Abstract Tech

The 2024 Intern’s Guide to the Market Structure Galaxy

Phil Mackintosh
Phil Mackintosh Nasdaq Chief Economist

It’s that time of year again when many of us have interns joining the desk. So, over the next few weeks, we’ll add guides on trading, exchange-traded funds (ETFs) and maybe even options. Plan your Fridays accordingly!

As always, we’ll include links to additional research for interns looking to take a deeper dive into any of the topics mentioned.

If you’ve worked in the market for years, we know you know all this. Just enjoy the refresher — you never know when an intern might ask a question about the basics.

Markets help match buyers and sellers in an efficient way

All markets, even the ones you shop in for groceries, have a pretty simple underlying purpose: to bring together buyers and sellers. Doing trade in a centralized way allows consumers to compare prices and producers to advertise to more customers at once. Economically, it’s a win-win.

Stock markets add another dimension, as they also provide companies with access to investors. Cash from investors allows companies to grow profits, which in turn provides income back to the investors.

The markets are an ecosystem

Whether centralized or not, markets work best with a diverse ecosystem of participants, each with their own specialized role to play in buying, selling and valuing stocks.

Investors provide capital to Companies, who then provide dividends and returns to investors. Banks help investors value stocks, while exchanges allow traders to provide liquidity and arbitrageurs to correct mispricings. This all happens at the same prices despite the different trade signals and lengths of time they hold shares. 

For example, an arbitrageur might see ETFs dislocate from stock values for a few seconds, but a mutual fund portfolio manager may decide to buy a stock to hold for two years based on expected growth in sales.

Chart 1: The stock market ecosystem

The stock market ecosystem

Listing exchanges bring all participants together

Listing exchanges play a central role in stock markets, literally. They list companies, help traders buy and sell their stocks, and share prices with other investors and analysts.

Listing exchanges also have listing standards, which work alongside SEC rules that require corporates to share quarterly accounting statements and other disclosures. That makes stock markets more transparent and relatively safer for investors. That’s why pension and mutual funds often only invest in so-called “listed” stocks.

There are around 5,500 companies and over 3,000 ETFs that are traded in the U.S. 

Where a stock is “listed” affects what “tape” its prices and trades are reported on. There are historic reasons for that. In the past, trades were literally printed onto paper “ticker tape” from the location where trades were happening. Today, there are still three “tapes” that publish trades and prices:

  • Tape A is for all NYSE listings (regardless of what exchange the trade actually occurs on).
  • Tape C is for all Nasdaq listings (regardless of where trades occur).
  • Tape B is for all other exchanges, including the Cboe exchanges and NYSE Arca (which predominantly list ETFs) as well as NYSE American (which typically lists small companies).

Chart 2: Number of U.S. companies on each “tape”

Number of U.S. companies on each “tape”

Index providers use the primary listing market’s closing auction to calculate the last “official” trade of the day. That makes the closing auction for the primary exchange important for matching liquidity and minimizing volatility. It’s also important for mutual funds who use the close to calculate unit prices used to invest customer cashflows.

Although only a few exchanges list stocks, all exchanges can trade stocks, and all are required to be open to everyone. Another thing that all exchanges do is to advertise prices to everyone. 

Public prices help buyers find sellers and trade at the best prices in the market. They also help non-traders value portfolios and let portfolio managers buy dips and sell peaks. Competition for the best prices also creates tighter spreads that reduce transaction costs for all investors (even those who don’t trade on an exchange).

That provides what economists call “positive externalities.” Everyone benefits – even those who aren’t trading. 

Issuers give us tickers to trade and dividends to save

Companies, also called “issuers” because they issue stocks, are critical to public markets. Without issuers joining public markets, there would be no companies for the public to invest in, no dividends for investors, and fewer ways to hedge and trade.

The day of an IPO is important for a company, too. Raising cash can allow a company to grow. Having a stock that trades also makes it easier to issue more shares (in a “secondary” raising) in the future. That makes it easier to invest in equipment and workers – growing revenues and the economy.

Interestingly, the level of IPOs rises and falls based on a number of economic factors. After increasing during the “zero interest rate” period, IPOs have slowed. However, our new IPO Pulse indicates most of the drivers or IPO activity are currently in favor of an increase in IPOs in 2024.

