Information technology and screen-based securities trading: Pricing the stock and pricing the trade

Many major stock exchanges rely on their member firms to act as dealer intermediaries, risking their own capital to trade as dealers with investor customers. A confluence of forces will dramatically alter the role of these intermediaries and the strategies available to them. Information technology is increasing the diversity of trading strategies used by investors; these impose different costs and risks upon intermediaries. Alternative electronic trading venues – off-exchange trading systems – are increasing the competition faced by established exchanges, and have been especially effective in targeting investors who impose low risks upon intermediaries. Finally, many of the automated systems developed by existing exchanges have stripped off many of the cues that have in the past been used by intermediaries to assess the riskiness of an investor's trade and to price accordingly. We believe that competitive pressure from alternative trading venues will drive exchanges to develop mechanisms to support risk-based pricing. We explore, through a stylized model of trading, how the use of risk-based pricing can preserve the established central market. This enables intermediaries to separate pricing the shares traded from pricing the services for dealing these shares, and provides low-cost execution while preserving the benefits of intermediation. Our model uses a detailed computer simulation, in which dealers interact with order flow to produce a sequence of trades, which determine market prices, which in turn influence order flow; the model enables us to calculate trading costs for different classes of investor, various other standard measures of market quality, and market maker profitability.