تجارت ETFs در همسایگی شما : مسابقه و یا تکه تکه شدن؟

On July 31, 2001, for the first time in its history, the New York Stock Exchange (NYSE) began trading three unlisted securities. The DIA, SPY, and QQQ are the most actively traded Exchange Traded Funds (ETFs) and are listed on the American Stock Exchange. On April 15, 2002 another 27 ETFs followed. These two events provide a unique experiment for studying the impact of a new entrant on market quality. In contrast to recently revived concerns about the adverse impact of market fragmentation, we document that the NYSE entry leads to a dramatic improvement in liquidity that we attribute to the elimination of market-maker rents.

In recent years, there has been a strong regulatory interest in the question whether fragmentation of order flow is beneficial or not. During the past two decades, certain order types for securities listed on the New York Stock Exchange (NYSE) have increasingly migrated to alternative trading venues including NASDAQ, Electronic Communication Networks (ECNs), and regional exchanges. This development was aided by the establishment of the National Market System (including the InterMarket Trading System) by the SEC, the elimination of NYSE Rule 390 which restricted off-board trading for some exchange-listed stocks (SEC Rule 19c-3), and the increasing availability of innovative electronic crossing and trading networks.1 The proliferation of alternative trading venues and practices such as internalization and payment for order flow have led to concerns raised by the Securities and Exchange Commission (SEC) about the attendant fragmentation of stock markets.2 The issue is whether increased competition among market centers has beneficial effects on trading costs and price discovery, or detrimental effects because order flow is dispersed across several locations without much interaction. We contribute to this discussion by examining the entry of the NYSE into the trading of Exchange Traded Funds (ETFs). On April 6, 2001, the NYSE announced that it seeks regulatory approval for trading the three most active ETFs, the Nasdaq-100 Trust Series I (the “QQQ”), the Standard and Poor’s Depository Receipt Trust Series I (the “SPY”), and the Dow Jones Industrial Average Trust Series I (the “DIA”).3 In early 2001, these three securities together generated an average daily trading volume of about $5 billion.4 The event was expected to pose a major challenge for the American Stock Exchange (AMEX), the main listing and trading venue for ETFs.5 Prior to the NYSE entry on July 31, 2001, ETFs traded on AMEX (constituting most of its equity-related trading volume), the Nasdaq InterMarket, the regional exchanges, and the Island ECN. On April 15, 2002, the NYSE began trading 27 additional AMEX-listed ETFs. These two events mark the first time in its history that the NYSE is trading unlisted securities under Unlisted Trading Privileges (UTP).6 We believe that the simultaneous presence of three characteristics make these events a unique experiment to study the effect of order fragmentation on competition, liquidity, trading volume, and price discovery. First, and most importantly, our experiment controls for the trading protocol: the NYSE uses virtually the same protocol as the dominant incumbent, the AMEX. Second, it does not involve a new competitor who focuses only on a narrow segment of order flow. While analyses of competitors such as Madoff (Battalio, 1997), crossing networks and ECNs (Conrad et al., 2001; Huang, 2002) and regional exchanges (Lee, 1993) provide valuable inferences on relative market quality, it is possible that their results reflect different types of order flow. If traders endogenously choose among these markets, it may be difficult to control for differences in order difficulty. For example, Madoff and other market centers that pay for order flow screen out ‘difficult’ orders, and ECNs may attract traders that value execution speed highly. In the ETF experiment, at least two markets (AMEX and NYSE) do not screen incoming orders. Third, the new entrant does not compete by paying for order flow. For third-market trades, Bessembinder (2002) documents lower trading costs when dealers compete on quotes and argues that without quote competition, trading costs are greater due to payment for order flow. This suggests that quote competition provides a cleaner experiment than payment-for-order flow competition when assessing market quality. We explicitly document that each of the major market centers engages in quote competition to attract ETF orders. This paper further expands a growing literature on ETFs. Previous work compares ETF returns to changes in their net asset value (Elton et al., 2002), analyzes the tax consequences of holding ETFs (Poterba and Shoven, 2002), studies the dynamics of price deviations from the underlying portfolios (Engle and Sarkar, 2002), and compares price discovery in the ETF cash market and index futures markets (Hasbrouck, 2000). Despite the apparent importance of this market, little is known to date about the costs and the market structure of ETF trading. To assess market quality in the 30 ETFs before and after NYSE entry, we use several measures of liquidity. We find substantially lower trading costs across market centers after the NYSE enters the market: overall liquidity improves not only because of the reduction in different spread measures, but also because quoted depth increases considerably and as a result the estimated price impact of trades declines. We argue that this result is difficult to reconcile with a competitive market for ETFs before the NYSE entry. The pre-UTP structure of ETF trading leads us to expect a highly competitive market. AMEX specialists compete with limit orders, ECNs, and regional exchanges for order flow. In addition, previous studies offer strong evidence that the implementation of the order handling rules (OHR) has increased competition among Nasdaq market makers since 1997.7 Given the additional competition for ETF order flow by third-market dealers, it is surprising to find large effects on trading costs associated with the NYSE entry. Thus, we provide a detailed analysis of alternative explanations for the decline in trading cost. First, we show that spreads are less sensitive to order difficulty after the NYSE entry. Put differently, more difficult orders demand a lower premium after competition has increased. This suggests that market maker rents associated with the execution of more difficult orders may have decreased. Second, we estimate an indirect measure of market maker rents based on a spread decomposition. We find that the decline in estimated rents explains most of the reduction in trading cost. The component due to informed trading, however, also declines and we investigate whether changes in informed trading can explain lower trading cost. We examine price discovery in the competing market centers before and after the NYSE entry by computing information shares (see Hasbrouck, 1995).8 The intuition is that a smaller portion of informed order flow, relative to trading volume, could explain lower spreads. Among the different market centers, only information shares for AMEX drop slightly after the NYSE enters the market. Thus, a smaller proportion of informed trading may explain lower spreads on AMEX, but not for the Nasdaq InterMarket or the overall market. Finally, competition for market share may have resulted in below-cost pricing. To address this issue, we estimate changes in trading cost and in ETF spreads relative to their underlying portfolios during the nine months after NYSE entry. While the analysis is confounded by the market closure in September 2001, we do not observe that trading costs revert back to pre-UTP levels in any of the market centers that trade the DIA, SPY, or QQQ. Moreover, given the substantial trading volume in the three ETFs, pricing below cost would seem prohibitively expensive over extended periods. Therefore, we conclude that lack of competition is a major cause of the apparent market maker rents before the NYSE entry. The remainder of the paper is organized as follows. The next section offers a brief review of related literature. We describe the data in Section 2. In Section 3 we conduct our empirical tests and establish that market liquidity improves after the NYSE begins UTP trading. In Section 4 we contrast alternative explanations for the decline in trading cost and Section 5 concludes the paper.

