For Whom the Bell Tolls: The Demise of Exchange Trading Floors and the Growth of ECNs

I. Introduction

The colorful "open outcry" trading in the "pits" of the Chicago futures exchanges and the bell-ringing opening of trading on the floor of the New York Stock Exchange (NYSE) have long dominated the public perception of how those markets operate. Those exchanges are now in the midst of radical changes that will soon be erasing those images. Exchange trading floors are fast fading into history as the trading of stocks and derivative instruments moves to electronic communications networks (ECNs) that simply match trades by computers through algorithms.1 Competition from ECNs has already forced the NYSE and the Chicago futures exchanges to demutualize, consolidate, and reduce the role of their trading floors, while expanding their own electronic execution facilities.2

The amazing growth of the ECNs and their displacement of the traditional exchanges have raised regulatory concerns. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have been struggling with that issue for nearly a decade. The SEC's burdensome regulations are driving capital away from public markets such as the NYSE and Nasdaq and into ECNs, which are more lightly regulated. Many public companies are also opting out of the public markets by going private; institutional trading markets in unregistered securities are growing; and foreign issuers are rethinking the value of listing in regulated U.S. markets. The ECNs are also encouraging U.S. investors to invest abroad. As a result, the SEC and the CFTC are experiencing the effects of regulatory arbitrages as issuers and market participants flee the excessive regulation imposed in domestic markets.

The CFTC initially tried to prevent virtually all non-exchange trading of derivatives. It then did a volte-face and decided against regulating ECNs that provide execution services only to institutional investors. The CFTC believed those entities had the wherewithal and were sophisticated enough to protect themselves. However, as the result of a number of problems in the energy markets, the CFTC is reversing course once again and is now seeking to regulate those institutional markets in much the same way that it regulates exchanges that service retail investors.

This Article will describe the growth of the securities and commodity exchanges in the United States. It will show how their traditional trading floors became the center of market activity well into the last century, a dominance which was aided in no small measure by the monopoly positions allowed them by their regulators. The Article will trace the growth of electronic competition that undermined those monopolies and will describe the responses of the exchanges to those upstarts. The Article will then describe the regulatory challenges that these electronic markets are facing in an increasingly global economy and the responses of the CFTC and SEC to these developments.3

II. Exchange Trading-Some History

A. Development of Stock Exchange Trading in the United States

Trading in stocks and commodities was first conducted in America through auctions that were the favored means for pricing goods of all descriptions in the colonial era.4Securities transactions were occurring in New York as early as 1725 at a commodity and slave auction house on Wall Street.5 However, there were few securities to trade, other than a limited number of bills issued by colonial governments.6 That situation changed after the success of the Revolution led to the issuance of tradable government obligations by the federal government, and a market in those bills soon developed. For example, in 1790, an auction was conducted at the Philadelphia Merchant's and Exchange Coffee House for the sale of $30,000 in 6 percent "stock" of the United States.7

More formal organization arrived in that year with the creation of what is now the Philadelphia Stock Exchange by ten merchants calling themselves the Philadelphia "Board of Brokers." They operated out of a coffee house and traded bank stocks and government securities.8 Within a year, express coaches were speeding to Philadelphia from New York bearing news from ships docking in the New York port that might affect security prices on the Philadelphia exchange.9

In New York, coffee house merchants were also dealing in securities, mostly government obligations, after the Revolution.10 In 1791, daily auctions of government "stock" were being held on Wall Street under a set of rules agreed to by the auctioneers.11More formal trading arrangements developed after concern arose that the auctions had fueled the speculation that touched off a market panic.12 A meeting at Corre's Hotel in March 179213 resulted in the so-called "Buttonwood Agreement" in which a group of traders agreed to fix their commissions on sales of public stock and ...

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