From Markets to Venues: Securities Regulation in an Evolving World

By Macey, Jonathan R.; O'Hara, Maureen | Stanford Law Review, November 2005 | Go to article overview

From Markets to Venues: Securities Regulation in an Evolving World


Macey, Jonathan R., O'Hara, Maureen, Stanford Law Review


INTRODUCTION
I. THE ORGANIZATION OF FIRMS AND THE ORGANIZATION OF MARKETS
II. SECURITIES TRADING--MARKET STRUCTURE AND REGULATION
     A. The Old Environment: Tradition Versus Transition
     B. The Modern Exchange: Demutualized and Publicly Traded
III. WHO SHOULD REGULATE WHAT? COMPETITION, COLLUSION, AND
     CAPTURE IN REGULATORY STRUCTURES
     A. Listing and Delisting Decisions
     B. Oversight of Exchange Trading Practices
     C. Insider Trading and Share-Price Manipulation
     D. Oversight of Exchange Trading Capacity
IV. ALTERNATIVE REGULATORY MODELS--GLOBAL EVIDENCE
CONCLUSION

INTRODUCTION

The world of securities trading is changing. Advances in technology, combined with the dramatic decrease in the cost of information processing, have conspired to change the way that securities transactions occur. While broker-dealers, specialists, and market makers still ply their trades, they are now joined by a host of new market participants such as robot traders and electronic limit order providers. And while exchanges and the Nasdaq continue to operate, they are confronted by a wide range of competitors including the trading desks of the large broker-dealer firms as well as Alternative Trading Systems (ATSs), the best known of which are Electronic Communications Networks (ECNs) such as Brut ECN, Instinet, and Inet ATS. (1) Trades in equities also are executed on the "third market," which simply refers to firms like Madoff Investment Securities, Knight Trading Group, Jefferies Group, and ITG, all of which arrange trades in exchange-listed stocks on venues other than an exchange. Trading has become a commodity, a standard process whose measure of success is increasingly captured by the simple metric of cost of transacting.

Against this backdrop, stock exchanges are also changing both in function and in governance. Forced to compete after enjoying decades of essentially monopoly franchises, exchanges and markets have had to embrace new technologies or face extinction. Traditionally owned by their members, exchanges worldwide are now converting to become publicly traded corporations. Since 1998, more than a dozen exchanges have publicly listed their shares, leaving only two of the world's ten largest exchanges (New York and Tokyo) as member-owned entities. (2) Soon there will be only one, as the New York Stock Exchange and the Archipelago Exchange announced on April 20, 2005, that the two firms had entered into a definitive merger agreement that will produce a new, combined entity to be called NYSE Group, Inc. (3)

In this new world of trading, market forces are requiring dramatic change in market structure and in the way in which competing firms are organized and operated; yet the regulatory structure of securities trading in the United States has remained the same. Can such immutability be optimal in the face of this economic upheaval in the markets in which the exchanges operate? (4)

This Article considers the role of self-regulation of the trading markets in the changing world in which exchanges and other trading venues conduct their business. Our particular focus is on the role of self-regulation in a world that has come to be dominated (indeed almost exclusively inhabited) by profit-seeking firms rather than member-owned associations. Our analysis draws on insights from the Coasean view of markets and firms to investigate how economic functions are evolving to meet the new trading environment. A particular thesis we develop is that shifts in transaction costs and agency costs have dictated changes in the optimal economic organization of trading. These changes have forced economic activity to migrate from a centralized market to multiple competing venues. We argue that these shifts, in turn, have changed the optimal ownership structure of exchanges, pushing exchanges away from a cooperative structure to a corporate structure. These new governance arrangements reflect the different incentives that exchange members face in a competitive environment and produce the need for a thorough reexamination of the principles of self-regulation in light of this new environment. …

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