The persistent questions of the electronic call market: If you build it, will they ever come? And will they ever trade in sufficient volumes?
Electronic call markets, their advocates note, are highly popular in Europe in places such as the ParisBourse and DeutscheBourse.
Electronic call markets will reward those visionary market officials who are willing to take a chance, advocates predict.
Electronic call markets provide better execution prices than traditional dealer dominated markets, according to many friends and enemies of the concept. Electronic call markets, advocates insist, are the wave of the future.
"They are inevitable. They are simply more efficient," according to Benn Steil, who has studied markets as a fellow for the Council of Foreign Relations.
Electronic call markets, others say, will never work in the United States.
"The primary reason they will never make it here is because no one truly understands them," said John Wheeler, head trader for American Century.
An electronic call auction, unlike the continuous trading system for most U.S. equity transactions, is not, however exceedingly complex.
It batches buy and sell orders, then executes them at fixed points in time, at prices which most accurately balance supply and demand.
The executions could be at the opening and the closing of a session. Call markets can also be used as part of a continuous system, creating a hybrid.
An electronic call is a price-discovery mechanism and should not be confused with the electronic crossing services operated by Instinet and others. These use a reference price from the continuous market to match orders.
The pure electronic call is not popular in the U.S. One system, the Arizona Stock Exchange, has struggled to survive. A manual call opens trading at the New York and American stock exchanges. But the specialist does the work performed by a computer in an electronic call.
The debate over market structure has been renewed because of recent rocky markets, the disturbing events of Sept. 11, and the expectation that those volatile markets will continue in the near future.
Before the Sept. 11 attacks, for example, the estimated earnings of companies in the S&P 500 stock index were expected to decline by 10.2 percent this year and rise by 23.2 percent in 2002, according to First Call/Thomson Financial. (Thomson Financial is the parent of Thomson/IMG, publisher of Traders Magazine).
A week later, First Call/Thomson adjusted the numbers to a decline of 10.2 percent this year and an increase of 20 percent in S&P earnings in 2002. Either way, most observers agree: Volatile times appear to be in the market's immediate future.
Historical Roots
So why do electronic call markets elicit such controversy? And why do many market observers and participants, even as they praise the concept, say that electronic call markets will never make it in the U.S.?
"We also have very unique markets here. Our markets are bigger and very different than what they are in Europe," according to Wheeler.
Several critics of the current system were more blatant: They privately told Traders Magazine that a call auction market would put market makers out of business, pushing many of their services into redundancy. That's because compensation for many of their services is trading related. Noting that Nasdaq is dominated by market makers, they say, that group will never support call auctions.
But a Nasdaq official said his group is not opposed to call auction markets. "The problem is we can't find a way to make them work. We simply can't find a way to integrate them into a continuous market," said Dan Franks, a senior vice president for technology services for Nasdaq and a former market maker. Nasdaq, pressed by Arthur Levitt, the former Securities and Exchange Commission Chairman, did try unsuccessfully to introduce a call to make the opening more orderly.
The idea of call auctions is actually old. It is a form of trading that was popular in the U.S. in the 19th century.
Explosive Growth
From 1817 to about 1870 the New York Stock Exchange ran a formal daily call auction for listed stocks. But the system came under strain in the 1860s because of the exploding growth of listed stocks.
Big Board officials eventually decided to adopt continuous trading as a way of accommodating large numbers of stocks and traders in a single physical location. That is the idea most traders accept today. It is the idea of automated trading in a continuous electronic market, or what is referred to as an "order-driven" market.
But the concept of call auctions has made a comeback in France and Germany.
Still, because U.S. market participants don't understand call auction markets, because they are comfortable with the traditional continuous market in which a transaction happens whenever a buy and sell offer meet in price, many are fearful of using this system.
That's even though much of the rest of the world uses it without problems. Nevertheless, Franks notes there are distinct differences between Europe and the U.S.
"They have mandatory books. They have volatility halts. We don't believe in volatility halts. We believe in the idea of continuous markets," he said.
Electronic call markets are unique electronic markets that operate without a trading floor. They are like a new restaurant in town. It is reputed to have wonderful food. It has a wonderful exotic chef with a great reputation because of past successes elsewhere. However, when one walks past this new business, peers in the window and sees that no one is trying its food, one is fearful of becoming a guinea pig.
The old standby restaurant suddenly seems just fine, even if it is more expensive or even if it is a greasy spoon. At least one knows what one is going to get!
"We'd love to make it work, but liquidity is a hard thing to attract," Franks added. For many participants, electronic call markets represent the shock of the unknown.
