The Trading Industry: Regulation and Market Types (Chapter 3, Part 2)
This is Part 2 of our coverage of Chapter 3 in Trading and Exchanges. Part 1 covered the players, trade facilitators, and instruments. Now we get into where trading actually happens and who makes the rules.
Harris uses the second half of this chapter to survey the world’s trading markets and explain how regulation shapes everything. Some of this is dated in terms of specific institutions. But the patterns and principles remain the same.
Where Are the Markets?
Harris starts with a surprising observation: stocks get way more attention than they deserve based on their share of total wealth. In the U.S., stocks represent only about 20 percent of the country’s capital wealth. Most wealth is in real estate, which rarely trades, and in various types of bonds. Derivative contracts represent no net wealth at all because they are in zero net supply.
But here is what really matters about trading volumes across different markets.
Stocks. The major U.S. exchanges listed about 8,250 stocks at the time of writing. Only a fraction traded actively. At the NYSE, the 250 most active stocks accounted for 62 percent of total reported volume. When trading the most active stocks, public traders often trade with each other. In less active stocks, they trade mostly with dealers. Most trades by count are small retail trades, but large institutional traders account for most of the actual share volume.
There is also a volume counting problem that Harris highlights. It is genuinely important and most people miss it. In a market like the NYSE where public buyers match directly with public sellers, a 100-share trade generates 100 shares of volume. In a dealer market like Nasdaq, the same trade could generate 200 or even 300 shares of reported volume because the dealers are intermediating. The World Federation of Exchanges distinguishes between “Trading System View” markets (like the NYSE) that count only trades passing through their systems, and “Regulated Environment View” markets (like Nasdaq) that count all transactions under their regulatory umbrella. So when you compare volume across exchanges, you have to be careful.
Bonds. The number of corporate and municipal bond issues is enormous, but most issues hardly ever trade. High-quality bonds are close substitutes for each other, so portfolio managers care more about financial terms than specific issues. Some bond issues never trade again after their initial offering. The buy side trades bonds almost exclusively with dealers because buyers and sellers rarely want to trade the same bond at the same time.
Government bonds are different. Fewer issues, but much larger ones, and widespread interest makes them extremely liquid. The Federal Reserve’s Open Market Operations Desk trades staggering volumes in Treasury instruments. Harris notes that in 2000, Fed traders purchased $44 billion in unmatched transactions and $4.4 trillion in matched transactions. And they do not get year-end bonuses.
Futures. Some of the world’s most liquid instruments trade in futures markets. Contracts on major agricultural, industrial, and financial commodities attract both hedgers and speculators. Futures exchanges generally have their own clearinghouses, which means they do not directly compete to trade the same contracts. Instead, each exchange tries to create contracts that will attract traders.
Most futures trading concentrates in the front month contract. In agricultural commodities, there is also significant interest in the first harvest contract, which is the first contract on which traders can deliver the currently growing crop.
Currencies. The most important world currencies trade in extremely liquid markets. Volumes are high because international trade and cross-border capital transactions require currency conversions. The structure also means dealers trade with each other several times for every client trade, amplifying volume.
Harris includes a great note about retail currency markets at airports: they are notoriously expensive due to high rents, security costs, and idle clerks. ATM withdrawals abroad give much better rates because your bank consolidates transactions and has more negotiating power.
Real estate. Every parcel is unique, which makes real estate the least liquid of the major markets. Electronic listing services have lowered search costs but they are still very high. Clearing and settlement is expensive because trades are large, complex, and between parties without standing credit relationships.
The U.S. Stock Market Landscape
Harris maps out the multi-layered structure of U.S. equity markets:
The primary listing markets are the NYSE, AMEX, and Nasdaq. NYSE and AMEX are floor-based (at the time). Nasdaq is electronic. Stocks listed at NYSE and AMEX are called “listed stocks.” Nasdaq stocks used to be called “over-the-counter” stocks.
Regional exchanges trade listed stocks under unlisted trading privileges. At the time, these included the Boston, Chicago, Cincinnati, Archipelago, and Philadelphia stock exchanges. The Cincinnati Stock Exchange is a fun piece of trivia: it became the first U.S. electronic stock exchange but ended up with its computers in Chicago.
The third market consists of dealers and brokers who trade exchange-listed stocks away from exchanges. The fourth market refers to trading in alternative trading systems (ATSs), including ECNs. So a single stock could trade at its primary exchange, multiple regional exchanges, in the third market, and in the fourth market, all simultaneously.
