A new approach to the regulation of trading across securities markets

New York University Law Review

Volumn 71, Issue 6, 1996, Pages 1411-1465

  Amihud, Yakov ^a,b,c   Mendelson, Haim ^b,d,e  

^a NEW YORK UNIVERSITY   (United States)

^b HEBREW UNIVERSITY OF JERUSALEM   (Israel)

^c NEW YORK UNIVERSITY   (United States)

^d STANFORD UNIVERSITY   (United States)

^e TEL AVIV UNIVERSITY   (Israel)

Author keywords

[No Author keywords available]

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EID: 0030343220     PISSN: 00287881     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (289)

1. See Laura Covill, Survival of the Fittest, Euromoney, Aug. 1996, at 60, 60-62 (discussing competition among European stock exchanges); Henry Harrington, Behind the Remote Reality, Survey of European Stock Exchanges, Fin. Times, Feb. 16, 1996, at 4 (discussing Investment Services Directive and its impact in context of electronic trading: "Today, there is nothing to stop a British broker trading shares on the Amsterdam stock exchange from under a sun umbrella on a Greek beach."); Hollowing Out Japan's Financial Markets, The Economist, Aug. 13, 1994, at 67, 67 (discussing migration of trading from Tokyo Stock Exchange to SEAQ International).
2. See Laura Covill, Survival of the Fittest, Euromoney, Aug. 1996, at 60, 60-62 (discussing competition among European stock exchanges); Henry Harrington, Behind the Remote Reality, Survey of European Stock Exchanges, Fin. Times, Feb. 16, 1996, at 4 (discussing Investment Services Directive and its impact in context of electronic trading: "Today, there is nothing to stop a British broker trading shares on the Amsterdam stock exchange from under a sun umbrella on a Greek beach."); Hollowing Out Japan's Financial Markets, The Economist, Aug. 13, 1994, at 67, 67 (discussing migration of trading from Tokyo Stock Exchange to SEAQ International).
3. See Laura Covill, Survival of the Fittest, Euromoney, Aug. 1996, at 60, 60-62 (discussing competition among European stock exchanges); Henry Harrington, Behind the Remote Reality, Survey of European Stock Exchanges, Fin. Times, Feb. 16, 1996, at 4 (discussing Investment Services Directive and its impact in context of electronic trading: "Today, there is nothing to stop a British broker trading shares on the Amsterdam stock exchange from under a sun umbrella on a Greek beach."); Hollowing Out Japan's Financial Markets, The Economist, Aug. 13, 1994, at 67, 67 (discussing migration of trading from Tokyo Stock Exchange to SEAQ International).
4. See Andrew Fisher, The Market That Comes to You, Fin. Times, Feb. 16, 1996, at II (survey) (discussing computer-based trading networks at Deutsche Börse). Of stocks listed on the Netherlands Exchange, 56% are nondomestic; in Germany, 49% of listed stocks are nondomestic; in Switzerland, 42% of listed stocks are nondomestic; and in France, 32% of listed stocks are nondomestic. See Office of Technology Assessment, U.S. Congress, Trading Around the Clock: Global Securities Markets and Information Technology - Background Paper 30 (OTA-BP-CIT-66, July 1990) [hereinafter Trading Around the Clock] (tabulating nondomestic stock percentages on various exchanges).
5. See Harrington, supra note 1, at 4.
6. See John Eisenhammer, Stock Exchange Gives Go-Ahead to Trading Reforms, The Independent, Mar. 22, 1996, available in 1996 WL 4064575 (outlining approval of reform proposals by London Stock Exchange); London Exchange Buckles Down to Fight Competition, Reuters World Service, July 1, 1996, available in LEXIS, News Library, Non-US File (summarizing London Stock Exchange's responses to increased competition).
7. A comprehensive analysis of these trends appears in Trading Around the Clock, supra note 2, and in Office of Technology Assessment, U.S. Congress, Electronic Bulls & Bears: U.S. Securities Markets and Information Technology 62-65 (OTA-CIT-469, Sept. 1990) [hereinafter Electronic Bulls & Bears].
8. The regional exchanges are the Pacific, Boston, Chicago (formerly Midwest), Philadelphia, and Cincinnati Stock Exchanges.
9. See James E. Shapiro, Recent Competitive Developments in U.S. Equity Markets 8-10 (New York Stock Exchange Working Paper No. 93-02, 1993) (discussing rise and use of private trading systems). The private trading systems include Posit, Instinet, and a system operated by Bernard Madoff Investment Securities. A proprietary trading system in Arizona now operates as the Arizona Stock Exchange.
10. NASDAQ is an acronym for the National Association of Securities Dealers Automated Quotation system. National Market System securities include NASDAQ securities whose transactions are reported as they occur as well as some listed securities whose transactions are reported by NASDAQ. See 17 C.F.R. §§ 240.11(A)(a)(2-1)-(3-1) (1996).
11. See id.
12. See infra Part I.
13. See infra Part I.
14. The Intermarket Trading System is a computer-based communication system that connects the six stock exchanges and NASDAQ and displays the best prices quoted on any stock market for stocks which are traded in more than one market. It also enables broker-dealers to route orders from one market to another. For additional discussion, see infra Part III.C.5; see also Electronic Bulls & Bears, supra note 5, at 52-53 (discussing praise and criticism of Intermarket Trading System); U.S. Equity Market Structure Study, Exchange Act Release No. 30,920, 51 SEC Docket 1524, 1530 (July 14, 1992) [hereinafter Equity Market Structure Study] (noting that Intermarket Trading System links participant markets and provides for routing of orders).
15. See James E. Shapiro, U.S. Equity Markets: A View of Recent Competitive Developments 7-8 (New York Stock Exchange Working Paper, 1993) (discussing reported trading in NYSE-listed stocks in London, Tokyo, Paris, and Frankfurt).
16. Foreign companies whose securities are traded on a U.S. securities exchange or on NASDAQ are subject to U.S. reporting requirements, unless the stocks traded on NASDAQ prior to 1983 and therefore qualify for an exemption. See James L. Cochrane, Assessing and Evaluating the Current Directions of Transactional Listings 6-7 (New York Stock Exchange Working Paper No. 93-03, 1993) (noting that foreign companies cannot be listed on U.S. Exchange or NASDAQ unless securities were registered on NASDAQ prior to 1983); Franklin R. Edwards, SEC Requirements for Trading of Foreign Securities on U.S. Exchanges, in Modernizing U.S. Securities Regulation: Economic and Legal Perspectives 57, 57-61 (Kenneth Lehn & Robert W. Kamphuis, Jr. eds., 1992) (discussing SEC requirements for trading foreign security on U.S. Exchanges).
17. Foreign companies whose securities are traded on a U.S. securities exchange or on NASDAQ are subject to U.S. reporting requirements, unless the stocks traded on NASDAQ prior to 1983 and therefore qualify for an exemption. See James L. Cochrane, Assessing and Evaluating the Current Directions of Transactional Listings 6-7 (New York Stock Exchange Working Paper No. 93-03, 1993) (noting that foreign companies cannot be listed on U.S. Exchange or NASDAQ unless securities were registered on NASDAQ prior to 1983); Franklin R. Edwards, SEC Requirements for Trading of Foreign Securities on U.S. Exchanges, in Modernizing U.S. Securities Regulation: Economic and Legal Perspectives 57, 57-61 (Kenneth Lehn & Robert W. Kamphuis, Jr. eds., 1992) (discussing SEC requirements for trading foreign security on U.S. Exchanges).
18. For example, in Germany, the stocks of the top 40 companies are traded on eight national exchanges as well as on IBIS, an electronic trading system. The eight exchanges in Germany are Berlin, Bremen, Düsseldorf, Frankfurt, Hamburg, Hanover, Munich, and Stuttgart. For an analysis of multimarket trading in these markets, see generally Hartmut Schmidt et al., Competition Among German Trading Mechanisms: Electronic Trading on IBIS vs. Trading on the Floor Based BOSS-CUBE System (Jan. 12, 1996) (unpublished manuscript, on file with authors).
19. See Yakov Amihud & Haim Mendelson, How (Not) to Integrate the European Capital Markets, in European Financial Integration 73, 75-89 (Albert Giovanni & Colin Mayer eds., 1991) [hereinafter Amihud & Mendelson, European Capital Markets], for an analysis of the effects of the ITS and similar systems. An analysis of the liquidity consequences of multimarket trading appears in Yakov Amihud & Haim Mendelson, Option Markets Integration: An Evaluation 11-16 (Jan. 1990) [hereinafter Amihud & Mendelson, Option Markets] (unpublished manuscript, on file with authors). See also Kalman J. Cohen et al., The Microstructure of Securities Markets 152-67 (1986); Robert A. Schwartz, Reshaping the Equities Markets: A Guide for the 1990s, at 169-80 (1991); Equity Market Structure Study, supra note 12, at 1531-33.
20. See Yakov Amihud & Haim Mendelson, How (Not) to Integrate the European Capital Markets, in European Financial Integration 73, 75-89 (Albert Giovanni & Colin Mayer eds., 1991) [hereinafter Amihud & Mendelson, European Capital Markets], for an analysis of the effects of the ITS and similar systems. An analysis of the liquidity consequences of multimarket trading appears in Yakov Amihud & Haim Mendelson, Option Markets Integration: An Evaluation 11-16 (Jan. 1990) [hereinafter Amihud & Mendelson, Option Markets] (unpublished manuscript, on file with authors). See also Kalman J. Cohen et al., The Microstructure of Securities Markets 152-67 (1986); Robert A. Schwartz, Reshaping the Equities Markets: A Guide for the 1990s, at 169-80 (1991); Equity Market Structure Study, supra note 12, at 1531-33.