IPOs also represent an opportunity for investors to benefit from the liquidity premium that public trading adds to a stock.On average, day-one returns for IPOs are positive.

Chart 3: IPO activity comes in cycles

IPO activity comes in cycles

Importantly, U.S. stock markets aren’t the only place new companies can find investors. Our listed markets have tocompete with private markets, OTC markets (formerly including pink-sheet and bulletin board stocks) and international stock markets for listings.

That said, the U.S. stock market is attractive to issuers. It has the largest source of equity capital, stronger valuations, the lowest trading costs and arguably the most liquidity in the world.

Issuers need investors

In order to raise capital, issuers need to attract investors. Long-term investors come in two main flavors: 

  • Mutual funds and pension funds (also called “institutional investors”) are where a professional manages a portfolio for a group of individual investors.
  • Retail investors (or “households” in Chart 4) can execute trades and manage their own portfolios directly from an app on their phones.

Data suggests they both have roughly the same amount of capital to invest (roughly $20 trillion each).

Chart 4: Who owns shares (based on year-end 2022 data) 

Who owns shares (based on year-end 2022 data)

All investors are trying to maximize their investment returns. Many mutual funds will research stocks to try to find companies that will grow revenues the fastest, pay the best dividends, have the best profit margins, or offer the best value (however you define that). 

These funds and the professionals managing them provide an important role in what we call “price discovery.” Their buying makes good companies’ prices go up, while companies with less rosy outlooks see their prices fall as investors sell. It is part of what helps markets efficiently allocate capital. However, actively picking stocks that outperform is also how portfolio managers beat the market.

Other portfolio managers run index funds. These try to buy every stock in an index, usually at market weight. These funds save costs, as they do less research and much less trading. They are also relying on the market’s overall efficiency to ensure the prices they pay are not inefficient. 

Data comparing returns of index and active funds suggests the market is very efficient. Recent data also shows that the assets in index funds are now larger than those in actively managed mutual funds.

Retail investors also want to maximize investment returns or at least minimize losses. As app-based trading and commission-free trading has made it easier for retail to trade than ever before, retail trading has also grown. One thing the data shows is that although retail trade stocks more, they net buy ETFs, a form of mutual fund that trades on exchange, consistently.

Issuers and investors need banks and brokers

Most of the time, issuers and investors need banks and brokers to help them enter and exit the market. 

Banks have many direct relationships with issuers and mutual funds. They often lend to companies. They also research companies and execute trades for mutual funds, sometimes using their own ATSs (Alternative Trading Systems, such as dark pools). So, they contribute to both capital formation and liquidity.

Ahead of an IPO, brokers will canvass investors to assess interest, help price and allocate shares in the IPO. The IPO is known as a primary market. 

Then, as investors buy and sell stocks to change their portfolio holdings in so-called “secondary” markets, they usually need brokers to “work” their orders over time.

Investors need shorter-term traders to keep markets efficient

There is not always another investor looking to sell when a new investor wants to buy. That’s where short-term traders – from hedge funds and banks to market makers and arbitrageurs – help. 

Although each has different investment objectives, they all play a critical role in keeping markets efficient and liquidity cheap. Our estimates also suggest they make up the majority of trading (Chart 5).

Chart 5: Investors have the majority of assets; intermediaries do the majority of trading

Investors have the majority of assets; intermediaries do the majority of trading

Market makers don’t hold stocks for long, but their specialty is being both a buyer and seller at the same time. Creating a “two-sided market” in each stock ensures investors can trade regardless of whether they are looking to buy or sell. In return, market makers hope to earn the spread, or the difference between the bid and the offer.

Arbitrageurs help futures and options track their underlying asset prices very well. Our research shows that ETFs trade in line with their portfolios’ net asset values even if the ETF doesn’t trade. Thanks to sophisticated statistical hedging strategies, many ETFs are actually cheaper to trade than their underlying stocks.

Hedge funds, in contrast, tend to hold long and short positions at the same time. Their strategies often keep similar stocks, sometimes called pairs, efficiently valued. That helps keep markets more efficient, adding selling to a buyer of one stock by buying a hedge from a seller of another stock. Research even shows that short sellers help keep markets efficient by adding sellers to overbought stocks.

