Commentary: During much of the last 100 years, the New York Stock exchange enjoyed near monopoly on the public trading of U.S. stocks and bonds. And while we are trained to think that monopolies are bad things, the near monopoly of the NYSE was in fact a good thing. The reason for this was NYSE need to maintain its good reputation for fairness.
Let me explain, until very recently, financial markets suffered from a chronic lack of liquidity. So a market that could provide that liquidity could attract a disproportionate share of trades. And the market that was the most liquid, by dent of that liquidity was able to attract more business, thereby becoming yet more liquid. A virtuous cycle, the beneficiary of which became immensely profitable.
To gain and maintain market share, traders had to be confident that they could execute in a fair an orderly manner. The NYSE used a particular tack to tack to achieve this, which was to build a system reliant on specialists to ensure that markets were orderly. Specialists are so called because they specialize in creating markets in particular stocks.
Market making was a marvelously profitable activity, but access to these profits came with a responsibility, which was that the market maker had to make sure that the price struck in each trade would be within a few pennies of the previous transaction. Thus, the specialists was to buy when there was no other buyer and to sell when there was no other seller. In so doing they ensured that the public could be assured that there would be a partner to every trade and that the trade would be near the price of previous trades. The prices were not allowed to widely gyrating trade to trade.
The system worked well. Oh, of course, during a panic, the sell orders would arrive at a sufficient pace that the specialist might not be able to keep up. When that happened, the price would crash. But for the most part the system worked well.
Then beginning in the mid 2000’s, processing speeds allowed for a massive increase in liquidity. High frequency traders came to dominate the market. These are firms that specialize in buying and sell massive quantities of securities over very short periods, changing positions thousands of times a second.
This vast increase in trading meant that there was sufficient liquidity to support many more trading floors than before. Large banks, broker-dealers and wall street firms opened new trading facilities in competition with the NYSE. Currently, trading is divided among 12 public exchanges, which are regulated by the SEC, 40 or so less regulated dark pools, and over 200 broker-dealers.
This increased fragmentation means competition for the big players. While in the past, the NYSE would compete by offering good governance, now trading floors compete by offering the best deal to the high-frequency traders and other big players, often to the determent of small traders. The table is now tilted toward the big guys in a way that has not been seen since the establishment of the SEC. It has always been hard for the little guy, now even more so.
In some ways, this change in the competitive landscape really doesn’t change much the advice for the small investor (and by small, I mean less than $100 million). The advice remains buy and hold a diversified portfolio, don’t actively trade, and avoid transaction costs as much as possible. For most investors this means buying an index fund, such as on that follows the S&P 500.
Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. For many years, he has taught a buy and hold strategy as the best approach financial investment. The opinions expressed here may not be shared by the regents and administration of NMSU. Chris can be reached at chrerick@nmsu.edu.