21. See Yakov Amihud & Haim Mendelson, How (Not) to Integrate the European Capital Markets, in European Financial Integration 73, 75-89 (Albert Giovanni & Colin Mayer eds., 1991) [hereinafter Amihud & Mendelson, European Capital Markets], for an analysis of the effects of the ITS and similar systems. An analysis of the liquidity consequences of multimarket trading appears in Yakov Amihud & Haim Mendelson, Option Markets Integration: An Evaluation 11-16 (Jan. 1990) [hereinafter Amihud & Mendelson, Option Markets] (unpublished manuscript, on file with authors). See also Kalman J. Cohen et al., The Microstructure of Securities Markets 152-67 (1986); Robert A. Schwartz, Reshaping the Equities Markets: A Guide for the 1990s, at 169-80 (1991); Equity Market Structure Study, supra note 12, at 1531-33.
22. See Yakov Amihud & Haim Mendelson, How (Not) to Integrate the European Capital Markets, in European Financial Integration 73, 75-89 (Albert Giovanni & Colin Mayer eds., 1991) [hereinafter Amihud & Mendelson, European Capital Markets], for an analysis of the effects of the ITS and similar systems. An analysis of the liquidity consequences of multimarket trading appears in Yakov Amihud & Haim Mendelson, Option Markets Integration: An Evaluation 11-16 (Jan. 1990) [hereinafter Amihud & Mendelson, Option Markets] (unpublished manuscript, on file with authors). See also Kalman J. Cohen et al., The Microstructure of Securities Markets 152-67 (1986); Robert A. Schwartz, Reshaping the Equities Markets: A Guide for the 1990s, at 169-80 (1991); Equity Market Structure Study, supra note 12, at 1531-33.
23. See infra Part I.
24. Liquidity is the ease with which a security can be transacted and converted to cash or with which cash can be converted to a security. The lower the liquidity of a security is, the higher the costs of transactions in that security will be. See infra Part II for a detailed analysis.
25. See, e.g., Kalman J. Cohen et al., An Analysis of the Economic Justification for Consolidation in a Secondary Security Market, 6 J. Banking & Fin. 117, 119 (1982) (stating that consolidation of all orders would maximize liquidity and immediacy of execution and help ensure that trades are executed at reasonable prices); Morris Mendelson & Junius W. Peake, Intermediaries' or Investors': Whose Market Is It Anyway?, 19 J. Corp. L. 443, 444 (1994) (stating that economic functions are performed most efficiently when all orders for particular financial instrument interact within single trading arena); see also infra note 119.
26. See, e.g., Kalman J. Cohen et al., An Analysis of the Economic Justification for Consolidation in a Secondary Security Market, 6 J. Banking & Fin. 117, 119 (1982) (stating that consolidation of all orders would maximize liquidity and immediacy of execution and help ensure that trades are executed at reasonable prices); Morris Mendelson & Junius W. Peake, Intermediaries' or Investors': Whose Market Is It Anyway?, 19 J. Corp. L. 443, 444 (1994) (stating that economic functions are performed most efficiently when all orders for particular financial instrument interact within single trading arena); see also infra note 119.
27. For an analysis of the globalization of securities markets and its impact on market regulation, see Joseph A. Grundfest, Internationalization of the World's Securities Markets: Economic Causes and Regulatory Consequences, 4 J. Fin. Services Res. 349 (1990); see also Diana B. Henriques, In World Markets, Loose Regulation, N.Y. Times, July 23, 1991, at D1 (discussing regulatory lag in growing global markets).
28. For an analysis of the globalization of securities markets and its impact on market regulation, see Joseph A. Grundfest, Internationalization of the World's Securities Markets: Economic Causes and Regulatory Consequences, 4 J. Fin. Services Res. 349 (1990); see also Diana B. Henriques, In World Markets, Loose Regulation, N.Y. Times, July 23, 1991, at D1 (discussing regulatory lag in growing global markets).
29. See Yakov Amihud & Haim Mendelson, Liquidity, Volatility and Exchange Automation, 3 J. Acct. Auditing & Fin. 369, 371-83 (1988) (showing how trading mechanisms applied in markets affect securities' liquidity); Jonathan Macey & Hideki Kanda, The Stock Exchange as a Firm: The Emergence of Close Substitutes for the New York and Tokyo Stock Exchanges, 75 Cornell L. Rev. 1007, 1012-20 (1990) (same).
30. See Yakov Amihud & Haim Mendelson, Liquidity, Volatility and Exchange Automation, 3 J. Acct. Auditing & Fin. 369, 371-83 (1988) (showing how trading mechanisms applied in markets affect securities' liquidity); Jonathan Macey & Hideki Kanda, The Stock Exchange as a Firm: The Emergence of Close Substitutes for the New York and Tokyo Stock Exchanges, 75 Cornell L. Rev. 1007, 1012-20 (1990) (same).
31. This has been shown both theoretically and empirically. See Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. Fin. Econ. 223, 223-49 (1986) [hereinafter Amihud & Mendelson, Bid-Ask Spread] (discussing empirical study of liquidity effect on value); Yakov Amihud & Haim Mendelson, Liquidity and Asset Prices: Financial Management Implications, Fin. Mgmt., Spring 1988, at 5, 12-13 [hereinafter Amihud & Mendelson, Liquidity and Asset Prices] (demonstrating theoretical effect of liquidity on valuation); Yakov Amihud & Haim Mendelson, Liquidity, Asset Prices and Financial Policy, 47 Fin. Analysts J., Nov.-Dec. 1991, at 56, 58-60 [hereinafter Amihud & Mendelson, Financial Policy] (demonstrating liquidity's theoretical effect on value).
32. This has been shown both theoretically and empirically. See Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. Fin. Econ. 223, 223-49 (1986) [hereinafter Amihud & Mendelson, Bid-Ask Spread] (discussing empirical study of liquidity effect on value); Yakov Amihud & Haim Mendelson, Liquidity and Asset Prices: Financial Management Implications, Fin. Mgmt., Spring 1988, at 5, 12-13 [hereinafter Amihud & Mendelson, Liquidity and Asset Prices] (demonstrating theoretical effect of liquidity on valuation); Yakov Amihud & Haim Mendelson, Liquidity, Asset Prices and Financial Policy, 47 Fin. Analysts J., Nov.-Dec. 1991, at 56, 58-60 [hereinafter Amihud & Mendelson, Financial Policy] (demonstrating liquidity's theoretical effect on value).
33. This has been shown both theoretically and empirically. See Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. Fin. Econ. 223, 223-49 (1986) [hereinafter Amihud & Mendelson, Bid-Ask Spread] (discussing empirical study of liquidity effect on value); Yakov Amihud & Haim Mendelson, Liquidity and Asset Prices: Financial Management Implications, Fin. Mgmt., Spring 1988, at 5, 12-13 [hereinafter Amihud & Mendelson, Liquidity and Asset Prices] (demonstrating theoretical effect of liquidity on valuation); Yakov Amihud & Haim Mendelson, Liquidity, Asset Prices and Financial Policy, 47 Fin. Analysts J., Nov.-Dec. 1991, at 56, 58-60 [hereinafter Amihud & Mendelson, Financial Policy] (demonstrating liquidity's theoretical effect on value).
34. See infra Part I.A, .C.
35. See Division of Mkt. Regulation, U.S. Sec. & Exch. Comm'n, Market 2000: An Examination of Current Equity Market Developments app. IV (1994) [hereinafter Market 2000] (outlining description of proprietary trading systems).
36. On the need for international coordination of regulatory actions and on some SEC initiatives in this area, see Grundfest, supra note 20, at 367-71.
37. See New York Stock Exch., Fact Book for the Year 1994, at 29 (1995) [hereinafter Fact Book] (discussing breakdown of NYSE trades). The distribution of volume gives a larger NYSE market share (83%), see id. at 28 (figures rounded), because the regional exchanges execute smaller trades on average, whereas larger blocks tend to be traded on the NYSE.
38. See Market 2000, supra note 24, at II-8 (discussing regional stock exchanges).
39. See S. 2693, 73d Cong., 2d Sess. § 11 (1934), reprinted in 11 J.S. Ellenberger & Ellen P. Mahar, Legislative History of the Securities Act of 1933 and Securities Exchange Act of 1934 (1973); H.R. 7855, 73d Cong., 2d Sess. § 11 (1934), reprinted in 10 Ellenberger & Mahar, supra.
40. See Securities Exchange Act of 1934, Pub. L. No. 73-291, § 12(f), 48 Stat. 881, 894 (1934).
41. See Securities & Exch. Comm'n, Report on Trading in Unlisted Securities upon Exchanges 7 (1936) [hereinafter Report on Trading in Unlisted Securities].
42. See id. at 24 (recommending that Commission be empowered to prescribe terms and conditions under which certain securities should be permitted to enjoy exchange market).
43. Id. at 9.
44. Id. at 10.
45. 5 U.S.C. § 78/(f) (1936).
46. See, e.g., In re Piedmont & N. Ry. Co., 1 Fed. Reg. 2171, 2171 (S.E.C. 1936) ("[B]y reason of inadequate public trading activity . . . the termination of . . . unlisted trading privileges is necessary and appropriate in the public interest and for the protection of investors . . . .").
47. For an analysis of this shift in SEC policy, see generally Walter Werner, Adventure in Social Control of Finance: The National Market System for Securities, 75 Colum. L. Rev. 1233, 1246-56 (1975).
