New Rules for Multimarket Trading

Illustration by Tim Lewis

When you trade stock, will it be on the NASDAQ, the NYSE, or the American Stock Exchange? Will it be in New York, London, Tokyo, or perhaps Bangkok or Paris? Electronic market access has made buying and selling the same security in more than one market an increasingly widespread practice both within and across countries, raising the issue of how markets should be regulated as stocks are traded around the clock and around the globe.
       Haim Mendelson, the James Irvin Miller Professor of Information Systems, has examined the impact of trading systems and rules in several studies. Recently he has focused on how markets should be regulated in the future, given their rapid globalization.
       The electronic ties between markets have brought securities trading to the brink of a new era in which national regulation will be of less relevance because of the ability to easily trade anywhere around the world at low cost. Country regulators cannot enforce worldwide trading rules. After all, if traders find one nation's regulations undesirable, they are free to move their trades to a different country. This raises the question of who will select and enforce the best trading platform for a stock.
       Mendelson and research colleague Yakov Amihud of New York University's Stern School of Business recommend a new regulatory framework for multimarket trading. They suggest that the company issuing a security should be given the exclusive right to decide how and where it is traded, because the issuer has the strongest incentive to choose the best trading venue for its securities. In the case of stock, Amihud and Mendelson propose that the company's board of directors has the authority to decide which markets will be allowed to trade its stock. Likewise, trading the security on any trading system would require the issuer's consent.
       The researchers show that the market in which a security is traded and the trading rules that apply affect the liquidity of the security, which in turn affects its value. Their proposed rule would induce markets to adopt trading practices that maximize the liquidity of securities, compared to the current system, which creates incentives for markets to participate in what they call a "race to the bottom" that can diminish liquidity. They argue that their proposal will be good for both the markets and investors.
       The authors believe their rule will change the behavior of securities markets and reduce the need for close regulation by legislators and by the Securities and Exchange Commission. For example, the new rules would give markets the incentive to self-enforce rules that are beneficial to securities holders as a group as well as to the economy as a whole. The market's objective will be to attract issuers by increasing liquidity and hence reducing the cost of capital. Under the current setup, this is not always so because securities can be traded without a company's consent.
       Amihud and Mendelson also believe the new rule would bring about greater diversity in trading rules among different trading forums, replacing much of the uniformity imposed by regulators. Market commentators have criticized the current system on the grounds that it discourages innovation and cost-effectiveness. The authors believe allowing issuers to decide where to trade their stock will transform the role of regulation from rule-making and the micromanagement of securities markets into the enforcement of an issuer's property rights.
       Currently, the SEC effectively sets the rules for the securities markets following a one-size-fits-all approach. For example, it recently mandated a tick size (the minimum stock price increment) of one-sixteenth of a dollar for most securities. It also recently required the dissemination of investors' limit orders (orders to buy or sell securities at a specific price or better) market-wide. It set the standards for "transparency," the disclosure of trade prices to the rest of the market. All of these are highly debated issues that can affect liquidity either way. As power shifts to the issuers, Mendelson and Amihud believe, they will be able to demand the optimal trading rules for their traded securities--or they will have them traded elsewhere.
       Regulatory bodies seem unlikely to support a proposal that would diminish their own authority. Ultimately, proposals like Amihud and Mendelson's may be implemented through international treaties, as was done with a treaty setting international standards for copyright protection. In the meantime, says Mendelson, "It's a matter of changing the mindset."

---BB

Illustration by Tim Lewis

"A New Approach to the Regulation of Trading Across Securities Markets," Yakov Amihud and Haim Mendelson, New York University Law Review, Vol. 71, No. 6, December 1996