The Structure of the U.S. Equity Markets

EQUITY MARKETS WORLDWIDE are in a state of change. Technology and the Internet have had and will continue to have a profound impact on the structure of equity markets. Moreover, recent rulings from the Securities and Exchange Commission (SEC) have unleashed new competitive forces that will challenge established markets. To date, the cost and awkwardness of the settlement processes across nations have restrained global competition, but these processes also are changing. As cross-border settlement becomes cheaper and easier, global trading may increase and U.S. regulators will need to adapt to this new environment.

The 1975 amendments to the Securities Exchange Act of 1934 set as a national goal that all securities should be traded in a national market system. ¹ This goal has shaped much of the SEC's thinking since that time, but it may collide with some of the ongoing structural changes occurring in the equity markets, both domestically and worldwide. As argued in this paper, a national market system represents a naïve and parochial view of the way in which equities trade. It is incompatible with how the markets are developing and will develop.

A national market system abhors fragmentation because it limits interaction among order flow. Yet fragmentation is at the heart of competition. New competition creates fragmentation, but significant fragmentation will occur only if the competition is successful. If the competition is extremely successful, existing markets will decline and fail, resulting ultimately in less fragmentation.

To be effective in this increasingly global world, the SEC will have to give up its goal of a national market system, recognize the global nature of the equity markets, and shape its regulatory thrust to the regulatory issues of a global market. The SEC and other U.S. regulatory authorities will have to coordinate their activities with those of other nations.

In future years, a firm like Microsoft will trade worldwide. Investors in Africa, Asia, Australia, Europe, and South America will be able to buy U.S. stocks during their normal business hours in their local currency. Of great significance to U.S. regulators is that a U.S. investor will be able to trade U.S. stocks in foreign markets. By so trading, U.S. investors may be able to circumvent some U.S. regulations legally and to hide some questionable, and possibly illegal, activities from U.S. surveillance.

The movement toward global trading has begun and will continue. When global trading becomes a reality, an investor will choose the country and currency in which the trade takes place. A U.S. investor will be able to trade on any market that provides advantages over those in the United States. Still, it is quite possible that the bulk of trading in a security will remain in the domestic market. To be successful, a market requires a critical mass of liquidity. Since the domestic market already has that mass, it is difficult, though not impossible, for another market to establish itself.

Monitoring and regulating this movement to global trading will be one of the major regulatory challenges over the next decade. Domestic regulators will have to coordinate their efforts with those of other countries. A short list of challenges in regulating worldwide trading includes the oversight of a global settlement system, the prevention of fraud, the maintenance of transparency, the enforcement of stockholder rights, the collection of taxes, and the integration of disparate and perhaps contradictory laws.

This paper consists of nine sections. The first two describe the legislated national market system and its limitations. Since the concept of a national market system underlies much of current U.S. regulatory efforts, it is important to understand this concept and its limitations. The following three sections highlight the current organization of the markets, including the consolidated reporting of information, the participants, and the regulations. Two sections examine some of the major issues of the day and...