New electronic systems for trading stocks could end the financial abuse suffered by investors when buying and selling NASDAQ market stocks and, in doing so, spur economic growth.
This new competition facilitates direct contact between buyers and sellers of stock and radically reduces middleman costs, often so high in the over-the-counter market.
Not only investors but also businesses and their employees benefit from improved securities trading. This improvement is especially relevant for small companies, which are the engine of economic growth and which are hurt the most by Wall Street trading practices.
Most small stocks trade in the OTC market, where dealers set bid/ask quotes. The bid represents the price at which dealers will buy from an investor; the ask represents the price they will sell to an investor. The larger the bid/ask spreads, the larger the trading costs to investors and the greater the profit to the dealers. New electronic trading systems enable investors to split the bid/ask spread and effectively eliminate the middleman cost.
From an investor's perspective, how big is the middleman cost? I recently bought an OTC stock for a price that finally became low enough to interest me. With the figures rounded, the quote was 9 bid by 10 ask. This means that a buyer pays $10 but a seller receives only $9. So I paid $10.
If I hold the stock for one year, and then sell it when the quote is the same 9 bid by 10 ask, I will receive $9. Hence, I lose 10% on my investment even though the quoted stock price did not change. But Wall Street dealers would make money. Smart investors react by lowering the price at which they will buy a stock to compensate for this surcharge of 10% of their original investment.
Passing on such trading costs results in Main Street businesses slowing their expansion and hiring. Why? Suppose you owned a small firm and went to the bank to borrow money for expansion. Instead of borrowing at an expected 10%, you are told that 20% is your cost of borrowed capital because of an extraordinarily large surcharge. So you borrow less or none at all, depending on what you could earn with the loan.
It works the same way in the stock market. Lower stock prices signal to management the cost of equity capital is higher, which results in less expansion and hiring, because there are fewer investment opportunities to cover the higher cost of capital.
It is well known that investments are priced to achieve a satisfactory return after paying taxes and transaction costs. Raising taxes on dividends or capital gains depresses stock prices. Similarly, higher trading costs are a surcharge that also lower stock prices.
With new electronic ways to trade stocks, instead of a buyer paying $10 and a seller receiving $9, both buyer and seller split the bid/ask spread and trade at $9.50. This mechanism strikes at the heart of the age-old Wall Street argument that less liquid stocks require large bid/ask spreads.
The established exchanges and dealer networks promote themselves as strong supporters of free-market competition because of their role in raising capital with stock offerings. But with rare exceptions, they seek to protect the status quo by molding regulations to prevent meaningful competition in trading securities. An analogy would be if the large retailers and distributors in 1970 could foretell the success of Wal-Mart Stores Inc. and then argued Wal-Mart's growth should be curtailed by regulations, as this retailing upstart could disrupt the existing national retail system.
Wall Street asserts a heavily regulated, "national market system" is the best way to "protect" investors. In practice, such a system blocks trading mechanisms that facilitate direct contact between buyers and sellers. As for investor protection, it is noteworthy that Wall Street trading abuses (that is, stealing) occur because of the opportunities for self-dealing by middlemen who stand between buyers and sellers.
But increasingly in recent years, professional money managers have electronic trading alternatives. The electronic, or so-called proprietary, trading systems, accounted for 1.4% of the New York Stock Exchange share volume and 13.4% of the NASDAQ volume during 1993. The dominant systems are POSIT, owned by Investment Technology Group Inc., Instinet Corp., and the Arizona Stock Exchange.
In September, ChicagoMatch, a crossing system operated by the Chicago Stock Exchange, is expected to begin trading. Regrettably, the stocks, which benefit the most from circumventing the OTC market makers, have not yet received much attention because of their low volume of trading. But small trades can be "packaged" into sizable volume via electronic auctions at periodic intervals. Hence, a genuine business opportunity exists for one or more of the electronic systems to centralize trading in illiquid stocks. Depending on a stock's trading volume, electronic auctions could be assembled daily or weekly.
Such periodic auctions would provide unequivocal evidence of substantial reductions in trading costs vs. the existing OTC dealer market. Managements increasingly would learn that their stock prices would be higher when investors in their stock are able to split the bid/ask spread. The result would be that investors radically reduce unnecessary trading costs, companies reduce their costs of equity capital, and OTC dealers awaken to the need for restructuring their industry.
The OTC dealer market's worst nightmare is both retail and institutional investors having a choice, during normal trading hours, of how their orders are executed. Many investors do not need immediate execution, especially since waiting for a periodic electronic auction would eliminate the bid/ask spread and give deeper liquidity.
Electronic trading is in its infancy. If the bureaucratic process of obtaining Securities and Exchange Commission approvals and the vagueness of existing SEC regulations can be kept manageable, then electronic trading eventually could be available to everyday retail investors, not just institutions. This competitive innovation is capable of improving the OTC market much the same as how competition from Wal-Mart improved the retailing industry.
Bartley J. Madden is a partner at HOLT Value Associates, Chicago.
