CIS Working Paper Series

WHAT HOLDS ONLINE MARKETS BACK?
AN EXAMINATION OF U.S. STOCKBROKERS' RULE 11AC1-6 REPORTS

Information technology enables the development of new markets and new channels to reach customers. Research on electronic markets proposes that transactions will become increasingly computerized in transparent, direct access market systems that will diminish the role of intermediation. Yet, in a range of industries many well-funded online markets, including numerous failed "B2B exchanges", have not attracted sufficient activity. What hinders the development of e-markets? Examination of new SEC-mandated Rule 11Ac1-6 disclosures from 11 U.S. brokerage firms reveals complexity and significant entrenchment of intermediated trading venues. Inter-mediaries received over 80 percent of customer orders in Nasdaq stocks, and over 50 percent of orders in NYSE stocks. For Nasdaq trading, 87 percent of customer orders in the sample were routed to market centers that are either owned by the broker (vertically integrated) or that make payments back to the broker ("payment for order flow"). Only 12 percent of the orders are routed to open markets provided by electronic communications networks (ECNs). For trading in NYSE stocks, 45 percent of orders are routed to market centers (other than the NYSE floor) that are owned by the broker or that make payments. Just 3 percent of orders in NYSE-listed securities are sent to electronic markets. Despite potential merits, online markets in many industries will struggle to attract activity because established intermediaries utilize practices such as "internalization", which are shown to influence where customers' trades take place. A lesson for other online marketplaces is that attractive, alternative institutional arrangements (e.g., equity stakes) and services to those in place must be developed in order to expand activity in their systems.

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