Transaction Costs in Dealer Markets: Evidence from the London Stock Exchange

New electronic trading technologies have drastically reduced the costs of financial transactions and put tremendous pressure on financial exchanges to lower their costs. The London Stock Exchange (LSE) is a prominent example of the changes being made in response to this pressure. In 1986, the LSE switched from a closed, floor-based, broker-dealer market to an open electronic quotation system dubbed SEAQ. The LSE’s SAQ system operates much like the NASD’s NASDAQ dealer system. On SEAQ, competing market makers post bid and ask prices and guaranteed trading volumes. Although SEAQ also displays trade information, brokers and dealers still negotiate trades by phone. Besides changing its systems, the LSE enacted new rules designed to encourage competition and narrow quoted spreads. These included the elimination of fixed commissions and members entry barriers, and the adoption of best execution rules. The exchange also imposed what it calls mandatory quote volumes. Mandatory quote volumes require market makers to accept trades equaling two or more percent of a security’s average daily trading volume. To reduce the capital risks associated with large trades, the Exchange granted market makers the right to delay their disclosure.