by Megan Groves
There are many things that Cincinnati is known for: Procter & Gamble, Kroger Corp., Gold-Star Chili and Graeter’s ice cream, to name a few. But hidden behind the façade of laundry detergent and bean-less chili is the untold story of a regional stock exchange that traded such companies as Delta Air Lines and American Electric Power Co. An exchange that gave birth to the national stock market system that allows 25 million transactions and 5 billion corporate shares to be traded daily. A story of new technology that now powers exchanges all over the world. A system that brought order to the chaos of seven independently operated national exchanges and threatened the dominance of the New York Stock Exchange.
For nearly two centuries the securities markets had operated on an outdated manual system grounded in a fixed-rate commission structure that benefited large dealer-brokers and the exchanges where they were members, with little or no regard for healthy competition. By 1971, the SEC actively studied the securities market to identify the problems posed by this protected business environment.
In the SEC’s (Security and Exchange Commission) Institutional Study Report in 1971, the Commission found that fixed commission rates impacted the securities market by limiting its usefulness to investors. Without question, the broker—rather than the investor—benefited from fixed commission transactions. The New York Stock Exchange and its brokerage members and securities specialists were eating up profits at the expense of the investing public customers. These findings led Congress to pass the Securities Act Amendments in 1975, ordering the development of a national market system using modern telecommunication and computerization tools and the un-fixing of commission rates; i.e., deregulation of the U.S. securities markets.
Anti-competitive practices existed in part because of the lack of communication and connectivity between the seven independent national exchanges then in existence in the United States: the Boston, Chicago, Cincinnati, Philadelphia, San Francisco and Los Angeles, (collectively the Pacific), New York and American Stock Exchanges. Lack of communication often led to large price disparities between the stock exchanges quoting the same stock. The NYSE was particularly fond of the fixed-rate commission practice, and most frequently benefited from it given that it was the dominant market with upwards of 90 percent market share.
Enter Regulation NMS (National Market System) 1975. This Regulation or set of amendments set the stage for competition. “It was the floor-based model versus the screen-based model,” said K. Richard B. “Nick” Niehoff, former president of the CSE. “The NYSE was definitely for the preservation of their floor and the thousands of people who worked as independent brokers.”
The Cincinnati Stock Exchange was the first of the seven exchanges to develop an automated system in accordance with the 1975 Securities Act Amendments, named the National Securities Trading System (NSTS). In 1985, after 10 years of research, development and use by member firms, he CSE became the first stock exchange in the world to operate on an approved, fully automated, screen-based trading system without a trading floor.
“We had created an exchange without walls,” says Niehoff. “Like air it was everywhere. The SEC Approval Order of the NSTS System in 1985, as a permanent cornerstone of the national markets of the United States, was the most significant event in modern U.S. exchange history.”
Twenty programmers were employed to write assembler code, according to Niehoff. Assembler coding takes numbered machine codes and translates them into specific instructions and inputs for users.
The NSTS saw a number of successes during its development. It increased the communications processing capability between exchanges by 25 to 35 percent, and added more than 400 securities by 1983. Between January 1982 and December 1984, the NSTS nearly doubled its number of traded stocks from 105 to 202, and saw its share volume increase from 3.2 million to 5.4 million.
The NSTS, in one form or another adaptation, remains pervasive throughout securities markets today. While software packages have evolved, the system is still based on the best execution model, where investors never want to pay more or sell for less money than they could have obtained in another market.
“The principles of best execution and first-come, first-served prevail and have always been the mantra of the CSE,” Niehoff says. What has changed is the technology. “If we used assembler code in 2010, the system would grind to a halt. But the core algorithmic principles of best execution have not changed.”
After the SEC began investigating the securities market in 1971, other institutions began publishing their own research findings. The Martin Report, written by William Chesney Martin, Jr., former president of the NYSE, addressed the SEC findings. The Martin Report proposed arguments for the protection of fixed commission rates and the creation of a national exchange system where individual stocks were automatically granted to a particular exchange, and allowed the NYSE and AMEX exchanges exclusive rights to trade a stock whenever it was considered to be of national importance.
More outrageous still was the Martin Report’s proposal of legislation granting antitrust exemption to the two exchanges. This was an especially bold move, in part because the SEC report specified that the need for a National Market System was based on the ineffectiveness and inability to enforce antitrust and monopoly regulation during the early 1970s. The SEC was often unable to determine cases of antitrust violation because a centralized system wasn’t yet in place and transparency was under a dark cloud. With no computer system to provide an audit trail, the orders of specific exchanges were often difficult to monitor due to the slow nature of paper processing.
Many of the regional exchanges strongly opposed the Martin Report, which represented the interests of the NYSE, while disregarding the interests and endangering the autonomy of the smaller regional exchanges. According to statements made on behalf of the CSE, the Martin Report encouraged anti-competitive practices, and did not consider smaller exchanges as participants in an evolving national marketplace—a plxw where all U.S. investors were not located in lower Manhattan. The CSE was, among other matters, concerned with the tardy execution of orders, and stated that the paper documentation process that was standard operating procedure on the NYSE “should open our eyes to the danger of channeling all business in a particular stock in one location.”
Centering the national stock market or the entire securities industry in one particular exchange would not only threaten the principles of capitalism that encompass competition and innovation. It would concentrate too much power within the realm of one business.