In this paper, we study the impact of the NYSE entry into the trading of 30 AMEX-listed ETFs. These securities previously traded primarily on AMEX, the Nasdaq InterMarket, Island, and several regional exchanges. The NYSE gained an average market share exceeding 10% of overall trading volume during the monthafter its entry. This volume appears to be primarily drawn away from AMEX, mostly in large trade sizes above 10,000 shares. We document double-digit percentage declines in quoted, effective, and realized spreads after the NYSE entry. The difference between effective and realized spread, an approximation for the permanent price impact of a trade and another aspect of liquidity, also decreases significantly. At the same time, quoted depth increases be- tween 68% and 569%, depending on the market center and the ETF. The NYSE entry considerably improves liquidity in the entire market and also in the individual market centers. We conduct detailed tests documenting that this result is not due to shifts in informed trading or a temporary phenomenon. In light of the similar trading protocols on AMEX and the NYSE, several studies that document increased competition on Nasdaq after the OHR were implemented in 1997, and additional competition by other exchanges, ECNs, and limit order traders, it is difficult to reconcile our finding with a competitive market before the NYSE entry. In particular, our analysis of spread components suggests that market-maker rents constitute the component of trading cost that experienced the greatest dollar de- cline after the NYSE entry. How could rents exist in the pre-UTP market? Bessem- binder (2002) argues that payment for order flow implies an agency problem in routing orders, and hence increased rents. As UTP trading started in the wake of dec- imalization, which likely reduced the profitability of payment for order flow, NYSE entry may have triggered a decline in this practice and promoted quote competition. As an alternative to the rent explanation, another hypothesis may also explain the decline in trading cost. It rests on the assumption that different market centers have comparative advantages with certain order types. For example, one market may be better able to handle a large volume of small, uninformed orders, because it has a low-cost execution and screening mechanism. Another market may be better able to handle a high volume of large orders, because it has a deeper pool of liquidity. Under this view, the NYSE entry may have led to a more efficient allocation of or- ders to the respective lowest-cost market center, such that all markets are able to offer lower trading costs. Harris (1993) suggests that segmentation of markets, which is not the same as fragmentation, improves service. We have shown that the NYSE has attracted an over-proportionate share of large and presumably more difficult or- ders. If it were able to execute these orders at lower cost than other market centers, we would expect market-wide trading costs, especially for large orders, to de- crease. 32 This is to some extent consistent with our evidence. However, we also find that market maker rents decline and that Nasdaq approximately maintains its share of informed trading. Furthermore, it is not clear why a market that has a competitive advantage in executing large orders has not an even greater advantage in executing small orders. Yet, we do not observe a whole-scale migration to the NYSE, which attains a market share of below 10%. Thus, the efficiency hypothesis can at besexplain part of the market improvement. To further differentiate this hypothesis from a beneficial increase in competition, it is necessary to observe either the actual cost or profit from market making; we hope that future studies using more compre- hensive data can address this question. Overall, our findings strongly support the view that competition for order flow among market centers is beneficial for overall liquidity and does not seem to ad- versely affect price discovery. While the substantial and growing volume in the ETF market may make the results relevant in their own right, a caveat against gen- eralizing our results is warranted. Our study includes only 30, albeit the most actively traded, ETFs. In addition, ETFs are derivative (‘‘basket’’) securities and their trad- ing characteristics may not generalize to common stocks. Yet, our results suggest that regulation that impedes competition between market centers is not optimal, es- pecially in the context of ETFs. For example, mandatory-display requirements in Regulation ATS and to some extent current ITS rules limit quote competition by let- ting markets free-ride on each other s price discovery. In this context, the SEC s re- cent decision to relax ITS trade-through rules for certain ETFs seems a step in the right direction.