Lecture 19: Brokers, Dealers,
Exchanges & ECNs
Economics 252, Spring 2008
Prof. Robert Shiller, Yale University
Brokers, Dealers Exchanges &
ECNs
• Broker-Dealer (BD) is an organization as defined
by SEC, hires natural persons as brokers and
dealers, its registered representatives
• An exchange is a private association of brokers
regulated (in the U.S.) by the SEC
• Electronic Communications Networks (ECNs)
allow investors to communicate with each other,
and to exchange: Archipelago (now part of
NYSE), BATS, Direct Edge.
Brokers
Brokers act on behalf of
Others as their
Agent for which they earn a
Commission
Dealers
A Dealer always acts for
Herself, in other words as a
Principal in the transaction for which she
makes a
Markup
The Traditional Four Markets
• First Market: NYSE
• Second market: NASDAQ National Market
(replaced the “pink sheets” in 1971)
• Third market: Nasdaq small cap
• Fourth market: large institutions trade
amongst themselves without the use of a
securities firm
Exchanges
• New York Stock Exchange, established 1792 by
the Buttonwood Agreement among 24 brokers.
• Exchanges provide standards and codes of ethics
for broker members, standards for stocks.
• Exchanges must register and are regulated by SEC
• National Best Bid Offer (NBBO) via Intermarket
Trading System (ITS)
• Regional Exchanges: Philadelphia Exchange,
Cincinnati Exchange now National Stock
Exchange
• Listing requirements for stocks. Delisting too.
Intermarket Trading System
(ITS)
• Securities Act of 1975 called for a national market system
• In response to this act, the ITS, an electronic system, was opened in
1978. Displays quotes on all exchanges where a stock is listed or
where traded under UTP (unlisted trading privileges)
• When a BD enters a trade, it is automatically routed via ITS to
exchange with best price, via Consolidated Quote System, though
slowly
• BDs may send trade instead to an ECN for “payment for order flow”
• Increasingly impatient investors may be happy to put trades to ECNs
for fast execution. They may suffer from poor execution
• NMS Linkage proposed to replace ITS by all major US stock
exchanges in 2006.(no news that it is implemented)
Electronic Communications
Networks
• ECNs (sometimes called Alternative Trading Systems, ATS) are
regulated by the SEC essentially as broker dealers (BDs), which puts
them in a (slightly) different category from exchanges
• Tend to handle over the counter (OTC) (small volume) securities
• ECNs started as basically web sites for traders created by young
computer geeks, but increasingly functioned more as exchanges
• New SEC rules January 1997 made ECNs important by granting them
access to Nasdaq National Market system
• Archipelago founded 1996 in anticipation of new rules
• Instinet: for professionals. Until 1999, it was the biggest ECN. In 2004
it ceased being an ECN and is now a broker-dealer.
• Island: for individuals, became the biggest ECN. In 1999 it did 4.9%
of all Nasdaq trading volume.
NYSE-ArcaEx Merger, 2005
• April, 2003 Archipelago was trading 8,800 stocks
• April 20, 2005, NYSE, then trading 2,744 stocks,
and ArcaEx announced they would merge to form
the NYSE Group
• NYSE now trading Nasdaq stocks
• After NYSE-ArcaEx merger and Nasdaq-INET
merger, worries emerge about a duopoly situation
in US stock market
NYSE-EuroNext merger 2006
• So it went frm NYSE to NYSE Group, Inc.,
to NYSE Euronext, Inc.
• NYSE likely to buy AMEX, 2008
Kinds of Orders
• Market Order
• Limit Order
• Stop Loss Order
– Market orders dangerous for thinly-traded
stocks
– ECNs may not allow market orders
Gambler’s Ruin Problem
• Starting with $S, betting $1 on heads on a
coin toss with probability p of coming up
heads, continuing to toss until ruin,
probability of eventual ruin equals 1 if p is
less than or equal to one half, otherwise
equals ((1-p)/p)^s:
Gambler’s Ruin Derivation
• Call probability of ever failing, playing
forever, given that one has S dollars today
Pr(S). Then Pr(S)=pPr(S+1)+(1-p)Pr(S-1)
and note that Pr(0)=1.,
Optimal Bid-Asked Spread
• Dealer must set a bid-asked spread in
consideration of the ultimate probability of ruin
and dealer’s utility weighting of this outcome
• Dealer has inferior information, expects to be
“picked off” by superior traders.
• Must set bid-asked spread so that the amount of
gain from spread offsets the expected loss.