48. See Report on Trading in Unlisted Securities, supra note 30, at 10.
49. Exchange Act Release No. 986 (Dec. 17, 1937).
50. Id. at 5.
51. See id. at 4.
52. Thin trading is defined as a situation where trading is of low and infrequent volume and without a great availability of buyers and sellers. In such circumstances, a buy or sell order of large size may have a strong impact on price: A large buy order will cause the price to rise, and a large sell order will cause the price to fall. The thinner the trading is, the greater the price impact any one order will have.
53. See In re Edison, Exchange Act Release No. 986 at 4.
54. Id. at 5.
55. Exchange Act Release No. 1992 (Jan. 19, 1939).
56. See id. at 2.
57. See id.
58. Id. at 4.
59. See id.
60. Exchange Act Release No. 3395, Fed. Sec. L. Rep. (CCH) ¶ 75,369 (Mar. 17, 1943).
61. See id. at 76,015-16.
62. Id. at 76,015.
63. See id. at 76,016.
64. See id. at 76,017.
65. Id.
66. See id. at 76,018.
67. See id. at 76,017-18.
68. See 140 Cong. Rec. H6508 (daily ed. Aug. 1, 1994) (statement of Rep. Markey).
69. Pub. L. No. 94-29, 89 Stat. 97 (1975) (codified at 15 U.S.C. § 78k-1 (1994)).
70. See 15 U.S.C. § 78k-1 (1994). The NMS was established by the Securities Act Amendments of 1975, which amended the Securities Exchange Act of 1934. See Securities Act Amendments of 1975, § 7, 89 Stat. at 111 (codified at 15 U.S.C. § 78k-1(a)(2) (1994)). It directed the SEC to "facilitate the establishment of a national market system for securities" and to eliminate hurdles to competition. 15 U.S.C. § 78k-1(a)(2) (1981). For a detailed discussion, see Electronic Bulls & Bears, supra note 5, at 47-49.
71. See Securities Act Amendments of 1975, § 11(a)(2), 89 Stat. at 112 (codified as amended at 15 U.S.C. § 78k-1(a)(2) (1994)).
72. Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban Affairs, Securities Industry Study, S. Doc. No. 93-13, 93d Cong., 1st Sess. 120-21 (1973).
73. 604 F.2d 704 (D.C. Cir. 1979).
74. See id. at 710.
75. See id. at 711.
76. Id. at 710 (emphasis omitted).
77. Id. at 711.
78. Id. at 708.
79. See Applications of Midwest Stock Exchange, Inc. for Unlisted Trading Privileges in Certain Securities, Exchange Act Release No. 16,422, [1979-1980 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 82,385, at 82,657 (Dec. 12, 1979) (finding grant of UTP consistent with broad goals of orderly markets and investor protection).
80. See Designation of National Market System Securities, Exchange Act Release No. 34-17,549, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 82,826 (Feb. 17, 1981).
81. Id. at 35 (quoting letter from Gordon S. Macklin, President, NASD, to George A. Fitzsimmons, Secretary, SEC (Aug. 13, 1979)).
82. Id. at 36.
83. Id.
84. See id. at 25.
85. See Designation of National Market System Securities, Exchange Act Release No. 34-24,635, 52 Fed. Reg. 24,149 (1987) (codified at 17 C.F.R. § 240 (1996)).
86. For our analysis of this issue, see infra Part III.D.
87. See Release Discussing Exchanges' and NASD's Proposed Rule Changes, Exchange Act Release No. 34-22,026, 50 Fed. Reg. 20,310, 23,313-14 (1985) (discussing NASD suggestion that exchanges require issuer consent before trading options). For an analysis of market structure issues involved in options trading, see generally Amihud & Mendelson, Option Markets, supra note 16.
88. Release Discussing Exchanges' and NASD's Proposed Rule Changes, 50 Fed. Reg. at 20,313. In addition, some commentators cited the possible negative impact of options on the market for the issuer's securities and on the company itself. See id.
89. Id.
90. See id.
91. 828 F.2d 586 (9th Cir. 1987).
92. For a description of the Options Clearing Corporation, see Electronic Bulls & Bears, supra note 5, at 190-93.
93. See Golden Nugget, 828 F.2d at 590.
94. Id. at 591.
95. Id.
96. See id.
97. See id.
98. Pub. L. No. 103-389, 108 Stat. 4081 (1994) (codified as amended at 15 U.S.C. § 78/(f) (1994)).
99. 15 U.S.C. § 78/(f) (1994).
100. See id.
101. See 139 Cong. Rec. E1633 (daily ed. June 24, 1993) (statement of Rep. Wyden) (introducing legislation and noting that SEC routinely grants UTP applications).
102. 140 Cong. Rec. H6508 (daily ed. Aug. 1, 1994) (statement of Rep. Markey).
103. See Amihud & Mendelson, Financial Policy, supra note 22, at 56-57 (discussing relationship between returns and liquidity). See generally Amihud & Mendelson, Bid-Ask Spread, supra note 22 (deriving theoretical relationship between returns and liquidity and confirming this relationship empirically); Amihud & Mendelson, Liquidity and Asset Prices, supra note 22 (discussing corporate financial implications of relationship between returns and liquidity).
104. See Amihud & Mendelson, Financial Policy, supra note 22, at 56-57 (discussing relationship between returns and liquidity). See generally Amihud & Mendelson, Bid-Ask Spread, supra note 22 (deriving theoretical relationship between returns and liquidity and confirming this relationship empirically); Amihud & Mendelson, Liquidity and Asset Prices, supra note 22 (discussing corporate financial implications of relationship between returns and liquidity).
105. See Amihud & Mendelson, Financial Policy, supra note 22, at 56-57 (discussing relationship between returns and liquidity). See generally Amihud & Mendelson, Bid-Ask Spread, supra note 22 (deriving theoretical relationship between returns and liquidity and confirming this relationship empirically); Amihud & Mendelson, Liquidity and Asset Prices, supra note 22 (discussing corporate financial implications of relationship between returns and liquidity).
106. For a detailed discussion of the costs of illiquidity, see Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 243-47; Amihud & Mendelson, Liquidity and Asset Prices, supra note 22, at 6-8; Amihud & Mendelson, Financial Policy, supra note 22, at 56-57.
107. For a detailed discussion of the costs of illiquidity, see Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 243-47; Amihud & Mendelson, Liquidity and Asset Prices, supra note 22, at 6-8; Amihud & Mendelson, Financial Policy, supra note 22, at 56-57.
108. For a detailed discussion of the costs of illiquidity, see Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 243-47; Amihud & Mendelson, Liquidity and Asset Prices, supra note 22, at 6-8; Amihud & Mendelson, Financial Policy, supra note 22, at 56-57.
109. See Electronic Bulls & Bears, supra note 5, at 45-47 (discussing evolution of NASDAQ bid-and-ask process).
110. See id. at 44 (discussing mechanics of NYSE transactions).
111. A limit buy order specifies a quantity and a price, meaning that the indicated quantity is to be bought at the designated price or at a lower price. A limit sell order specifies a quantity and a price, meaning that the indicated quantity should be sold at the designated price or at a higher price. An incoming market buy order (an order to buy immediately at any price) is executed against the offer to sell with the lowest available price, and an incoming market sell order is executed against the offer to buy with the highest available price.
112. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
113. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
114. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
115. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
116. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
117. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
118. For models of the effect of asymmetry of information between buyers and sellers in the market on the buying and selling prices and on the bid-ask spread, see generally Yakov Amihud & Haim Mendelson, Asset Price Behavior in a Dealership Market, Fin. Analysts J., May-June 1982, at 50, 55-58; Walter Bagehot, The Only Game in Town, 27 Fin. Analysts J., Mar.-Apr. 1971, at 12, 12-14; Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. Fin. 1457, 1464-67 (1983); Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 76-91 (1985) (discussing model of asymmetric information in pure dealership market); Albert S. Kyle, Continuous Auctions and Insider Trading, 53 Econometrica 1315, 1317-30 (1985) (positing discrete models of sequential trading based on asymmetry of market information). For analyses of inventory effects, see Yakov Amihud & Haim Mendelson, Dealership Market: Market Making with Inventory, 8 J. Fin. Econ. 31, 44-51 (1980); Thomas Ho & Hans R. Stoll, The Dynamics of Dealer Markets Under Competition, 38 J. Fin. 1053, 1060-69 (1983).
119. See Amihud & Mendelson, supra note 21, at 371-72 (noting that illiquidity is given by trading costs paid over lifetime of stock).
120. For a mathematical model, see Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 225-31.
121. See id. at 232-35. The return for a period is calculated as the dividend yield plus the percentage price appreciation over the period. A recent study corroborates these results for NASDAQ stocks. See generally Venkat R. Eleswarapu, Cost of Transacting and Expected Returns in the NASDAQ Market (July 1996) (unpublished manuscript, on file with authors).
122. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
123. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
124. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
125. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
126. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
127. Strong corroborating evidence, using recent NASDAQ data, is presented in Eleswarapu, supra note 100, at 6-13. Others used another measure of illiquidity - the price-impact cost - and found that average stock returns were increasing in illiquidity. See Michael J. Brennan & Avanidar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Adverse Selection in Stock Returns 2-4, 19-21 (Nov. 22, 1994) (unpublished manuscript, on file with authors). Recent studies measured liquidity by the stock turnover (ratio of trading volume to number of shares outstanding) and found a very strong and statistically significant relationship: Higher liquidity (thus measured) correlated with a lower average return earned on stocks after controlling for risk. See Vinay Datar et al., Role of Trading Activity in the Cross-Section of Stock Returns 12-18 (London Business Sch. Working Paper No. 175-93, 1995) (discussing results of study where more actively traded stocks provided lower average returns); Robert A. Haugen & Nardin L. Baker, Commonality in the Determinants of Expected Stock Returns, 41 J. Fin. Econ. 401 (1996) (discussing results of study finding that lower average return correlated with higher vol-ume); Venkat R. Eleswarapu & Chandrasekhar Krishnamurthi, Liquidity, Stock Returns and Ownership Structure: An Empirical Study of the Bombay Stock Exchange 15-22 (Apr. 1995) (unpublished manuscript, on file with authors) (analyzing results of study where returns were inversely related to trading frequency). A theoretical analysis of the tradeoff between asset return and trading costs appears in Alex Kane, Trading Cost Premiums in Capital Asset Returns - A Closed Form Solution, 18 J. Banking & Fin. 1177, 1179-82 (1994) (considering model of quoted and nonquoted assets). For a general equilibrium analysis of the impact of changes in securities' liquidity on their values, see Dimitri Vayanos & Jean-Luc Vila, Equilibrium Interest Rate and Liquidity Premium Under Proportional Transaction Costs 14-21 (Jan. 1995) (unpublished manuscript, on file with authors).
128. See generally Yakov Amihud & Haim Mendelson, Liquidity, Maturity and the Yields on U.S. Treasury Securities, 46 J. Fin. 1411 (1991) (examining effects of asset liquidity on yields of U.S. Treasury bills and notes with maturities of less than six months). Confirming evidence is presented in Avraham Kamara, Liquidity, Taxes, and Short-Term Treasury Yields, 29 J. Fin. & Quantitative Analysis 403, 405-09 (1994) (demonstrating that less-liquid notes have higher yields than otherwise identical bills). The relationship of yield differential between Treasury notes and bills and liquidity differential was first noted by Kenneth D. Garbade, Bankers Trust Co., Analyzing the Structure of Treasury Yields: Duration, Coupon, and Liquidity Effects, in Topics in Money and Securities Markets 3-4 (1984).
129. See generally Yakov Amihud & Haim Mendelson, Liquidity, Maturity and the Yields on U.S. Treasury Securities, 46 J. Fin. 1411 (1991) (examining effects of asset liquidity on yields of U.S. Treasury bills and notes with maturities of less than six months). Confirming evidence is presented in Avraham Kamara, Liquidity, Taxes, and Short-Term Treasury Yields, 29 J. Fin. & Quantitative Analysis 403, 405-09 (1994) (demonstrating that less-liquid notes have higher yields than otherwise identical bills). The relationship of yield differential between Treasury notes and bills and liquidity differential was first noted by Kenneth D. Garbade, Bankers Trust Co., Analyzing the Structure of Treasury Yields: Duration, Coupon, and Liquidity Effects, in Topics in Money and Securities Markets 3-4 (1984).
130. See generally Yakov Amihud & Haim Mendelson, Liquidity, Maturity and the Yields on U.S. Treasury Securities, 46 J. Fin. 1411 (1991) (examining effects of asset liquidity on yields of U.S. Treasury bills and notes with maturities of less than six months). Confirming evidence is presented in Avraham Kamara, Liquidity, Taxes, and Short-Term Treasury Yields, 29 J. Fin. & Quantitative Analysis 403, 405-09 (1994) (demonstrating that less-liquid notes have higher yields than otherwise identical bills). The relationship of yield differential between Treasury notes and bills and liquidity differential was first noted by Kenneth D. Garbade, Bankers Trust Co., Analyzing the Structure of Treasury Yields: Duration, Coupon, and Liquidity Effects, in Topics in Money and Securities Markets 3-4 (1984).
131. See William L. Silber, Discounts on Restricted Stock: The Impact of illiquidity on Stock Prices, Fin. Analysts J., July-Aug. 1991, at 60, 60-64 (comparing price of restricted stock with price of publicly traded stock from same company to demonstrate relationship between liquidity and value of stock).
132. For a formal model, see Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 225-31, showing that higher illiquidity costs result in investors requiring a higher return. For all securities, higher illiquidity costs result in investors requiring a higher return. Moreover, the sensitivity of return to illiquidity costs is greater for securities that are traded more frequently. The trading frequency of a security is affected, in part, by its liquidity. In equilibrium, investors who expect to hold the security for a short period of time will prefer a more-liquid security; an investor with a longer holding period will be less sensitive to the illiquidity costs and thus will select a less-liquid security if the additional return earned on the security is sufficient to compensate her for the higher illiquidity costs. See id. at 224. Because the illiquidity costs are incurred more frequently for securities whose holding periods are shorter, more-liquid securities which have low transaction costs and shorter holding periods will be more sensitive to illiquidity costs. In addition, in equilibrium the net-of-transaction-cost returns will be higher for less-liquid securities. See id. at 228. This is true because all investors, short-term and long-term alike, prefer securities with low costs, and thus higher-cost securities must offer higher net returns to induce longterm investors to hold them.
133. See, e.g., Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 59 (5th ed. 1996) (noting that present value of stock is equivalent to present value of expected future dividends). In what follows, we use for simplicity the cost of capital, r, which, by our model, needs to be adjusted for investors' equilibrium holding periods. See Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 228-29 (noting that present value of stock is equivalent to present value of expected future dividends net of transaction costs).
134. See, e.g., Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 59 (5th ed. 1996) (noting that present value of stock is equivalent to present value of expected future dividends). In what follows, we use for simplicity the cost of capital, r, which, by our model, needs to be adjusted for investors' equilibrium holding periods. See Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 228-29 (noting that present value of stock is equivalent to present value of expected future dividends net of transaction costs).
135. This corresponds to a 50% turnover rate. The average turnover of stocks traded on the NYSE was 54% in 1994, 54% in 1993, and 48% in 1992. See Fact Book, supra note 26, at 94.
136. See Amihud & Mendelson, Liquidity and Asset Prices, supra note 22, for a comprehensive survey of corporate policies which affect the liquidity of the corporate claims (stocks and bonds).
137. See id. at 13 (noting that "[t]he liquidity-increasing motive may
138. See William G. Christie & Roger D. Huang, Market Structures and Liquidity: A Transactions Data Study of Exchange Listings, 3 J. Fin. Intermediation 300, 307-15 (1994); Gregory B. Kadlec & John J. McConnell, The Effect of Market Segmentation and Illiquidity on Asset Prices: Evidence from Exchange Listings, 49 J. Fin. 611, 619-21 (1994); see also references therein for earlier studies that established similar results.
139. See William G. Christie & Roger D. Huang, Market Structures and Liquidity: A Transactions Data Study of Exchange Listings, 3 J. Fin. Intermediation 300, 307-15 (1994); Gregory B. Kadlec & John J. McConnell, The Effect of Market Segmentation and Illiquidity on Asset Prices: Evidence from Exchange Listings, 49 J. Fin. 611, 619-21 (1994); see also references therein for earlier studies that established similar results.
140. See Christie & Huang, supra note 109, at 307-12.
141. See Kadlec & McConnell, supra note 109, at 612.
142. For example, markets developed electronic systems that facilitate placement of limit orders and accelerate the execution of market orders. The NYSE's SuperDOT automated system for order placement is one example of such a system. For a discussion of the manner by which the NYSE's system operates, see Electronic Bulls & Bears, supra note 5, at 44.
143. See, e.g., N.Y. Stock Exch. Rule 72(I)(a), 2 N.Y.S.E. Guide (CCH) ¶ 2651 ("If it is possible to determine clearly the order of time in which bids were made such bids shall be filled in that order."); Am. Stock Exch. Rule 126(e)(1), 2 Am. Stock Ex. Guide (CCH) ¶ 2459 ("[W]hen a bid is clearly established as the first made at a particular price, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."); Pac. Stock Exch. Rule 5.8(c), Pac. Stock Ex. Guide (CCH), ¶ 3999 ("When a bid or offer is clearly established as the first made at a particular price regardless of the floor, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."). On the role of secondary priority rules in securities markets, see Cohen et al., supra note 16, at 156-60 (discussing prominence of time priority rule); Merton H. Miller, Financial Innovations and Market Volatility 152-57 (1991) (discussing effect of exchange rules on market transparency); Schwartz, supra note 16, at 39 (noting that secondary trading priority rule "specifies the sequence to be followed for orders that have been submitted at the same price"); Amihud & Mendelson, European Capital Markets, supra note 16, at 85-87 (explaining time priority, size priority, and public order priority rules); Amihud & Mendelson, Option Markets, supra note 16, at 21-24 (same).
144. See, e.g., N.Y. Stock Exch. Rule 72(I)(a), 2 N.Y.S.E. Guide (CCH) ¶ 2651 ("If it is possible to determine clearly the order of time in which bids were made such bids shall be filled in that order."); Am. Stock Exch. Rule 126(e)(1), 2 Am. Stock Ex. Guide (CCH) ¶ 2459 ("[W]hen a bid is clearly established as the first made at a particular price, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."); Pac. Stock Exch. Rule 5.8(c), Pac. Stock Ex. Guide (CCH), ¶ 3999 ("When a bid or offer is clearly established as the first made at a particular price regardless of the floor, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."). On the role of secondary priority rules in securities markets, see Cohen et al., supra note 16, at 156-60 (discussing prominence of time priority rule); Merton H. Miller, Financial Innovations and Market Volatility 152-57 (1991) (discussing effect of exchange rules on market transparency); Schwartz, supra note 16, at 39 (noting that secondary trading priority rule "specifies the sequence to be followed for orders that have been submitted at the same price"); Amihud & Mendelson, European Capital Markets, supra note 16, at 85-87 (explaining time priority, size priority, and public order priority rules); Amihud & Mendelson, Option Markets, supra note 16, at 21-24 (same).
