Secondary Securities Markets Continued: Third Market

Third Market—Trading Listed Securities in the OTC Market

The third market is the trading of exchange-listed securities in the over-the-counter market.

Up until 1972, the NYSE charged fixed commissions on all trades on its exchange. 

 

However, many traders felt that there should be lower commissions for larger trades. Consequently, traders with large blocks to trade started trading NYSE listed stocks in the OTC market for reduced commissions, using brokers who were not members of the NYSE. Eventually, in May, 1975—known as May Day—all commissions became negotiable. In that year, the lowest price for a seat on the NYSE was $55,000, whereas 10 years earlier, the lowest price was $190,000.

Fourth Market—Electronic Communication Networks (ECNs)

Electronic Communication Networks (ECNs) are electronic networks that can connect buyers directly with sellers for listed securities—no brokers or market makers are involved. Often called the fourth market or network, ECNs can eliminate the spread that dealers charge, if a crossing match can be found for the buy or sell orders that were entered. The ECN earns its money from fees for the transactions, rather than from commissions or a spread. Most ECNs are also connected to NASDAQ through the Intermarket Trading System. Participants, mostly institutional investors, post bids or offers on the ECN. The ECN will try to match the order with another participant on the ECN, or, if that fails, it will send the order to NASDAQ. Most large traders also like ECNs because of their anonymity—the rest of the market does not know who is buying or selling large blocks of securities.

ECNs must be registered by the SEC, and by the NASD if it wants to connect to the NASDAQ market. 

The National Market System (NMS)

Because stocks are listed on multiple exchanges and in the OTC markets for different prices, the SEC wanted to promote competition among the different trading centers by consolidating the quotes in 1 place—the National Market System, which was the result of Regulation NMS. The SEC has been trying to implement this strategy since 1975, but because of technical problems and industry opposition, it has taken some time, with the latest changes being implemented in 2007. The NMS would allow individual investors to see the same quotes as big institutional investors. 

Consolidated Tape—Network A and Network B

 

The National Market System began with the Securities Act Amendments of 1975 that gave the SEC authority to effect some institutional changes so that quotes from different markets could be consolidated. One result was the consolidated tape, which began operating in June, 1975, and is composed of Network A and B.

Network A lists the best prices for NYSE-listed stocks from the NYSE, local exchanges, and the OTC market. Network B lists the best prices for AMEX-listed stocks from AMEX, the local exchanges, and the OTC market, and also stocks that are only listed on local exchanges and the OTC market.

The Consolidated Quotation System (CQS) electronically disseminates these quotes across the networks.

Intermarket Trading System (ITS)

 

The Intermarket Trading System is a network that links the NYSE, the AMEX, NASDAQ, and the Boston, Chicago, National (formerly Cincinnati), Pacific and Philadelphia local exchanges, and the Chicago Board Options Exchange. This system, begun in 1978, allows market makers and brokers to transmit quotes to other exchanges for better prices for the approximately 4,500 stocks listed on multiple exchanges. Thus, if a customer for a broker who is a member of the Philadelphia Stock Exchange, sees a better price on the NYSE, the broker can route the customer’s order to the NYSE, then the trade is reported on the Consolidated Quotation System. 

One of the problems with the ITS is that the orders are not routed automatically to the best price, but must be sent there by a market participant. For instance, if an NYSE specialist receives an order for a stock, but sees a better price on the ITS system, then he must either send the order to that exchange, or match the price. The ITS system is also considered too slow for the NYSE.

However, a major drawback is that it does not include quotes from ECNs, which are transacting increasing numbers of shares because of their low cost.

The solution for the future is to have an electronic network that links all of the markets, aggregating all orders into 1 central limit order book, where the best inside prices can be quoted. This not only gives the best prices to the customers, but will also force the exchanges to become more efficient, since the lowest cost networks will generally have the best prices. Eventually, there will be no market makers or specialists—buyers will simply buy directly from sellers, electronically, for the lowest transaction cost possible.