U.S. Secondary Stock Markets: A Survey of Current Regulatory and Structural Issues and a Reform Proposal to Enhance Competition

Abstract

U.S. stocks trade on an increasing number of structurally diverse and competitive stock markets. However, there is concern about the type of competition that has emerged and its implications for investor protection and market efficiency. For instance, the increasing challenge posed to the principal stock exchanges (like the NYSE) by alternative markets raises concerns about excessive order flow fragmentation and its implications for stock price efficiency and liquidity. The controversial practice of payment for order flow (POF), whereby dealers pay brokers to route customers' orders to them whether or not such routing results in the best price for the customer, also causes concern because it significantly reduces investors' choice over where their trades will occur. The paper considers these and other contemporary issues (like market transparency and collusion in dealer markets) in considerable detail. It also provides a useful survey of the financial economics literature on these topics.

The paper argues that the current regulatory framework (the National Market System) inadequately addresses the above concerns. In light of technological and regulatory changes over the past two decades, the theoretical framework upon which the present regulatory system is based is no longer appropriate. In particular, recent developments cast doubt on the view that the primary exchanges are natural monopolies. Therefore, I propose a fundamentally different approach to the regulation of U.S. secondary trading markets: a genuinely competitive regime that gives issuers and, derivatively, investors a genuine choice over where their shares will trade.

Keywords: Market microstructure, payment for order flow, market transparency, National Market System

JEL Classification: G14, G18, G28, K22