Governance Heterogeneity and Performance at US Stock Exchanges : Evidence from Regulation NMS

Regulation NMS, announced in June 2005 by the SEC, was intended to generate competition with the New York Stock Exchange (NYSE). The NYSE had for many decades maintained a near monopoly on the trading of securities initially listed on the exchange. Reg. NMS allowed trades on electronic communications networks (ECNs) without considering prices on the NYSE trading floor. With Reg. NMS in place, the NYSE immediately began losing market share and average bid-ask spreads for NYSE-listed shares increased, sometimes getting significantly closer to the average spreads for shares listed on the traditionally more volatile Nasdaq. What explains this outcome? The conventional wisdom predicts that consumers (here, investors) would benefit as the profits of a monopoly producer (here, dealers executing trades) declined, but evidence of wider spreads suggests the opposite. The literature relies on a standard model of a member-governed non-profit in which broker-dealers own the exchange. But that standard model fails to capture the actual heterogeneity in governance structure: the Nasdaq fits this model, but the NYSE does not. Thus, we consider an alternative to the standard model in which underwriters are owners, for which there is anecdotal evidence. However, a statistical test is possible because of the starkly different objective function that underwriters would have as compared with dealers; for underwriters, efficient trading is an input to their production function where for dealers, trading is the primary source of profits. Using panel data of Corwin-Schultz bid-ask spreads, we measure differences in market quality between the NYSE and Nasdaq, which the new regulation allows because NYSE-listed shares trade on multiple new venues after Reg. NMS but Nasdaq-listed shares do not trade on the NYSE. A difference-in-differences test finds that spreads for NYSE-listed shares increased after Reg. NMS issue to resemble more closely spreads for Nasdaq-listed shares