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Equity Trading in the 21st Century

Chester Spatt Story Thumbnail 102x83Dark pools, flash orders, and indications of interest (IOIs) might sound like something from science fiction, but these innovative trading systems have benefited investors and enhanced the capital formation process.

These are the conclusions of a recently-released study commissioned by Knight Capital Group that examined the impact of recent innovations in the U.S. market structure, the measurable dimensions of market quality, and the effect these changes have had on both institutional and retail investors. The study was co-authored by Chester Spatt, a former chief economist of the U.S. Securities and Exchange Commission and current director, Center for Financial Markets at Carnegie Mellon University, where he is the Pamela R. and Kenneth B. Dunn Professor of Finance. His collaborators were professors James Angel of Georgetown University and Larry Harris of the University of Southern California.

“Our study shows that technological innovations have led to major improvements in market quality,” says Spatt. “Execution speeds have increased, making it much easier for retail investors to monitor execution quality. In addition, retail commissions have significantly dropped and bid-ask spreads have narrowed.”

The study touches on some of the issues raised in the recent U.S. Securities and Exchange Commission Concept Release that requests public comment on the current equity market structure.

"Trading volume has dramatically increased, from nearly three billion shares per day in 2003 to nearly ten billion shares per day in 2009," says Spatt. "In addition, the nature of trading has changed as 'high frequency' trading or 'algorithmic' trading has become a large part of the overall trading volume. As a result, automated traders have provided increased liquidity, supplementing and displacing traditional liquidity suppliers."

Spatt adds that the study provides recommendations for market improvements. Specifically, the researchers express concerns over the implementation of the "make or take" pricing model and suggest that the SEC require that all brokers pass through fees and liquidity rebates to their clients. In addition, the researchers agree with the SEC's concern regarding brokerage firms that provide "naked access" and support the proposed rule that would require such firms to have appropriate risk management policies in place to prevent a catastrophic trading meltdown.

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