Financial Markets, Information Technology and Electronic Commerce
April 13 – 14, 2003

The Financial Markets Research Center conference, held on April 13th and 14th, focused on the theme, “Financial Markets, Information Technology and Electronic Commerce.” In his introductory remarks, Hans Stoll, director of the FMRC, identified a few specific questions that reflect the reshaping of financial markets in the wake of new technology: How will on-line trading by retail investors affect the markets? What will be the future structure of exchanges and trading centers? Will floor trading survive in competition with electronic markets? How should regulators deal with market fragmentation? What is the appropriate organizational structure of exchanges to adapt to new technology? Will self regulation be effective in exchanges that are for-profit corporations, rather than mutual organizations?

The conference was sponsored by the Financial Markets Research Center, and by a generous grant from the New York Stock Exchange.

Tom Ho, President of Thomas Ho Company, chaired the first session, “The Online Environment.” The first speaker, Tom Novak, Associate Professor of Marketing at the Owen School, discussed his research (with Donna Hoffman and Marcos Peralta) on the subject of building consumer trust in on-line environments. Novak stressed that customers are willing to buy over the internet only if they trust the seller’s technology and integrity. The customer must be confident that the transaction is secure, and that the seller will not give or sell information about the customer to other businesses. Peter Wysocki, Assistant Professor of Accounting at the University of Michigan, discussed his study of “Cheap Talk on the Web.” He finds that stock message board activity is consistent with both positive investor behavior, such as searching for and interpreting information, as well as with problematic behavior, such as hyping stocks.

Jack Lavery, Global Macro Consultant, Merrill Lynch, chair of the second session, “’Online Trading,” commented on the importance of technology in the current business expansion. The first speaker of the session, Dana Rudolph, Vice-President, Merrill Lynch, described Merrill’s on-line trading strategy and the changing role of the financial advisor. Terry Odean, Assistant Professor of Finance at the University of California at Davis presented the results of a study (with Brad Barber) of full-service brokerage customers who changed to on-line accounts. Investors that switched to online accounts traded more frequently and suffered deteriorating performance. Possible explanations for this result include: overconfidence; the ease of placing an order, which eliminates a friction to hasty action; and incomplete awareness of all transaction costs.

After a lunch break, the group reconvened to hear Laura Unger, Commissioner of the Securities and Exchange Commission, discuss a host of significant issues facing the SEC: How will the “suitability” obligation be met in an on-line environment? How can the definition of ‘best execution’ be expanded to take speed and certainty of execution into account, in addition to best price? How accurate are prices when much of the order flow is not included in determining market price but is internalized? How will the abolition of Rule 390 and the growth of ECNs (Electronic Communications Networks) affect market fragmentation? Brandon Becker, a partner at Wilmer Cutler Pickering, presented a lively commentary on these and other issues. He noted that individual “fortress” markets were undesirable and that markets should be linked. He listed a number of issues that regulators must deal with, including the relation between the SEC and CFTC (Commodities Futures Trading Commission), access to foreign electronic markets, achieving best execution in options markets, and transparency in the debt markets.

Rick Kilcollin, chair of the panel on “Technology and Option Markets,” predicted that electronic option trading is inevitable. Tom Bond, Vice Chairman, Chicago Board Options Exchange, discussed the information overload in options markets resulting from the need to update quotes on each of the many contracts on a given underlying security, all of which react to the same information at the same time. Decimalization and multiple-market listing of options magnify this problem. He noted that the success of Eurex in capturing the German Bund futures market from the Liffe raises questions about the value of floor trading in relation to screen-based trading systems. Blair Hull, Chairman of the Hull Group, noted that the option markets have grown more slowly than equity markets, due in part to slow execution, poor transparency, and the uneven playing field, in which market makers have a privileged position. He suggests that the options exchanges can address these problems by embracing technology and by giving investors and market makers the same privileges and responsibilities. Thomas Peterffy, Chairman, TimberHill Inc., discussed incentives for posting firm quotes in dealer markets. He noted that the obvious incentive for posting quotes is that trades will go to the party who has posted the best quote. That incentive is destroyed when time priority is relaxed, thus allowing anyone in a market to match the best quote and take the trade. In the global electronic market, it will be a challenge to insure that customers around the world have access to the best quotes, and to insure that orders are routed to the dealer posting the best quote, so that the motive for posting quotes remains compelling.

The final session of the day, “Technology and Equity Markets,” was chaired by Peter , Hull Group. The first speaker of the session, Mike Edleson, Senior Vice President and Chief Economist, NASD, discussed the competition between Nasdaq and ECNs for order flow, which has forced Nasdaq dealers to become more efficient. As an example of the efficiency gains resulting from this competition, he noted that the average cost of a trade on Selectnet, a NASD broker-dealer, has declined from $5.00 to 10 cents. George Sofianos, Vice President, New York Stock Exchange, suggested that a central limit-order book (CLOB) might not be the best approach to ensuring competition and connectivity among markets. He proposed an alternative solution: a full disclosure market, with standardized reporting across trading venues, which would allow comparison of execution costs and speed. He also discussed his research on whether floor trading adds anything of value that electronic markets do not offer. He found that the NYSE has gained market share in block trades (over 10,000 shares) in recent years, suggesting that exchange trading offers an incremental benefit in the execution of large trades.

Discussion continued over cocktails and dinner at the Loew’s Vanderbilt Hotel, which provided a relaxing close to the first day of the conference.