Market rules have evolved over time

Stock markets have rallied and crashed multiple times in history. Often, following bear markets, rules are changed to protect investors. That’s exactly what happened after the largest bear market in U.S. history, which followed the Great Depression in the U.S., where stocks fell over 85% from their highs as unemployment reached 24.9%.

In the decade that followed the Great Depression, U.S. markets saw the introduction of a number of new rules to protect investors:

  • Securities Act of 1933: Established rules for IPOs so that investors would have information on which to base their investment valuations.
  • Banking Act of 1933 (also known as the Glass-Steagall Act): Separated commercial banks that lent homebuyers money and investment banking that traded stocks and bonds. To this day, insurance on bank accounts (FDIC) and brokerage accounts (SIPC) is different, although Glass-Steagall was repealed allowing today’s mega-banks to do stock broking and banking for their customers.
  • Exchange Act of 1934: Established the Securities and Exchange Commission (SEC) to regulate stock and options markets and set exchanges as self-regulatory bodies (SROs) responsible for policing their own listed companies and trading rules.
  • Formation of NASD in 1938: The National Association of Securities Dealers (NASD) regulated the trading of stocks that were not listed on exchanges. It has since become Nasdaq (trading) and FINRA (broker regulation).
  • Investment Company Act of 1940: Set all the rules that mutual funds (including ETFs) need to follow, including safe custody of assets and limits on leverage.

Chart 6: Market rises and falls (log scale)

Market rises and falls (log scale)

Setting up for fragmentation of liquidity and trading

Another significant regulatory change happened in 1975 with the Securities Act Amendments. Those rules set up what we now call the National Market System (NMS). Perhaps most importantly, brokerage commission rates were deregulated by the SEC, a move that drew significant criticism as Wall Street cried May Day. However, in a trend that would play out again over the following decades, lower costs led to rising volume that has long since made up for lower fees.

Then, in 1994, Congress passed the Unlisted Trading Privileges Act of 1994, which allowed any exchange to trade any ticker—regardless of where that stock was listed. Today, there are 16 exchanges and more than two dozen dark pools, all of which can trade any listed U.S. stock.

Although Instinet launched the first dark pool in 1986, Reg ATS didn’t set consistent rules for dark pools to trade in in1999.

Chart 7: Today’s market is fragmented, with many venues able to trade any stocks they want 

Today's market is fragmented, with many venues able to trade any stocks they want

Market automation also started in the ’70s

It probably seems hard for an intern to believe, but as recently as the 1990s, most stocks were traded in person, in “pits” or at “posts” on the floor of an exchange, with each trade written down on tiny pieces of paper that were taken back to the office to be processed for customers. The next day, interns would probably join “runners,” delivering physical stock certificates from the seller’s broker to the buyer’s broker.

Some floors do still exist today, but the U.S. market started to automate back in 1971, an event that ultimately created Nasdaq. Although Nasdaq’s first “data centers” had tape drives, monochrome cathode tube screens, sideburns and plaid trousers. A lot has changed since then.

Exhibit 1: A Nasdaq data center in 1971, the year the company’s electronic exchange began operating

Nasdaq

With most floor-based markets, all investors would see was a ticker tape of historic trades, literally a rolled-up piece of paper with typing on it, well after the trades had actually happened. Even today, the industry refers informally to the record of all quotes and trades as “the tape.” You might even hear a trader still say a trade has “hit the tape,” which means it is now on the screen and in the database.

Moving from automated quotes to trades

In its first iteration, the National Association of Securities Dealers (NASD, now FINRA) built a system for market makers in OTC (generally micro-cap) stocks to electronically update their bid/ask quotes. That became the NASD Automated Quotations (hence the acronym NASDAQ).

Exhibit 2: One of the early Bunker-Ramo computer terminals used to make and see quotes

Bunker Ramo terminal

Over time, as computers improved, more data could be shared more easily. This benefited investors and traders who could not necessarily see what was happening on other human trading floors.

The main data innovation in the 1980s was the creation of a real-time “Level 2” data feed. More than simply providing the best bid and offer, Level 2 showed all market maker quotes at different prices below the bid and above the offer. What is now called “depth.”

