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ElectronicTradinginStockMarkets - Journal of Economic...

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Electronic Trading in Stock Markets Hans R. Stoll I n 1792, 24 brokers met under a buttonwood tree to found what became the New York Stock Exchange (NYSE). Thereafter, they carried out transactions in a coffeehouse located at Wall and Water streets in lower Manhattan. Transactions were consummated via face-to-face negotiation. From its beginning, the NYSE was a member organization—a club—in which trading could be con- ducted only through members at uniform fees established by the members. Each member was required to purchase a membership, or seat, in order to do business on the exchange. Today there are 1,366 seats. Trading was conducted by hand- carrying orders to the appointed trading post where trading by members would take place. Modern trading technology clashes with the traditional organization of a stock exchange. The facility—the coffeehouse—has changed. The modern facility is no longer a place. Rather, it is a computer system over which transactions are entered, routed, executed and cleared electronically with little or no human intervention. The role of the brokers and dealers has changed, and the need for a physical meeting place has become of little importance. Competition from fully electronic markets—electronic communications networks (ECNs)—and from regional exchanges—Boston, Chicago, Philadelphia, Pacific, Cincinnati—as well as regula- tory pressures, are forcing the NYSE to adapt. As it does, the role of members as brokers and dealers will diminish and their role as owners and operators of the technology will increase. The clearest reflection of change is the NYSE’s announce- ment, on April 20, 2005, that it intended to become a publicly owned company and to merge with Archipelago, one of the most successful ECNs. The Nasdaq Stock y Hans R. Stoll is the Anne Marie and Thomas B. Walker Professor of Finance and Director of the Financial Markets Research Center, Owen Graduate School of Management, Vanderbilt University, Nashville, Tennessee. His e-mail address is [email protected] . Journal of Economic Perspectives—Volume 20, Number 1—Winter 2006—Pages 153–174
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Market, facing even greater competitive pressures than the NYSE, has announced a merger with Instinet, the other major ECN. 1 As a consequence of these pending mergers, one can expect increased electronic trading in all markets. In this article, I examine how electronic trading has altered stock markets. I begin with an overview of how the stock trading process works and then address a number of questions. How have the jobs of traditional stock market dealers on the NYSE and on Nasdaq been affected by electronic trading? How do electronic communications networks differ from traditional markets? How has electronic trading affected bid-ask spreads and commission costs? What subtle issues arise in electronic trading when dealer and customer interests diverge? Will computer programs replace human judgment? What is the effect of electronic trading on the number and types of securities markets? What is the role of regulation in electronic
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