145. See, e.g., N.Y. Stock Exch. Rule 72(I)(a), 2 N.Y.S.E. Guide (CCH) ¶ 2651 ("If it is possible to determine clearly the order of time in which bids were made such bids shall be filled in that order."); Am. Stock Exch. Rule 126(e)(1), 2 Am. Stock Ex. Guide (CCH) ¶ 2459 ("[W]hen a bid is clearly established as the first made at a particular price, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."); Pac. Stock Exch. Rule 5.8(c), Pac. Stock Ex. Guide (CCH), ¶ 3999 ("When a bid or offer is clearly established as the first made at a particular price regardless of the floor, the maker shall be entitled to priority and shall have precedence on the next sale at that price . . . ."). On the role of secondary priority rules in securities markets, see Cohen et al., supra note 16, at 156-60 (discussing prominence of time priority rule); Merton H. Miller, Financial Innovations and Market Volatility 152-57 (1991) (discussing effect of exchange rules on market transparency); Schwartz, supra note 16, at 39 (noting that secondary trading priority rule "specifies the sequence to be followed for orders that have been submitted at the same price"); Amihud & Mendelson, European Capital Markets, supra note 16, at 85-87 (explaining time priority, size priority, and public order priority rules); Amihud & Mendelson, Option Markets, supra note 16, at 21-24 (same).
146. Value discovery is the process by which investors in the market gather information about securities and use it to establish their assessment of securities' values. Through trading by the market participants, the price of the security is established.
147. In general, a positive externality occurs when an activity by one party produces a benefit to another party. In our case, those who reveal their own information by posting their price quotes facilitate the process of value discovery for other investors in the market.
148. See Cohen et al., supra note 16, at 156 ("A larger order has priority over an equally priced order that is smaller.").
149. See Amihud & Mendelson, supra note 21, at 369 (discussing how market trading mechanisms and trading rules affect liquidity); see also Macey & Kanda, supra note 21, at 1009-10 (discussing role of markets in providing liquidity as well as their role in monitoring, standardizing rules to reduce transaction costs, and signaling).
150. See Equity Market Structure Study, supra note 12, at 1531 (noting that while some commentators believe that competition has led to harmful fragmentation of equity markets, others view this competition as invigorating).
151. Fragmentation of the order flow occurs when the flow of orders by investors that normally would be directed to one market center is split, or fragmented, among a number of markets. The likelihood of finding a match between buyers and sellers in each market decreases because of the smaller number of orders in each market. As a result, under fragmentation of an order flow, the execution of a given order may produce results that are different from what could be obtained in a single auction market. See Cohen et al., supra note 16, at 150-69 (surveying consolidation-fragmentation debate); Haim Mendelson, Consolidation, Fragmentation, and Market Performance, 22 J. Fin. & Quantitative Analysis 189, 197-206 (1987) (providing comprehensive analysis of effects of market fragmentation on traders' benefits (surplus), volatility, and informativeness of asset prices); Mendelson & Peake, supra note 19, at 459-65 (discussing additional costs of fragmentation including information system, market selection, marketing, and regulatory expenses and providing proposal for consolidating order flow on single exchange per issue, where exchange is competitively selected). On exchange rules regarding order consolidation and on fragmentation, see Cohen et al., supra note 16, at 156-60; Schwartz, supra note 16, at 175-80; Lawrence E. Harris, Liquidity, Trading Rules, and Electronic Trading Systems 17-26, 35-40 (N.Y. Univ. Monograph Series in Fin. & Econ. 1990); Ananth Madhavan, Consolidation, Fragmentation, and the Disclosure of Trading Information 7-12 (Aug. 1994) (unpublished manuscript, on file with authors).
152. Fragmentation of the order flow occurs when the flow of orders by investors that normally would be directed to one market center is split, or fragmented, among a number of markets. The likelihood of finding a match between buyers and sellers in each market decreases because of the smaller number of orders in each market. As a result, under fragmentation of an order flow, the execution of a given order may produce results that are different from what could be obtained in a single auction market. See Cohen et al., supra note 16, at 150-69 (surveying consolidation-fragmentation debate); Haim Mendelson, Consolidation, Fragmentation, and Market Performance, 22 J. Fin. & Quantitative Analysis 189, 197-206 (1987) (providing comprehensive analysis of effects of market fragmentation on traders' benefits (surplus), volatility, and informativeness of asset prices); Mendelson & Peake, supra note 19, at 459-65 (discussing additional costs of fragmentation including information system, market selection, marketing, and regulatory expenses and providing proposal for consolidating order flow on single exchange per issue, where exchange is competitively selected). On exchange rules regarding order consolidation and on fragmentation, see Cohen et al., supra note 16, at 156-60; Schwartz, supra note 16, at 175-80; Lawrence E. Harris, Liquidity, Trading Rules, and Electronic Trading Systems 17-26, 35-40 (N.Y. Univ. Monograph Series in Fin. & Econ. 1990); Ananth Madhavan, Consolidation, Fragmentation, and the Disclosure of Trading Information 7-12 (Aug. 1994) (unpublished manuscript, on file with authors).
153. Fragmentation of the order flow occurs when the flow of orders by investors that normally would be directed to one market center is split, or fragmented, among a number of markets. The likelihood of finding a match between buyers and sellers in each market decreases because of the smaller number of orders in each market. As a result, under fragmentation of an order flow, the execution of a given order may produce results that are different from what could be obtained in a single auction market. See Cohen et al., supra note 16, at 150-69 (surveying consolidation-fragmentation debate); Haim Mendelson, Consolidation, Fragmentation, and Market Performance, 22 J. Fin. & Quantitative Analysis 189, 197-206 (1987) (providing comprehensive analysis of effects of market fragmentation on traders' benefits (surplus), volatility, and informativeness of asset prices); Mendelson & Peake, supra note 19, at 459-65 (discussing additional costs of fragmentation including information system, market selection, marketing, and regulatory expenses and providing proposal for consolidating order flow on single exchange per issue, where exchange is competitively selected). On exchange rules regarding order consolidation and on fragmentation, see Cohen et al., supra note 16, at 156-60; Schwartz, supra note 16, at 175-80; Lawrence E. Harris, Liquidity, Trading Rules, and Electronic Trading Systems 17-26, 35-40 (N.Y. Univ. Monograph Series in Fin. & Econ. 1990); Ananth Madhavan, Consolidation, Fragmentation, and the Disclosure of Trading Information 7-12 (Aug. 1994) (unpublished manuscript, on file with authors).
154. This issue is explained in detail infra text accompanying notes 124-25.
155. See Cohen et al., supra note 16, at 163 (noting that competition has led to "the institution of more attractive trading systems by rival market centers"); Schwartz, supra note 16, at 172 ("The exchanges have reacted [to competition] by developing new products and new trading technologies. They have also opened their doors to new members, lengthened trading hours, tightened their regulation of the specialists, and greatly improved the intermarket trading system."); Electronic Bulls & Bears, supra note 5, at 52 (noting that, according to some critics, "a universal message switch (UMS) that would automatically route brokers' orders to the market where the best price was being displayed," as opposed to SEC-approved Intermarket Trading System (ITS), "would encourage the regional exchange specialists to more effectively compete by offering better prices than offered by the NYSE or AMEX specialist").
156. See Electronic Bulls & Bears, supra note 5, at 3 (noting advent of "automated systems" in United States markets in 1970s and movement on foreign exchanges toward "completely electronic marketplaces"); Trading Around the Clock, supra note 2, at 2 (noting emergence of "highly automated markets" as part of "movement toward 'round-the-clock global securities trading").
157. A basic tenet of economics is that competition between suppliers of a service leads to a reduction in the cost of that service to consumers. In contrast, a supplier that possesses market power would charge higher prices that provide it with a rent. Here, competition between markets would drive down the cost to investors of the liquidity services that these markets provide. Put differently, the cost to investors of executing trades would decline.
158. Free riding occurs when one entity is using a product of another entity without paying for the use of that product. For a detailed analysis of the free-rider problem, see Cohen et al., supra note 16, at 161; Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84; Amihud & Mendelson, Option Markets, supra note 16, at 17-20; see also Lawrence Harris, Consolidation, Fragmentation, Segmentation and Regulation, Fin. Markets Institutions & Instruments, Dec. 1993, at 1, 1-28.
159. Free riding occurs when one entity is using a product of another entity without paying for the use of that product. For a detailed analysis of the free-rider problem, see Cohen et al., supra note 16, at 161; Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84; Amihud & Mendelson, Option Markets, supra note 16, at 17-20; see also Lawrence Harris, Consolidation, Fragmentation, Segmentation and Regulation, Fin. Markets Institutions & Instruments, Dec. 1993, at 1, 1-28.
160. Free riding occurs when one entity is using a product of another entity without paying for the use of that product. For a detailed analysis of the free-rider problem, see Cohen et al., supra note 16, at 161; Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84; Amihud & Mendelson, Option Markets, supra note 16, at 17-20; see also Lawrence Harris, Consolidation, Fragmentation, Segmentation and Regulation, Fin. Markets Institutions & Instruments, Dec. 1993, at 1, 1-28.