Exhibit 3: The quote montage from the Nasdaq Workstation II in the late 1990s, showing depth (Note prices are in fractions of a dollar; some bonds still trade in fractions today)

Nasdaq level II

Automating executions after the 1987 crash

Another big market crash happened in 1987 when the S&P 500 fell more than 20% in one day. Back then, there were no Market-Wide Circuit Breakers or other guardrails to slow markets down and allow buyers to assemble.

In the aftermath, it was discovered that many market makers were unable or unwilling to trade even though buy prices could be seen on the screens. Shortly after, the process of matching trades was also automated, creating what we now call “actionable quotes.” Although in their early forms:

  1. The Small Order Execution System (SOES) automated executions up to a maximum of just 1,000 shares to protect market makers from large market movements.
  2. The SelectNet system allowed traders to create locked-in trades—although it worked a lot more like email for trading.

Lower costs drive liquidity and activity into the 2000s

However, that set the scene for a market that looks more like what we know today – where almost all trades are executedelectronically. And as the market adopted computerized trading, important new rules were introduced:

  • 1997 - Order Handling (Manning) Rules: Now that customers could join the same bid as market-makers, manning required brokers to put customer orders first. That made it easier for investors to trade with each other and capture more spreads.
  • 2001 - Decimalization led to quotes being in cents, which we see today, not fractions, as we saw above. That followed fractional ticks reducing from eighths to sixteenths in 1997, all of which made spread costs much smaller and market-making less profitable.
  • 2007 - Reg NMS mandated many things we take for granted today: quotes that are publicly available and actionable, prices that can be consolidated in real-time to create an NBBO and an interconnected market that helps investors always trade on markets with the best prices.

As a result, market-making became more automated, and trading got cheaper. From 1995 to 2005, markets saw spreads decline 90%, and liquidity increased tenfold.

Chart 8: The impact of market-wide automation cut trading costs and boosted liquidity 

The impact of market-wide automation cut trading costs and boosted liquidity

Because spreads are so tight, and trades are all reported electronically now, newer SEC rules have been focused on changing ticks once more, as well as adding more data and smaller trades to public feeds.

Trading at the speed of light

This all means that over the past 50 years, trading has gone from human speed to computer speed to the speed of light

Computerized trading has led to fewer manual errors, faster processing and cheaper trading. It has also made trading faster. A lot faster

In reality, almost all trading in U.S. stocks is done in data centers in New Jersey these days. At the speed of light, it takes trades less than 0.2ms to travel from one exchange to another. To put that in perspective, a human blink takes around a quarter of a second (that’s 250 milliseconds). 

All of this is to say that arbitrage happens very quickly, and markets are now very efficient.

Chart 9: Distances between trading centers at the speed of light

Distances between trading centers at the speed of light

Where do public prices come from?

Although spreads have not come down in the past 20 years, the market infrastructure has continued to evolve to keep up with the changes in computing power. In the past 14 years, the computer that puts all the fragmented quotes back together(called the SIP) has increased its capacity more than 40-fold while at the same time reducing the time it takes to calculate the best price by more than 99.6%.

Chart 10: The SIP has been able to handle more messages at a faster rate over time

The SIP has been able to handle more messages at a faster rate over time

What the SIP does is receive the best bid and offer from all the exchanges, for every stock, in the market. It then sorts them to find which exchange has the best bid and which exchange has the best offer. Then it creates a single unified national best bid and offer (NBBO) which is made is available to all investors

This is the “tape” that we talked about earlier.

Chart 11: SIPs compile the NBBO based on all the exchanges’ quotes in a specific security

SIPs compile the NBBO based on all the exchanges’ quotes in a specific security

Market structure helps everyone invest and trade better

Today’s stock markets are fast and complicated. But the good news is that there are lots of rules designed to make it look simple and protect investors. 

That’s not to say they are perfect. There are ongoing debates about things like odd lots and tick sizes, retail trading and short selling rules, as well as competing ideas on the optimal way to allocate the economics of price setting and trading.

Overall, though, our market structure helps make U.S. markets some of the cheapest and most liquid to trade in — and that is good for investors and issuers

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