AmplifiedVolatility 61one seeking to buy 100 shares of Dell at $50 and one seeking to sell
the same. When the price of an offer to buy matches the price of
an offer to sell (as in this case), the trade occurs automatically. The
middleman disappears, and the price is formed directly by two orders
meeting in the market. ECNs can thus reduce transaction volatility
caused by the bid-ask spread required by market makers.
If particular ECN offer prices do not match, however, they still
get posted on the computer along with the bid and as koffers of
specialists and market makers. When the orders don’t match, there
is an “order imbalance” and the screens cannot do anything about
it. A middleman must step in to buy or sell to eliminate the imbal-
ance and keep the market alive.
Even if it were theoretically possible for ECNs to eliminate trans-
action volatility caused by the bid-as kspread required by middlemen,
that could not happen without effectively shutting down the market.
Thus, any reduction in transaction volatility you see coming from
ECNs is not going to eliminate it. And there is some reason to be-
lieve it won’t even reduce it—depending on how markets shape up.
ECNs shoo kup mar ket trading as they proliferated in the late
1990s and early 2000s. The leading players in this market are Island
and Instinet, both of which do a huge business in this kind of com-
puter trading. Any business they get, however, is business that the
traditional exchanges—and the brokers, traders, and market makers
who participate in them—do not get. At stake for traditional bro-
kerage firms is the franchise value from their roles as specialists and
market makers in stocks. At stake for the proprietors of the ECNs
and the on-line and discount brokers who get more order flow
through their use is a new franchise value the systems can create.
Not surprisingly, then, the explosion of ECNs as alternative trad-
ing places produced an excited debate among the traditional firms
and the newer firms and at the SEC and in Congress. All factions
recite a variation of the same mantra: The goal is to help investors
get the best price available each time they trade.
Traditional firms say the goal of getting customers the best price
would be best accomplished by having a single source of pricing
information,^19 and so they call for a centralized order boo kwhere all
orders would be posted and through which all participants could
insure that their customers get the best price. The ECNs and on-
line and discount firms say you will get better pricing if you have
lots of competition between firms, and so they call for permitting a