161. See Electronic Bulls & Bears, supra note 5, at 48 ("The ITS does not require that an order be routed to the market with the best quote. The order can be executed in the market in which it is received, provided the specialist or a floor broker matches the best quote available elsewhere."); see also Equity Market Structure Study, supra note 12, at 1530 (noting that ITS has "increased the opportunities for brokers to secure the best execution of their customers' orders without developing order-by-order routing systems").
162. See Order Execution Obligations, 60 Fed. Reg. 52,792, 52,794 (1995) (commenting on technological advances aimed at improving handling and execution of customer orders); Payment for Order Flow, 59 Fed. Reg. 55,006, 55,009 (1994) (discussing systems designed to offer price improvements for small orders in listed securities).
163. For example, more than 20% of NYSE trades were estimated to take place strictly between the best ITS bid and the best ITS ask. See Market 2000, supra note 24, at Exhibit 39.
164. See Kenneth D. Garbade & William L. Silber, Dominant and Satellite Markets: A Study of Dually-Traded Securities, 61 Rev. Econ. & Stat. 455, 455-60 (1979).
165. See Joel Hasbrouck, One Security, Many Markets: Determining the Contribution to Price Discovery, 50 J. Fin. 1175, 1197 (1995) (concluding that "price discovery appears to be concentrated at the NYSE: the median information share is 92.7 percent").
166. See id. ("[F]or twenty-eight of the Dow stocks, the information share is larger than the NYSE's market share (by trading volume).").
167. See Marshall E. Blume & Michael A. Goldstein, On the Integration of the US Equity Markets 13-15 (Jan. 12, 1995) (unpublished manuscript, on file with authors).
168. These means include personal service and cultivation of long-term relationships. Also, over-the-counter and regional market-makers attract customer orders by paying brokers for order flow. See Equity Market Structure Study, supra note 12, at 1537 (noting that "[a]s competition among firms providing automatic execution systems has increased, it appears that firms increasingly use payment for order flow as a means of attracting order flow to their automated execution systems").
169. See supra note 127.
170. See Cohen et al., supra note 16, at 161 (discussing nature of price discovery as public good); Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84 (discussing information externality provided by quotes in securities markets); Amihud & Mendelson, Option Markets, supra note 16, at 17-19 (same). For empirical evidence on the existence of such an externality, see Yakov Amihud et al., Market Microstructure and Securities Values: Evidence from the Tel Aviv Stock Exchange 17-19 (Feb. 1996) (unpublished manuscript, on file with authors).
171. See Cohen et al., supra note 16, at 161 (discussing nature of price discovery as public good); Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84 (discussing information externality provided by quotes in securities markets); Amihud & Mendelson, Option Markets, supra note 16, at 17-19 (same). For empirical evidence on the existence of such an externality, see Yakov Amihud et al., Market Microstructure and Securities Values: Evidence from the Tel Aviv Stock Exchange 17-19 (Feb. 1996) (unpublished manuscript, on file with authors).
172. See Cohen et al., supra note 16, at 161 (discussing nature of price discovery as public good); Amihud & Mendelson, European Capital Markets, supra note 16, at 83-84 (discussing information externality provided by quotes in securities markets); Amihud & Mendelson, Option Markets, supra note 16, at 17-19 (same). For empirical evidence on the existence of such an externality, see Yakov Amihud et al., Market Microstructure and Securities Values: Evidence from the Tel Aviv Stock Exchange 17-19 (Feb. 1996) (unpublished manuscript, on file with authors).
173. See Kenneth D. Garbade et al., On the Information Content of Prices, 69 Am. Econ. Rev. 50, 50-59 (1979) (reporting results of empirical study on information content of prices in dealer markets).
174. Each trader prefers that the other side be the first party to provide a quote, which then becomes a "sitting duck" to be picked off by the other party who may have superior information. See Yakov Amihud & Haim Mendelson, An Integrated Computerized Trading System, in Market Making and the Changing Structure of the Securities Industry 217, 221 (Yakov Amihud et al. eds., 1985) (analyzing role of open-auction trading procedures in context of computerized exchange).
175. For a discussion of the market transparency issue in the international context, see Equity Market Structure Study, supra note 12, at 1538-39.
176. On block trading in the United States, see Electronic Bulls & Bears, supra note 5, at 50-51. For a discussion of block trading in the London Exchange, see John Board & Charles Sutcliffe, The Effects of Trade Transparency in the London Stock Exchange: A Summary 54-62 (Financial Mkts. Group, London Sch. of Economics Special Paper No. 67, Jan. 1995).
177. See Alan Kraus & Hans R. Stoll, Price Impacts of Block Trading on the New York Stock Exchange, 27 J. Fin. 569, 574-78 (1972) (examining price effects within day of block trade).
178. Asymmetric information between traders increases the bid-ask spread and reduces liquidity. See, e.g., Glosten & Milgrom, supra note 97, at 71-100 (demonstrating effect of traders with superior information on bid-ask spread through model of securities market).
179. See Macey & Kanda, supra note 21, at 1022-23 (noting cost-saving role of exchanges in monitoring insider trading, share price manipulation by market professionals, and contract adherence, as well as in providing standard rules for intrafirm contracting).
180. The "race to the bottom" is a situation where markets compete by lowering standards in the hope that lower and more lenient standards will attract more trading. As a result, the general level of standards across markets keeps declining, and markets continue to lower the standards. A recent example of a race to the bottom is the relaxation of rules of the Paris Bourse in September 1994 in an effort to regain part of the trading volume in French stocks that had migrated to London's SEAQ. On the Paris Bourse's CAC trading system, where orders are executed according to pure price and time priorities, block trades were usually executed at a price within the bid-ask spread. If executed at a price outside the spread, they had to satisfy all other orders already on the book with higher priority. This practice preserved priority rules and protected smaller investors. Traders, however, could circumvent these rules by trading French stocks on SEAQ in London, where rules were less strict. The Bourse, trying to regain trading from London, relaxed its rules to allow both block trading outside the bid-ask spread and a substantial delay in the disclosure of block transactions. See Alexandros Benos & Michel Crouhy, Changes in the Structure and Dynamics of European Securities Markets 9-10 (1995) (unpublished manuscript, on file with authors).
181. Equity Market Structure Study, supra note 12, at 1539.
182. Id. at 1531.
183. Id. at 1532.
184. See generally Walayet A. Khan & H. Kent Baker, Unlisted Trading Privileges, Liquidity, and Stock Returns, 16 J. Fin. Res. 221 (1993).
185. See id. at 226-30.
186. See id. at 229.
187. See id. at 230-33.
188. See id. at 234.
189. See Walayet A. Khan et al., Competition Versus Consolidation of Order Flow: Common Stock Listing on Dual Domestic Exchanges (1994) (unpublished manuscript, on file with authors).
190. See id. at 13-14, 18.
191. See id. at 13-15, 18-19.
192. See id. at 15-18.
193. See id. at 18 (noting that while daily average trading volume increased for low liquidity group and decreased for high liquidity group, these changes were not statistically significant).
194. See Robert Battalio et al., Do Competing Specialists and Preferencing Dealers Affect Market Quality? An Empirical Analysis (Nov. 15, 1995) (unpublished manuscript, on file with authors).
195. See id. at 32.
196. See id.
197. See Marco Pagano & Ailsa Röell, Dually-Traded Italian Equities: London vs. Milan 12 (Mar. 1991) (unpublished manuscript, on file with authors) (citation omitted) ("[M]inute-by-minute price data reveal total absence of arbitrage opportunities [between the London and Paris exchanges].").
198. See id. at 11-12, 14-17 (examining size of "market touch" in London when Milan markets were and were not open).
199. See Marco Pagano & Ailsa Röell, Stock Markets, Econ. Pol'y, Apr. 1990, at 63, 97-100 (noting that Italian securities suffer greater fragmentation, which results in higher price volatility).
200. See Robert Neal, Potential Competition and Actual Competition in Equity Options, 42 J. Fin. 511, 521-25 (1987).
201. Grundfest, supra note 20, at 371-73.
202. See supra Part II.B.1.
203. See supra Part II.A.
204. Naturally, conflicts of interest may arise both between managers and security holders and between the holders of different classes of securities. As a result, there may be agency costs that are value-decreasing to the security. While these may be serious problems, they are but a special case of the many other agency problems that are encountered in a corporation. In our analysis, we assume these problems away because they are not pertinent to our particular proposal. In general, parties deal with these problems by designing appropriate incentive schemes and contractual arrangements. We assume that these agency problems, when they arise in conjunction with our proposal, are dealt with in the proper way so as to make this issue moot.
205. For simplicity, we refer both to the initial issuer and to the company's board of directors or management as "the issuer."
206. when a security's liquidity is improved, the required return by investors declines because the required return on a security is increasing in the security's illiquidity. See Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 237-46 (showing that, for cross-section of NYSE-listed stocks, the higher a security's bid-ask spread, the higher its return, after adjusting for security's risk). The firm's cost of capital is the return on investing in its securities required by market investors. See Stephen A. Ross et al., Essentials of Corporate Finance 309-10 (1996). Therefore, improvement in liquidity, which reduces the cost of capital, induces business firms to increase their investments.
207. when a security's liquidity is improved, the required return by investors declines because the required return on a security is increasing in the security's illiquidity. See Amihud & Mendelson, Bid-Ask Spread, supra note 22, at 237-46 (showing that, for cross-section of NYSE-listed stocks, the higher a security's bid-ask spread, the higher its return, after adjusting for security's risk). The firm's cost of capital is the return on investing in its securities required by market investors. See Stephen A. Ross et al., Essentials of Corporate Finance 309-10 (1996). Therefore, improvement in liquidity, which reduces the cost of capital, induces business firms to increase their investments.
