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 markets will have profound effects on many securities exchanges and their member firms. New screen-based markets can match buy and sell orders, and confirm trades electronically to the participants. In many cases, investors' orders meet directly in the system without the involvement of a broker or a dealer, saving intermediation costs such as the bid-ask spread and broker commission costs. Competing market makers operating on the London Stock Exchange's SEAQ market system provide an intermediated, "quote-driven" trading mechanism. Nearly all equities trading in London today occurs through SEAQ, but the approaching roll-out of several alternative trading systems will provide investors with new opportunities to trade without market makers. A simulation model of order arrival, information change, and trading in a competing dealer market based on the London Stock Exchange is used to examine the consequences of disintermediated trading systems. The results indicate that trading by market makers at their discretion at "midspread" prices leads to a significant reduction in dealing margins. In two other scenarios, the operation of 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 those requiring immediate execution and dealer intermediation may pay more.