This fragmentation is not accidental. It exists because different traders have different needs, and multiple venues compete to serve them. Arbitrageurs keep prices from diverging too much across markets.
International Stock Markets
Stock markets grew substantially worldwide in the late twentieth century as firms sought public equity financing and governments privatized enterprises. Former Communist countries established stock exchanges as symbols of free market economies, sometimes before they had stocks to trade or adequate property and securities laws.
Harris notes that the most successful post-Communist markets are in countries that carefully defined property rights, privatized government enterprises, adopted good securities laws, and actually enforced them. Rules without enforcement do not count.
Some interesting trivia: Telmex, Mexico’s largest stock, traded more volume on the NYSE than on the Bolsa Mexicana. By capitalization and volume, the largest Israeli stock market was Nasdaq, because many Israeli tech companies did not list in Tel Aviv.
Market Regulation
This section is where Harris gets philosophical, and it is some of the best writing in the chapter.
The purpose of regulation: Most traders believe markets work best when well regulated but not excessively regulated. Good regulation helps ensure effective communication, prevents fraud, and makes things generally as they appear.
But Harris is refreshingly honest about the dark side. Regulators sometimes create rules that promote other objectives. They might give privileges to favored traders, protect domestic markets from foreign competition, or protect incumbents from new competition. Ideologically motivated regulators may impose restrictions because they do not like markets or want to redistribute wealth.
Here is the kicker: the stated purpose of a regulation often is not its true objective. Regulators justify their rules with explanations about the common good, but through ignorance, self-interest, or malice, they often adopt regulations that do not actually promote it. Harris is basically telling you to be skeptical of regulatory justifications and to develop the analytical tools to judge their true effects.
The U.S. regulatory structure splits responsibilities between the SEC (securities, equity options, cash-settled index options) and the CFTC (commodity spots, forwards, futures). Most countries consolidate these functions into one agency. The split has created ongoing turf wars, especially when new instruments blur the line between securities and commodity contracts.
The Shad-Johnson Accord of 1982 divided jurisdiction: the CFTC got futures on broad equity indexes and their options, the SEC got options on individual stocks and cash-settled index options, and futures on individual stocks were banned entirely (until 2000). This means two agencies separately regulate instruments with nearly identical risk characteristics. Some people think this is foolish. Others think the regulatory competition keeps both agencies more reasonable. Others think it makes both agencies too lax.
Self-regulatory organizations (SROs) include exchanges, clearinghouses, and trader associations like the NASD and the National Futures Association. They regulate their members to lower business costs, improve standards, and provide quality assurances. SROs enforce rules by threatening to expel members, which works well when compliance costs are low and benefits are high. It works poorly when dishonest members can profit enormously from breaking the rules.
Harris also discusses private regulators like FASB (accounting standards), AIMR (performance reporting standards for investment managers), and insurance companies that regulate the brokers they insure.
Unintended Consequences
One of the best sidebars in the chapter describes what happened when Brazil imposed a 0.38 percent tax on all financial transactions in 1997. Institutional traders simply moved their trading to New York, buying and selling Brazilian stocks as American depository receipts to avoid the tax. Daily volume at the Sao Paulo exchange dropped dramatically. The tax raised less revenue than expected and drained liquidity from Brazilian markets. Eventually, Brazil exempted stock transactions from the tax.
This is regulation in a nutshell. The stated objective (raising revenue) conflicted with the reality that capital is mobile and traders will find the path of least resistance. Any regulation that makes trading more expensive in one venue will push volume to competing venues. This principle has played out countless times across countries and markets.
Key Takeaways
Harris wraps up Chapter 3 with a clean summary:
- The buy side buys liquidity. The sell side provides it.
- Dealers trade for their own account. Brokers trade for others.
- Stocks get more attention than their values would indicate.
- Many markets compete for order flow.
- Exchanges often compete with brokerages to arrange trades.
- Legislatures provide the regulatory framework, SROs provide the details, and governmental agencies provide oversight.
But the biggest takeaway for me is about the interplay between market structure and regulation. Markets are not natural phenomena that just happen. They are designed systems with rules, and those rules determine who wins and who loses. Understanding this is essential for anyone who wants to trade intelligently or think clearly about financial markets.
Book Details
- Title: Trading and Exchanges: Market Microstructure for Practitioners
- Author: Larry Harris
- Publisher: Oxford University Press, 2003
- ISBN: 0-19-514470-8