"We haven't been able to get critical mass," complained Steven Wunsch, president and chief executive of the Arizona Stock Exchange, which was fighting for survival last year until it found a partner to inject cash.
"In fact, we haven't had revenues for months," he recently said. The Arizona Stock Exchange, which already has several partners, is once again searching for a merger partner or buyer, a partner who might be able to convince trading firms to try its cooking.
"It is very difficult to get order flow in these things," said Professor Robert Schwartz, a business professor at Baruch College in New York. Schwartz, who has written extensively on electronic call markets, is an investor in the troubled Arizona Stock Exchange (AZX).
Nevertheless, he is convinced, based on his studies of those call auctions operating abroad, that they would work here and would have a broad appeal.
"Call auctions, because they focus on liquidity, have commonly been thought appropriate for mainly small cap, less frequently traded stocks. However, they also have particular appeal for large caps because they cater to the needs of institutional participants whose portfolios are mostly comprised of these issues," Schwartz wrote in a book called "The Call Auction Alternative," which he is co-authoring with Professor Marvin Speiser.
"Market impact," they write, "is reduced for the institutional investor because the call is a point in time where orders are batched together for a multilateral trade. Commissions may be lower due to a greater ease of handling orders and clearing trades in the call auction environment.
For the broad market, call auctions can reduce price volatility, unreliable pricing, unequal access to the market, and various forms of manipulation and abuse."
Trading Places
Another study estimates that replacing the NYSE and Nasdaq's current continuous system with a system of "nointermediated electronic-order matching system" would result in a cost saving to S&P 500 companies of some seven percent.
"In Europe, where such trading systems already predominate, we estimate that disintermediating the exchange members who currently route buy and sell orders from investors to the exchanges would result in a decline of trading fees of roughly 70 percent, which would translate into a 7.8 percent cost of capital savings for European blue-chip companies," according to "Innovation in Equity Trading Systems. The Impact of Transaction Costs and Cost of Capital."
That's a paper written by Benn Steil, David Victor and Richard Nelson. The work was published by Princeton University Press. These conclusions are supported by Dr. William Christie, a finance professor at Vanderbilt University. He has called for Nasdaq to use a call auction system in cases when it halts and reopens trading in a stock.
American Century's Wheeler, who respects these comments of academics, nevertheless, has a unique view of this dicey market structure debate. He believes electronic call markets could be more efficient than the present structure, but that they won't work in the huge, unique U. S. markets.
Intermediaries depend on the traditional dealer dominated market to survive and most clients are willing to accept higher execution costs for the assurance of quicker transactions, he adds.
"There is a need to be assured of execution, with call markets one can't depend on that," Wheeler added. So dealers and specialists, who expect to be compensated for providing liquidity, are feeling no compelling pressure from clients to provide lower execution costs.
The implication of Wheeler's comments is that, warts, locked markets and all, most participants can live with the current system. Therefore, call auction systems are an interesting idea, but appear to be mainly the plaything of academics who don't trade for a living. However, supporters of it hope that recent events and regulatory policy could give call auctions a new boost.
Since the 1970s, regulators and lawmakers have been pushing for a better system. That means, "the centralization of all buying and selling interest so that each investor will have the opportunity for the best execution of his order, regardless of where in the system it operates," according to the 1975 law written by Congress.
The National Market System also mandated the promotion of "orderly markets." Later, in the 1990s after an investigation found evidence purporting to show Nasdaq dealers colluding, the regulators wrote the order handling rules. The growth of ECNs followed the order handling rules. Today ECNs are executing about a quarter of Nasdaq's daily dollar volume.
Regulators, especially former SEC Chairman Levitt, have pushed for these alternate, competing channels, as a way of reducing execution costs and giving the average investor a break.
But the recent acts of terrorism and the imminence of war have also given another boost to the friends of electronic call markets.
"After the attacks on the World Trade Center, online call auctions are a big issue again, as people want to reduce market volatility as much as possible, especially at the beginning and end of each closing day," according to AZX's Wunsch. Maybe.
Changing World
Certainly there is a greater need today for stable markets given the recent dangerous events of the world and of lower Manhattan. But the hard fact in the market structure debate is this: Academics and theorists, brilliant as many of them are, don't build markets – investors and their agents, traders, do. Are the markets going to stabilize?
Will there be enough liquidity in the times of crisis that some anticipate as America and his Allies wage their worldwide war against terrorism?
Call auctions, in the near term, will probably continue to be an academic exercise that few traders want to risk money on. But if war, or other dramatic events, lead to more roller coaster rides on the Nasdaq, then traders might finally, reluctantly, be ready to build something very different.
