Trade Execution Costs and the Disintermediation of Trading in a Competing Dealer Market

Abstract

The growth of alternative trading systems that compete with established stock marketswill have profound effects on many securities exchanges and their member firms. Newscreen-based markets can match buy and sell orders, and confirm trades electronically tothe participants. In many cases, investors' orders meet directly in the system without theinvolvement of a broker or a dealer, saving intermediation costs such as the bid-askspread and broker commission costs. Competing market makers operating on the LondonStock Exchange's SEAQ market system provide an intermediated, "quote-driven" tradingmechanism. Nearly all equities trading in London today occurs through SEAQ, but theapproaching roll-out of several alternative trading systems will provide investors with newopportunities to trade without market makers. A simulation model of order arrival, informationchange, and trading in a competing dealer market based on the London StockExchange is used to examine the consequences of disintermediated trading systems. Theresults indicate that trading by market makers at their discretion at "midspread" pricesleads to a significant reduction in dealing margins. In two other scenarios, the operationof an alternative, disintermediated order crossing mechanism, reduces market makers'trading volumes and lowers the level of intermediation at some savings to investors.Alternative trading systems reduce transactions costs borne by some traders, but thoserequiring immediate execution and dealer intermediation may pay more.