical day is no more
than a few hundred thousand.