Editors' Summary

BEGINNING WITH THE trans-Atlantic cable that linked the London and New York markets for foreign exchange, a series of technological innovations has transformed the securities industry, changing not only the patterns of financing but also the regulation and governance of institutions that provide the infrastructure for financial flows. But the impact has been uneven. Trading floors have been abandoned in favor of an electronic interface in some stock exchanges, but not others (including the largest, the New York Stock Exchange). The Internet has transformed the brokerage business but has had very little impact to date on initial public offerings. Greater international competition among exchanges has put increasing pressure on regulators to regulate more efficiently or face the prospect of regulating an increasingly irrelevant fragment of the securities industry.

What lies ahead for securities and other financial markets in light of these and other developments? What other changes are likely to affect the trading of financial instruments in the near future? The Brookings Institution and Wharton School convened their fifth annual conference on financial services at Brookings in January 2002 to help answer these questions. This introduction summarizes some of the issues and conclusions that were discussed in papers presented at the conference as well as some of the comments made by financial experts who attended the conference.

Is Stock Trading a Natural Monopoly?

A threshold question is whether recent technological advances are creating a natural monopoly for the largest exchanges, at least in their respective national markets, if not on a global scale as well. Certainly, there are network externalities associated with exchanges—that is, the greater is the number of issuers and investors who do business on them, the greater is the value they provide to all parties. But, if left unconstrained by political forces, will the "exchange market" become a natural monopoly?

Ruben Lee of the Oxford Finance Group in the United Kingdom predicted a future in which trading is increasingly concentrated among a small number of exchanges. Although he believed that network externalities are important, Lee conceded that they may not be all powerful, and thus it is possible that the number of exchanges may proliferate simply because automated exchanges are so cheap to operate. Stijn Claessens, Daniela Klingebiel, and Sergio Schmukler of the World Bank Group found evidence in support of this trend in the migration of listings from emerging markets to the largest markets in the Organization for Economic Cooperation and Development. Indeed, they identified a paradox of financial development in which the more successful a country is in strengthening its financial infrastructure, the more likely are its firms to list on larger, more liquid foreign markets.

In contrast, Marshall Blume of the Wharton School placed greater emphasis on the differing needs of various categories of market participants and believed that this will lead to greater fragmentation of trading. He noted that liquidity-motivated traders (such as large index mutual funds) seek out separate markets in which they are identified and can expect to get better prices than information-motivated traders (who act on the basis of new information and prefer anonymity). Investors will differ in their willingness to trade off the degree of anonymity versus the speed of execution versus price improvement, and so different markets will emerge to satisfy these differing preferences.

Blume highlighted the tension between the Securities and Exchange Commission (SEC) model of a national market system and the reality of a competitive global market in which it is impossible to define a best price and best execution without reference to the particular needs of each market participant. He emphatically rejected the notion that "one market fits all" and posed the question "Whom should the SEC try to protect?" He noted that the SEC appears to be excessively concerned with active retail traders who constitute a very small minority of retail investors. Although Blume perceived benefits in greater fragmentation, he was concerned about maintaining transparency of the prices at which trades take place in an environment of...