Aurora Borealis
1 May 2014 CFA Institute Journal Review

Market Evolution: 1996–2012 (Digest Summary)

  1. Mark K. Bhasin, CFA

Technological changes since 1996 have enabled traders to execute trades faster and led exchanges to introduce electronic trading platforms. This evolution in US stock markets can be examined by analyzing trading volumes of common stocks on the major exchanges. Changes in the microstructure of US markets during the 1996–2012 period have led to significant increases in trading volume over that period—particularly from 2006 to 2010.

What’s Inside?

The authors document a link between changes in the microstructure of US stock markets and increases in trading volume of actively traded common stocks. The evolution of US stock markets from 1996 to 2012 can be categorized into four different subperiods. The authors analyze each of these subperiods and describe the developments in US stock markets.

How Is This Research Useful to Practitioners?

Because of changes in US stock markets since 1996, minimal trading now occurs on the floor of the NYSE (New York Stock Exchange). Most stock transactions take place electronically and are executed through an electronic trading mechanism.

The authors analyze the determinants of trading volume by using regressions that explain more than 95% of trading volume. The research indicates that trading volume and stock price volatility are closely correlated in electronic markets. The combination of low transaction costs, high standard deviation (volatility), and quick trade execution in electronic markets results in more viable arbitrage opportunities. These opportunities likely explain much of the black box (algorithmic) trading that is a concern to many stock market participants.

There are currently 13 different trading venues for US common stock transactions. The authors conjecture that the United States will experience a period of consolidation, resulting in fewer trading venues. Each of these venues will likely have a comparative advantage in serving the needs of a different clientele of institutional investors, individual investors, market makers, and speculators. This consolidated space will likely be similar to the primary roles of the NYSE and NASDAQ in the 1980s and 1990s.

How Did the Authors Conduct This Research?

The authors identify four separate subperiods within this 17-year period (1996–2012) as a framework for analysis. These subperiods are before decimalization (1996–2000), after decimalization (2001–2005), the first period of electronic trading (2006–2010, when electronic trading became dominant), and the second period of electronic trading (2011–2012). Significant increases in trading volume occurred between 1996 and 2012, especially during the first electronic trading subperiod.

Using regressions, the authors analyze the evolution of determinants of trading volume from 1996 to 2012. Prior research has revealed that trading volume is influenced by such determinants as the number of shares outstanding, share price, and return volatility. The authors seek to demonstrate that the relationship between these determinants and trading volume has changed over the last three decades.

A company’s annual trading volume is the dependent variable in the regression. The independent variables are shares outstanding, share price, standard deviation of daily returns on company stock, and type of exchange. The authors conduct regression analyses on all four identified subperiods from 1996 to 2012.

Abstractor’s Viewpoint

The authors’ research suggests that the increase in trading volume from 2006 to 2012 may be linked to short-term and high-frequency trading. The results seem to confirm that trading volume is positively correlated with more volatile stock prices, in part because of the increased presence of algorithmic trading that seeks to profit from more abundant arbitrage opportunities. Market participants should note the types of trading opportunities and environments that attract algorithmic trading, given the concern this type of trading causes many participants.

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