208. A single small security holder will refrain from action when he alone bears the costs of such action and the benefit to him is too small to justify the cost. While the total benefit which accrues to all security holders may exceed the costs, no single small security holder will have sufficient incentive to take action.
209. International intellectual property law is governed by a series of multilateral and bilateral treaties between countries. For example, the Berne Convention, created in 1886, protects the copyrighted works of one country in each of the other member countries. See generally, M.M. Boguslavsky, Copyright in International Relations: International Protection of Literary and Scientific Works 54-66 (David Catterns ed. & N. Poulet trans., Australian Copyright Council Ltd. 1979) (1973).
210. In his analysis of the SEC's decisionmaking processes, Grundfest notes: Regulations adopted by the SEC are often based on acts of faith more than on the exercise of reason. The cost-benefit analyses included in many adopting releases are, at bottom, nothing more than extended ipse dixits that argue that, if the Commission is willing to adopt a rule, then the rule's benefits must of course exceed the rule's costs because otherwise the Commission would not adopt the rule. Joseph A. Grundfest, Zen and the Art of Securities Regulation, in Modernizing U.S. Securities Regulation: Economic and Legal Perspectives 3, 8 (Kenneth Lehn & Robert W. Kamphuis, Jr. eds., 1992).
211. Dead weight costs are those costs which constitute a loss to all parties involved without benefitting any of the parties. Whereas some costs constitute a transfer from one party to another (e.g., labor costs), in the case of dead weight costs, neither of the parties involved benefits. In the case at hand, the dead weight costs result from inefficiency in trading procedures that make trading more expensive.
212. As discussed in Part III.A, issuers' choices on the liquidity dimension are consistent with the interests of securities holders (taken as a group).
213. See N.Y. Stock Exch. Rule 62, 2 N.Y.S.E. Guide (CCH) ¶ 2062.
214. See Am. Stock Exch. Rule 127, 2 Am. Stock Ex. Guide (CCH) ¶ 9277.
215. See Sanford J. Grossman & Merton H. Miller, Liquidity and Market Structure, 43 J. Fin. 617, 630 (1988) (stating that minimum tick size should be "high enough to sustain a viably competitive supply of floor traders, but not so high as to give rise to the problems of rationing and queue discipline so often encountered under price controls" (footnote omitted)). For an empirical analysis of the tick size, see Lawrence E. Harris, Minimum Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes, 7 Rev. Fin. Stud. 149, 149-78 (1994); see also James J. Angel, Tick Size, Share Prices and Stock Splits 1-9 (Nov. 7, 1994) (unpublished manuscript, on file with authors) (comparing approaches to tick size in several countries).
216. See Sanford J. Grossman & Merton H. Miller, Liquidity and Market Structure, 43 J. Fin. 617, 630 (1988) (stating that minimum tick size should be "high enough to sustain a viably competitive supply of floor traders, but not so high as to give rise to the problems of rationing and queue discipline so often encountered under price controls" (footnote omitted)). For an empirical analysis of the tick size, see Lawrence E. Harris, Minimum Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes, 7 Rev. Fin. Stud. 149, 149-78 (1994); see also James J. Angel, Tick Size, Share Prices and Stock Splits 1-9 (Nov. 7, 1994) (unpublished manuscript, on file with authors) (comparing approaches to tick size in several countries).
217. See Sanford J. Grossman & Merton H. Miller, Liquidity and Market Structure, 43 J. Fin. 617, 630 (1988) (stating that minimum tick size should be "high enough to sustain a viably competitive supply of floor traders, but not so high as to give rise to the problems of rationing and queue discipline so often encountered under price controls" (footnote omitted)). For an empirical analysis of the tick size, see Lawrence E. Harris, Minimum Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes, 7 Rev. Fin. Stud. 149, 149-78 (1994); see also James J. Angel, Tick Size, Share Prices and Stock Splits 1-9 (Nov. 7, 1994) (unpublished manuscript, on file with authors) (comparing approaches to tick size in several countries).
218. See Grossman & Miller, supra note 176, at 629 (proposing that because fixed costs tend to be larger than "entry-inhibiting trading risks, a competitive market may not be viable because market makers would have no way of recovering their fixed costs of maintaining a presence on the floor").
219. See supra Part II.B.1.
220. See V. Ravi Anshuman & Avner Kalay, Market-Making Rents Under Discrete Prices § 3.2 (Dec. 1995) (unpublished manuscript, on file with authors) (proposing that "informed traders make less expected profits when prices are discrete," resulting in "a wealth transfer from informed traders to the market maker").
221. See Harris, supra note 176, at 153-54 (noting that decrease in minimum price variation would clearly benefit small, liquidity-demanding traders while large liquidity-demanding traders will benefit in most circumstances).
222. Market depth refers to the quantities quoted at the best bid and ask prices.
223. See Hee-Joon Ahn et al., Tick Size, Spread, and Volume, 5 J. Fin. Intermediation 2, 3-4, 13-14 (1996) (noting that "there is no significant increase in trading volume attributed to the reduction in tick size").
224. Market 2000, supra note 24, at app. IV.
225. See Harris, supra note 176, at 178 n.1 (summarizing rules for determining tick sizes in primary U.S. stock markets); supra text accompanying notes 174-75.
226. This benefit may accrue because disclosure of, for example, a discounted sale is likely to depress the stock price. The UK Securities and Investment Board has argued that "[the] SIB acknowledges the need to strike a balance between the desirability of promoting transparency and the risk of reducing liquidity." Securities & Invs. Bd., Regulation of the United Kingdom Equity Markets 33 (June 1995). This argument seems to be concerned with the liquidity interests of some, but not all, traders. In fact, on the London Stock Exchange, rules enable delayed reporting of block trades. See Board & Sutcliffe, supra note 138, at 6-7 (discussing transparency regime of London Stock Exchange). On the price movements surrounding block trades, see Minder Cheng & Ananth Madhavan, In Search of Liquidity: Block Trades in the Upstairs and Downstairs Markets 12-14 (New York Stock Exchange Working Paper No. 94-02, Oct. 1994) (finding that both upstairs and downstairs markets allow for large block trades without significant price movements).
227. See Equity Market Structure Study, supra note 12, at 1538-39 (discussing regulatory considerations regarding market transparency); Board & Sutcliffe, supra note 138, at 1-2 (noting that delayed publication can protect against additional inventory risk).
228. Pagano and Röell, who analyzed the European markets, pointed out that the London market, which allows delayed reporting of large trades, attracted large traders. See Marco Pagano & Ailsa Röell, Auction and Dealership Markets: What is the Difference?, 36 European Econ. Rev. 613, 613-23 (1992) (arguing that differences between alternative trading technologies affect traders' choice of trading systems).
229. Madhavan, supra note 119, at 15.
230. See Market 2000, supra note 24, at 4-5 ("In the United States, for exchange-listed and NASDAQ stocks, all market centers (exchanges and OTC market-makers) must report trade prices and volumes within seconds of the trade, as well as the quotes at which they are prepared to buy and sell securities.").
231. See Paul J. Seguin, The Value of Transaction Reporting 8-18 (Sept. 1992) (unpublished manuscript, on file with authors).
232. See id. at 8, 12-13.
233. See id. at tbl.2.
234. See supra Part II.B.1.
235. See Maurice Anslow, Zurich's Trading Rings Consigned to History, European Sec. Trading, Aug.-Sept. 1996, at 13, 16.
236. See Benos & Crouhy, supra note 142, at 10.
237. See Toronto Stock Exchange, Final Report of the Rule Review Committee on the Operation of the Auction Market 67 (Dec. 7, 1989).
238. See id.
239. See Board & Sutcliffe, supra note 138, at 23.
240. See Equity Market Structure Study, supra note 12, at 1539 (questioning whether order flow is going offshore for purpose of escaping transparency); Trading Around the Clock, supra note 2, at 19-22 (describing need for government participation to develop international standards for trading).
241. see, for example, the procedure discussed supra text accompanying notes 144-45.
242. See supra text accompanying notes 144-45.
243. See supra Part III.C.1-4.
244. See Amihud & Mendelson, Option Markets, supra note 16, at 19-20 (describing result of quote matching as undesirable for all market participants because it destroys incentives to enter competitive quotes and openly announce best buying and selling prices). Cooperation between markets may subject them to antitrust scrutiny. See Kenneth Lehn, Globalization of Financial Markets: A Comment, 34 Carnegie-Rochester Conf. Series on Pub. Pol'y 97, 100-02 (1991) (arguing against relying solely on private incentives of exchanges).
245. See Amihud & Mendelson, Option Markets, supra note 16, at 19-20 (describing result of quote matching as undesirable for all market participants because it destroys incentives to enter competitive quotes and openly announce best buying and selling prices). Cooperation between markets may subject them to antitrust scrutiny. See Kenneth Lehn, Globalization of Financial Markets: A Comment, 34 Carnegie-Rochester Conf. Series on Pub. Pol'y 97, 100-02 (1991) (arguing against relying solely on private incentives of exchanges).
246. See Equity Market Structure Study, supra note 12, at 1529-30 (describing role of ITS as facility created to establish "national" market); Electronic Bulls & Bears, supra note 5, at 48, 52-53 (explaining purpose of ITS and comparing it to proposed universal method switch which would route order to market with best quote).
247. See Equity Market Structure Study, supra note 12, at 1530.
248. See supra Part II.B. For empirical evidence raising questions about the adequacy of the ITS, see Charles M.C. Lee, Market Integration and Price Execution for NYSE-Listed Securities, 48 J. Fin. 1009, 1016-34 (1993).