On Friday, Kevin Ershov, Managing Director, Thales Fund Management, introduced the first session, “Electronic Networks.” Amit Basu, Professor of Telecommunications and Electronic Commerce at the Owen School, discussed his work on the architecture of e-commerce (with Steve Muylle). Whereas in the past, technology has been applied to traditional business processes and products, in the future, he noted, technology will shape processes and products. He commented that customized information content and new commerce-support functions may generate surprising new businesses and business models. He cited the example of search engines, which provide a customized information service, and which have a business model that has redefined our ideas about what is given away. Jeff Smith, Economist, Nasdaq Economic Research, reported on his study of preferencing among dealers on the Nasdaq. He explained that Nasdaq dealers try to internalize as many customer trades as possible, and that dealers trade with each other in order to adjust their inventory. Smith studied trades on SelectNet, an interdealer trade system. While preferencing is possible, Smith found that 93% of the orders in SelectNet are sent to the dealer with the best quote. The closing speaker in this session, Roger Huang, Professor of Finance at the Owen School, discussed his study of price discovery by ECNs and Nasdaq dealers. He finds that the quotes posted by ECNs and Nasdaq dealers appear to move in reaction to the same information, providing some reassurance that trading fragmentation does not interfere with price connectivity. He also finds that ECN quotes tend to be more informative than Nasdaq dealer quotes for 8 of the 10 most actively traded Nasdaq stocks.

Jim Klingler, Senior Vice President, Eclipse Capital Management, introduced the topic of the final conference session, “Developments in the Futures Market.” John Damgard, President, Futures Industry Association, underscored the necessity for the US futures exchanges and regulators to move quickly, to prevent futures markets from moving out of the US. He noted the CFTC recognizes this problem and has proposed that the futures exchanges be guided by a set of core principals, based on customer protection, rather than by detailed rules, so that regulation is less of an impediment to innovation. Dick McDonald, Economist, Chicago Mercantile Exchange, spoke in some detail about the ambiguous jurisdictions of the CFTC, SEC, and Treasury Department. He mentioned the demutualization of the Merc, as one of the many reforms that are intended to make the Merc more agile in its competition with other exchanges in the US and abroad.

Participants

Seema Arora, Owen School, Vanderbilt University
Clifford Ball, Owen School, Vanderbilt University
Amit Basu, Owen School, Vanderbilt University
Brandon Becker, Wilmer Cutler & Pickering
Suzanne Bellezza, Owen School, Vanderbilt University
Bob Blanning, Owen School, Vanderbilt University
Thomas Bond, Chicago Board Options Exchange
Amy Bonkoski, Owen School, Vanderbilt University
G. Geoffrey Booth, Michigan State University
Anchada Charoenrook, Owen School, Vanderbilt University
Tarun Chordia, Owen School, Vanderbilt University
William G. Christie, Owen School Vanderbilt University
Chris Concannon, The Island ECN, Inc.
J. Dewey Daane, Owen School, Vanderbilt University
John Damgard, Futures Industry Association
William Damon, Economics Department, Vanderbilt University
Juliana Deans, Owen School, Vanderbilt University
Mike Edleson, NASD
Kevin Ershov, Thales Fund Management, LLC
Greg Faulk, Belmont University
Jamie Farmer, Susquehanna Partners Group
Amar Gande, Owen School, Vanderbilt University
Suzan Gibbs, Caterpillar Financial Services
John Gonas, Belmont University
Patrick Greenlee, Department of Justice
Frank Hansen, Stafford Trading, Inc.
Lew Harris, Media Relations, Vanderbilt University
Hans Gerhard Heidle, Owen School, Vanderbilt University
William I. Henderson, Owen School, Vanderbilt University
Thomas S.Y. Ho, Thomas Ho Company
Donna Hoffman, Owen School, Vanderbilt University
Chris Hogan, Owen School, Vanderbilt University
Roger D. Huang, Owen School, Vanderbilt University
Blair Hull, Hull Group
Vladimir Ivanov, Owen School, Vanderbilt University
Debra Jeter, Owen School, Vanderbilt University
T. Eric (Rick) Kilcollin, Consultant
Jim Klingler, Eclipse Capital Management, Inc.
Jack Lavery, Merrill Lynch
Peter Layton, Hull Transaction Services
Craig M. Lewis, Owen School, Vanderbilt University
Xi Li, Owen School, Vanderbilt University
David H. Malmquist, Office of Thrift Supervision
Ronald W. Masulis, Owen School, Vanderbilt University
Richard McDonald, Chicago Mercantile Exchange
Rajarishi Nahata, Owen School, Vanderbilt University
Scott Nieboer, 5th Market
Christine D. Niles, The Nasdaq Stock Market
Tom Novak, Owen School, Vanderbilt University
Terrance Odean, University of California-Davis
Alex Pasdan, Eclipse Capital Management
Liangang (Frank) Qu, Owen School, Vanderbilt University
Thomas Peterffy, Timber Hill LLC
David Rados, Owen School, Vanderbilt University
Diane Rochon, Futures Magazine
Peter Rousseau, Economics Department, Vanderbilt University
Dana Rudolph, Merrill Lynch
Christoph Schenzler, Owen School, Vanderbilt University
Christian Schlag, University of Frankfurt & Owen School
Ed Scott, Caterpillar Financial Services
Jamie Selway, Goldman, Sachs & Co.
Thomas Sexton, National Futures Association
Qi Shen, Stafford Trading, Inc.
Jeffrey Smith, Nasdaq Economic Research
George Sofianos, New York Stock Exchange
Hans Stoll, Owen School, Vanderbilt University
Kenneth Sutrick, Murray State University
Laura Unger, Securities & Exchange Commission
Alice Patricia White, Federal Reserve Board
Huimin Wu, State Street Global Advisors
Peter Wysocki, University of Michigan