Securities and Exchange Commission Historical Society

Transformation & Regulation: Equities Market Structure, 1934 to 2018

Rulemaking and Linkages, 1975 - 2005

Increments and ECNs

In the mid-1990s it became clear that NASDAQ market makers were distorting the market to their own advantage. In 1994, economists William Christie and Paul Schultz published an article entitled “Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?” The professors had noticed a phenomenon that, apparently, regulators and investors alike had missed. And the question in the title had an obvious answer—they were doing it to make money.

Trading of securities in the United States had been done in eighths of a dollar since the earliest days of the markets—at a time when Spanish dollars could be, and sometimes were, split into “pieces of eight.” By holding the size of the spread between bid and ask down to 12.5 cents, eighths seemed to limit compensation for market makers to a reasonable minimum. Sometime in the late 1980s or early 1990s, however, market makers on the NASDAQ began skipping odd-eighths when quoting some 70 to 100 of the most heavily traded securities. In effect they were quoting in quarters and artificially inflating the spread. This failure of transparency by the NASDAQ resulted in a wholesale reform of the over the counter market.

In 1996, as a result of the odd-eighths scandal, the SEC imposed a new Limit Order Display Rule which, coupled with revisions to the existing Quote Rule, obliged market makers to publicly display a customer’s limit order if the price quoted was better than theirs, thereby enabling the investing public to post limit orders that were inside the existing spread and creating a more efficient market. Known collectively as the “Order Handling Rules,” and applied first to the 100 most heavily traded NASDAQ stocks, these innovations not only rolled back the artificial advantage that market makers had given themselves, but it also obliged market makers to post prices in other venues such as Instinet, thereby spurring new competition by giving buyers and sellers access to competing quotes.

Even as the Order Handling Rules were introducing more competition in the OTC, public and regulatory pressure was building to dismantle the old Spanish dollar system of quoting entirely. Steven Wallman, who became an SEC Commissioner in 1994, was intrigued by the persistence of quoting in eights. “The more I looked, the more it was obvious that having fractions was simply a means to maintain an artificially wide tick size,” he recalled. 33 That year, the SEC issued a report to that effect, and although he agreed that removing fractions would save investors money, Wallman hesitated to push the measure. The initiative shifted to Congress, which, in 1997, introduced the Common Cents Stock Pricing Act, which advocated trading in pennies rather than fractions. While the politicians pondered, market participants acted. The same year, third market market-maker Bernard Madoff, not yet known as a fraudster, was upset that the NYSE was not sending order flow his way. He contacted the SEC and threatened to “break the eighth” if that continued. Division of Market Regulation Director Rich Lindsey told him “go ahead.” Madoff’s resulting move to sixteenths was taken up by all other exchanges within days. 34

Congress withdrew the bill and the SEC took up the initiative, demanding plans from the specialist exchanges and the dealer market for full decimalization. By April 2001, the interlude of sixteenths was over and the nation’s securities markets had gone to pennies. NYSE specialists quickly learned to appreciate decimalization, which allowed them to step ahead of other market makers by a penny—or even a sub-penny. Decimalization’s direct effect was to narrow spreads and promote competition to the benefit of the investing public. A concurrent development, the proliferation of electronic trading systems, had a similar effect by providing investors with more trading venues from which to choose.

Electronic trading systems were not entirely new, of course. Instinet, founded in 1969, was the first. Its ability to endure could be traced back to 1986 when, in the face of marketplace pioneering, the SEC opted to adopt a light regulatory touch in a no-action letter issued that year, approving the regulation of Instinet not as an exchange, but as a broker dealer. This allowed Instinet to invest its limited resources on innovation rather than on the obligations and costs involved in being a registered exchange with self-regulatory obligations. As director of Market Regulation Rick Ketchum later put it, “in the Instinet letter the Commission determined to encourage innovation and to take a risk.” 35

The wisdom of the move appeared to be borne out the next year when, during the 1987 market break, the NASDAQ and the auction exchanges all slowed to a crawl while Instinet continued to pump liquidity into the markets. Then, in 1996, the SEC’s Order Handling Rules allowed for more such systems with the creation of the “Electronic Communications Network” or ECN, which could make markets but would not have to register as an exchange. Instinet was behind this decision as well. “We didn’t want to force them to register as an exchange and take on all the burdens that an exchange had,” said Lindsey. “We wanted to give them the opportunity to continue to operate as a broker-dealer and run their marketplace as long as their quotes were included in the market.” 36 The Order Handling Rules spurred the prompt creation of similar ECNs: Island, BRUT, Archipelago, and REDIBook. Not surprisingly, these ECNs sought market share by innovating. BRUT, for example, allowed anonymous matching of NASDAQ-listed shares. Having moved on from Instinet, Bill Lupien co-founded Optimark to enable institutions to buy and sell large blocks of stock anonymously, although Optimark failed to capture market share.

But other ECNs were thriving, and by 1999 they were doing about one-third the volume of the NASDAQ. At that point, Island, with only 19 employees and no market makers (trades were conducted by algorithms), was doing 10 percent of the volume of the NASDAQ. In addition to the beleaguered NASDAQ and the booming, but non-integrated, ECNs there were also broker-dealers who conducted internalized transactions. The only thing linking the markets was ITS, which, once pioneering, was now a slow-moving outmoded liability. Market Regulation Director Eric Sirri recalled that the SEC understood that “better systems were arising, kind of spontaneously, but in a non-integrated way.” 37 At this point, both Wall Street and Washington were abuzz about “fragmentation.”

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(33) May 15, 2015 Interview with Steven Wallman, 23.

(34) Regulation and Market Structure from ATS to NMS, June 1, 2018, 14.

(35) "Securities Regulation in the Global Internet Economy" Major Issues Conference (Day I) Transcript, November 14, 2001, 51

(36) Regulation and Market Structure from ATS to NMS, June 1, 2018, 9.

(37) April 29, 2015 Erik Sirri Interview, 28-29.

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Regulation and Market Structure from ATS to NMS

Moderator: Dr. Ken Durr
Presenter(s): Discussion between moderator Dr. Ken Durr and 3 former directors of SEC's Division of Trading and Markets -- Richard G. Ketchum, Dr. Richard R. Lindsey, and Annette Nazareth.

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