The Martin Report became a source of contention between the NYSE and the CSE and other regional exchanges because of its inherent NYSE bias. “In all candor, the suggestions in the Martin Report seemed calculated to solve all of the problems of the NYSE, but they most definitely do not seem to be in the best interest of the public or of the entire securities industry. This is completely understandable because Mr. Martin was employed by the NYSE and while he visited the American Stock Exchange, also in New York City, the second largest national exchange, the smaller regional stock exchanges were ignored,” according to the statement on the behalf of the CSE.
The Martin Report was also widely discussed in the media. An editorial published by The New York Times in August 1971 prompted Milton H. Cohen, then general counsel to the Midwest Stock Exchange, to write a letter to the editor. Cohen found the Martin’s Report’s lack of emphasis on competition within market systems disturbing. “The critical question is whether greater concentration or enhanced competition is more likely to produce the result consistent with the public interest. The Martin Report comes out for a structure in which each security would be traded exclusively in a single marketplace, but it does not say where competition would fit in,” Cohen wrote.
Cohen, like others, was concerned with the need for different exchanges to protect their competitive interests against a large and powerful exchange like the NYSE. “Unquestionably, it is necessary to move toward a strong communications system to enhance access, data disclosure and competition itself. Unquestionably, collaboration in dealing with common problems should be encouraged. Unquestionably, there is a need for further equalization of regulations, so that degradation of standards does not become a competitive weapon. But a trend toward elimination of autonomous market and regulatory centers, which have proven their worth as breeders of innovation and wellsprings of incentive, should not be tolerated,” Cohen wrote.
The Martin Report was only the start of a long series of rivalries between the CSE and the NYSE, particularly when the CSE began to have success with its automated system and invited other regional exchanges to join as participants. The NYSE resisted automation efforts because of “the personal interests of their brokers and specialists, who were making a lot of money off maintaining the status quo,” Niehoff says. “After all, the members owned the place, so why wreck a good business?”
This pattern continued until 1979, when Congress began an investigation of why the SEC had not started enforcing the 1975 amendments.
Another reason the SEC was interested in automation was to prevent brokers from using inside information for personal or competitive gain. The very recordable nature of the NSTS made such practices less likely. ”As you move farther and farther away from the ability of people to communicate with each other in an oral fashion, such as in a floor crowd , so as to give clues to what may or may not be going on, the opportunity to trade on inside information starts to disappear,” Niehoff explains.
Automation also resulted in a series of reports each day for the SEC to analyze; an audit trail that could be evaluated and followed and from which to make determinations and findings from facts.
Despite its benefits and its move toward transparency, automation brought its own set of technical problems. In 1980, William S. Batten, a NYSE Board member, wrote an essay outlining some of the remaining problems that needed to be solved by the National Market System, entitled “The U.S. National Market System: Progress, Problems and Issues.” While the installation of computer terminal stations made market floor transactions obsolete, it also required skilled workers to learn and utilize the software. “To begin with, a comprehensive training program was essential to familiarize brokers and trading floor employees with the complex operation of the system—and for them to gain sufficient expertise to feel comfortable using it,” Batten wrote.
A second concern was concentrated on the effort to protect filed limit orders, or orders that are filed at a specific price above or below the current market price. “One of our major remaining tasks—and one of the most difficult issues for the participating markets to resolve—focuses on how to protect limit orders held in the various market centers against inferior executions in other market centers,” Batten concluded.
By 1978, the NSTS had moved into the production phase, and was being independently implemented by various member firms: first the CSE, and later by the Boston and Pacific Stock Exchanges. Many of the execution problems were by now resolved, but common complaints from member firms included slow response times, problems with the function (F) keys, incorrect processing and delays in entering orders at the start of the business day.
Batten’s concerns were alleviated when the NSTS implemented a specific order of execution: existing limit orders were filled as soon as the price became fixed, next the excesses were filled by the Cincinnati market-makers who had a 30-second window in which to act, and any remaining excess was then sent through the Inter-market Trading System to the exchange, offering the best size at the fixed price.
The NSTS report described the system’s impact. It brought “the market to the CSE member’s office, an exchange without walls, through an inexpensive terminal and communications line. The NSTS provides CSE members with the least-cost access to the market in order to maximize the opportunity to receive an immediate best execution. Its main effects on the Cincinnati Stock Exchange have been to reduce costs dramatically and fuel a growth in membership, currently accelerating.”
The NSTS’s greatest success was, and still is, its ability to maintain best-order execution as the lowest cost provider in a very rapid trading environment. “The principles of transacting trades have not changed,” Niehoff says. “The thing that drives transactions is what is known as best execution. Filling stock orders is like an auction. The principles of best execution require that a broker obtain the best price for the client irregardless of where that price is being displayed.”
The NSTS allowed best execution to become an accepted, enforceable practice through automation software.
While the CSE was absorbed into the Chicago Board Options Exchange (CBOE), the NSTS remains as a guiding set of principles for U.S. securities markets. By 1986, with the occurrence of “Big Bang” in London, or de-regulation of the fixed rate structure in the U.K. securities markets, the NSTS had gained global recognition. In fact, the NSTS model was adopted by the London Stock Exchange (“LSE”) before the NYSE, according to Niehoff.
In addition to London, the CSE model has been adopted by the majority of international exchanges. And though the NYSE is still a predominant force in the U.S. and global securities markets, the CSE’s open architecture and early support of open, competitive markets has allowed new exchanges like the BATS, the Better Alternative Trading System, and the International Stock Exchange’s DirectEdge to emerge into the still growing and changing U.S. and global marketplace for securities, derivatives and commodities.