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The document discusses brokers, dealers, exchanges and electronic communication networks. It describes how brokers act as agents while dealers act as principals. Exchanges provide standards and ethics codes for brokers and list stock trading requirements. The Intermarket Trading System displays quotes across exchanges. Electronic communication networks allow over-the-counter trading and started as websites but now function more like exchanges.

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11 views

Lecture19 0

The document discusses brokers, dealers, exchanges and electronic communication networks. It describes how brokers act as agents while dealers act as principals. Exchanges provide standards and ethics codes for brokers and list stock trading requirements. The Intermarket Trading System displays quotes across exchanges. Electronic communication networks allow over-the-counter trading and started as websites but now function more like exchanges.

Uploaded by

Agazzi
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 19: Brokers, Dealers,

Exchanges & ECNs


Economics 252, Spring 2008
Prof. Robert Shiller, Yale University
Brokers, Dealers Exchanges &
ECNs
• Broker-Dealer (BD) is an organization as defined
by SEC, hires natural persons as brokers and
dealers, its registered representatives
• An exchange is a private association of brokers
regulated (in the U.S.) by the SEC
• Electronic Communications Networks (ECNs)
allow investors to communicate with each other,
and to exchange: Archipelago (now part of
NYSE), BATS, Direct Edge.
Brokers
Brokers act on behalf of
Others as their
Agent for which they earn a
Commission
Dealers
A Dealer always acts for
Herself, in other words as a
Principal in the transaction for which she
makes a
Markup
The Traditional Four Markets
• First Market: NYSE
• Second market: NASDAQ National Market
(replaced the “pink sheets” in 1971)
• Third market: Nasdaq small cap
• Fourth market: large institutions trade
amongst themselves without the use of a
securities firm
Exchanges
• 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.
• Exchanges must register and are regulated by SEC
• National Best Bid Offer (NBBO) via Intermarket
Trading System (ITS)
• Regional Exchanges: Philadelphia Exchange,
Cincinnati Exchange now National Stock
Exchange
• Listing requirements for stocks. Delisting too.
Intermarket Trading System
(ITS)
• 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 or
where traded under UTP (unlisted trading privileges)
• When a BD enters a trade, it is automatically routed via ITS to
exchange with best price, via Consolidated Quote System, though
slowly
• BDs may send trade instead to an ECN for “payment for order flow”
• Increasingly impatient investors may be happy to put trades to ECNs
for fast execution. They may suffer from poor execution
• NMS Linkage proposed to replace ITS by all major US stock
exchanges in 2006.(no news that it is implemented)
Electronic Communications
Networks
• ECNs (sometimes called Alternative Trading Systems, ATS) are
regulated by the SEC essentially as broker dealers (BDs), which puts
them in a (slightly) different category from exchanges
• Tend to handle over the counter (OTC) (small volume) securities
• ECNs started as basically web sites for traders created by young
computer geeks, but increasingly functioned more as exchanges
• New SEC rules January 1997 made ECNs important by granting them
access to Nasdaq National Market system
• Archipelago founded 1996 in anticipation of new rules
• Instinet: for professionals. Until 1999, it was the biggest ECN. In 2004
it ceased being an ECN and is now a broker-dealer.
• Island: for individuals, became the biggest ECN. In 1999 it did 4.9%
of all Nasdaq trading volume.
NYSE-ArcaEx Merger, 2005
• April, 2003 Archipelago was trading 8,800 stocks
• April 20, 2005, NYSE, then trading 2,744 stocks,
and ArcaEx announced they would merge to form
the NYSE Group
• NYSE now trading Nasdaq stocks
• After NYSE-ArcaEx merger and Nasdaq-INET
merger, worries emerge about a duopoly situation
in US stock market
NYSE-EuroNext merger 2006
• So it went frm NYSE to NYSE Group, Inc.,
to NYSE Euronext, Inc.
• NYSE likely to buy AMEX, 2008
Kinds of Orders
• Market Order
• Limit Order
• Stop Loss Order
– Market orders dangerous for thinly-traded
stocks
– ECNs may not allow market orders
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
equals ((1-p)/p)^s:
Gambler’s Ruin Derivation
• Call probability of ever failing, playing
forever, given that one has S dollars today
Pr(S). Then Pr(S)=pPr(S+1)+(1-p)Pr(S-1)
and note that Pr(0)=1.,
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.

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