249. See Amihud & Mendelson, Option Markets, supra note 16, at 14-20 (concluding that these problems are fostered by existence of ITS in its present form).
250. See Suzanne McGee, Futures Exchange Alliances Are Jilting Electronic Networks, Wall St. J., Mar. 23, 1995, at C1.
251. See id.
252. Strips are claims that divide a security's cash flows into segments. The most prevalent are bond strips. Each individual claim is equal to one of the coupon payments on the bond. There is an additional claim against the principal. Putting the proper strips together effectively reconstitutes the original bond.
253. The claims, "score" and "prime," traded on the AMEX.
254. For an analysis, see Robert A. Jarrow & Maureen O'Hara, Prime and Scores: An Essay on Market Imperfections, 44 J. Fin. 1263, 1263-87 (1989).
255. For example, the Dow Jones Industrial Index is composed of the prices of the stocks of thirty companies traded on the NYSE, and the Standard & Poor's 500 index is composed of the prices of the stocks of 500 companies traded on the NYSE and AMEX.
256. 828 F.2d 586 (9th Cir. 1987); see supra text accompanying note 80 and the discussion in Part I.
257. See Aswath Damodaran & Marti G. Subrahmanyam, The Effects of Derivative Securities on the Markets for the Underlying Assets in the United States: A Survey, Fin. Markets Institutions & Instruments, Dec. 1992, at 1, 5-8 (summarizing several empirical studies regarding effects of option listing on price levels and mean returns).
258. See Rezaul Kabir, Options Introduction and the Dutch Stock Market (Dec. 1995) (unpublished manuscript, on file with authors) (finding that, in Netherlands, options introductions reduce shareholders' wealth). See generally Wing H. Watt et al., The Impact of Option Listing on Underlying Stock Returns: The UK Evidence, 19 J. Bus. Fin. & Acct. 485, 485-503 (1992).
259. See Rezaul Kabir, Options Introduction and the Dutch Stock Market (Dec. 1995) (unpublished manuscript, on file with authors) (finding that, in Netherlands, options introductions reduce shareholders' wealth). See generally Wing H. Watt et al., The Impact of Option Listing on Underlying Stock Returns: The UK Evidence, 19 J. Bus. Fin. & Acct. 485, 485-503 (1992).
260. See Damodaran & Subrahmanyam, supra note 215, at 7.
261. Consent would be required, for instance, in an index using the security's price, a listed option, or a private, over-the-counter option. This example is a special case of the broader issue of property rights on price information. On the effects of free riding on price information, see Amihud & Mendelson, European Capital Markets, supra note 16, § 3.2; Amihud & Mendelson, Option Markets, supra note 16, at 19-20. A comprehensive analysis of property rights in price information appears in J. Harold Mulherin et al., Prices are Property: The Organization of Financial Exchanges from a Transaction Cost Perspective, 34 J.L. & Econ. 591, 591-644 (1991); see also Clifford W. Smith, Jr., Globalization of Financial Markets, 34 Carnegie-Rochester Conf. on Pub. Pol'y 77, 88 (1991) (concluding that "being located in a country with a long tradition of property rights security provides a competitive advantage").
262. Consent would be required, for instance, in an index using the security's price, a listed option, or a private, over-the-counter option. This example is a special case of the broader issue of property rights on price information. On the effects of free riding on price information, see Amihud & Mendelson, European Capital Markets, supra note 16, § 3.2; Amihud & Mendelson, Option Markets, supra note 16, at 19-20. A comprehensive analysis of property rights in price information appears in J. Harold Mulherin et al., Prices are Property: The Organization of Financial Exchanges from a Transaction Cost Perspective, 34 J.L. & Econ. 591, 591-644 (1991); see also Clifford W. Smith, Jr., Globalization of Financial Markets, 34 Carnegie-Rochester Conf. on Pub. Pol'y 77, 88 (1991) (concluding that "being located in a country with a long tradition of property rights security provides a competitive advantage").
263. Consent would be required, for instance, in an index using the security's price, a listed option, or a private, over-the-counter option. This example is a special case of the broader issue of property rights on price information. On the effects of free riding on price information, see Amihud & Mendelson, European Capital Markets, supra note 16, § 3.2; Amihud & Mendelson, Option Markets, supra note 16, at 19-20. A comprehensive analysis of property rights in price information appears in J. Harold Mulherin et al., Prices are Property: The Organization of Financial Exchanges from a Transaction Cost Perspective, 34 J.L. & Econ. 591, 591-644 (1991); see also Clifford W. Smith, Jr., Globalization of Financial Markets, 34 Carnegie-Rochester Conf. on Pub. Pol'y 77, 88 (1991) (concluding that "being located in a country with a long tradition of property rights security provides a competitive advantage").
264. Consent would be required, for instance, in an index using the security's price, a listed option, or a private, over-the-counter option. This example is a special case of the broader issue of property rights on price information. On the effects of free riding on price information, see Amihud & Mendelson, European Capital Markets, supra note 16, § 3.2; Amihud & Mendelson, Option Markets, supra note 16, at 19-20. A comprehensive analysis of property rights in price information appears in J. Harold Mulherin et al., Prices are Property: The Organization of Financial Exchanges from a Transaction Cost Perspective, 34 J.L. & Econ. 591, 591-644 (1991); see also Clifford W. Smith, Jr., Globalization of Financial Markets, 34 Carnegie-Rochester Conf. on Pub. Pol'y 77, 88 (1991) (concluding that "being located in a country with a long tradition of property rights security provides a competitive advantage").
265. The copyright law gives authors exclusive rights over their work. For a description of those rights, see Copyright Act, 17 U.S.C. § 106 (1994).
266. 17 U.S.C. § 107 (1994).
267. Wainwright Sec. Inc. v. Wall St. Transcript Corp., 558 F.2d 91, 94 (2d Cir. 1977).
268. Unlike standardized option contracts that trade in established exchanges, private over-the-counter option contracts are usually "tailor made" for end users, not for trading.
269. A derivative work, as defined by the Copyright Act, is: [A] work based upon one or more preexisting works, such as a translation, musical arrangement, dramatization, fictionalization, motion picture version, sound recording, art reproduction, abridgment, condensation, or any other form in which a work may be recast, transformed, or adapted. A work consisting of editorial revisions, annotations, elaborations, or other modifications which, as a whole, represent an original work of authorship, is a "derivative work". 17 U.S.C. § 101 (1994).
270. See, e.g., Sony Corp. of Am. v. Universal City Studios, Inc., 464 U.S. 417, 455 n.40 (1984) (noting, however, that distinction between productive and unproductive uses cannot be wholly determinative); American Geophysical Union v. Texaco Inc., 802 F. Supp. 1, 10-11, 13 (S.D.N.Y. 1992) (finding that merely photocopying articles in scientific journals was neither productive nor transformative).
271. Pierre N. Leval, Toward a Fair Use Standard, 103 Harv. L. Rev. 1105, 1111 (1990) (footnotes omitted) (quoting Folsom v. Marsh, 9 F. Cas. 342, 348 (C.C.D. Mass. 1841) (No. 4901)).
272. See Campbell v. Acuff-Rose Music, Inc., 114 S. Ct. 1164, 1171-73 (1994) (noting that the more transformative the new work is, the less significant the other factors will be).
273. Id. at 1175-76 (noting that level of copying recognized as fair use is dependent upon purpose and character of use).
274. This inability is one reason for both the difficulty of interpreting the "fair use" factors and the ensuing confusion. See Levai, supra note 225, at 1106-07 (noting divisions among courts and frequent reversals as evidence of lack of consensus regarding fair use).
275. This would be particularly true if A's prices could be replicated given B's prices.
276. The value of an option depends on other factors such as interest rate and price volatility that also may change over time.
277. The variance is a measure of the volatility, or variability, of the returns around their mean. It is calculated as the average value of the squared deviations of the returns from their average.
278. 2 throughout.
279. See supra Part II.B.
280. This condition also includes any function of asset A's prices, such as the returns on asset A.
281. Accordingly, the vast array of derivative contracts entered into for purposes of hedging, as well as contracts for compensation, are excluded. In fact, many private commercial contracts between parties include contingent claim features, but they do not satisfy condition (ii).
282. 2.
283. The index composition is tabulated as of the end of February 1989. The returns on USX were available only as of April 12, 1991.
284. Equally weighted means that each stock in the index has the same weight, and thus the return on the index on a given day is simply the average across stocks of the returns on the individual stocks that compose the index.
285. "Top" means having the largest market value of the outstanding stock as of the end of February 1989.
286. The Black-Scholes formula of options prices was developed in Fischer Black & Myron Scholes, The Pricing of Corporate Liabilities, 81 J. Pol. Econ. 637 (1973). It describes the price of an option on an underlying asset as a function of the price of that asset, using an additional four parameters: the variance of the price changes on the asset, the interest rate, the time until expiration of the option, and the exercise price of the option. See id. at 638-39. Given the four parameters, the changes in the option price can be traced to the changes in the price of the underlying asset. See id. at 637-54.
287. The volatility was estimated for each daily calculation using the high, low, and close price data for the preceding 22 trading days. The risk-free rate was assumed to be 6%.
288. Needless to say, others may choose to set the threshold value differently while still adhering to our proposed framework.
289. See William J. Baumol, Contestable Markets: An Uprising in the Theory of Industry Structure, 72 Am. Econ. Rev. 1, 2 (1982) (defining "contestability" as generalization of perfectly competitive markets that applies to all industry structures).