Scholar Reveals the Hidden Costs of Electronic Trading

When Pamela C. Moulton, Ph.D., began her career as a fixed-income researcher on Wall Street, her passion for understanding liquidity was sparked by an observation.

No matter how attractive a strategy appeared on paper, she noticed, its success depended critically on how easily securities could be traded and at what cost. At the time, transactions were conducted almost exclusively on frenzied trading floors, the setting of numerous Wall Street-themed movies.

Moulton’s interest in understanding market liquidity was so great that she made it her life’s work to learn as much as she could about what makes markets tick. Today, Moulton is an assistant professor of business at Fordham, and more and more stock transactions occur far from Wall Street—thanks to electronic trading.

No less passionate now than she was at the start of her career, Moulton is dedicated to learning how this hybrid market—part live trading and part electronic trading—is changing stock transactions. As a researcher, she confronts questions such as, “Has the price of trading fallen or risen now that more traders buy and sell from a computer?” and “Has the quality of the market improved or declined?”

“It’s research into the role of human interaction in trading,” Moulton said of her latest study, which indicates that more electronic trading yields faster trades, but also increased transaction costs and higher market volatility.
When trading was largely confined to trading floors, traders enjoyed the benefit of having established a working relationship—a reputation—with other traders, Moulton said. “If I knew we’d be meeting up in person and trading over and over again, I cooperated with you and you with me because we might meet again in five minutes.”

This “reputation benefit” seems to be evaporating with the advent of the hybrid market, she said. “With electronic trading, there is no reputation. I don’t know who you are and you don’t know who I am. Who knows when that next time we trade will be?”

At the outset of her study, Moulton knew that finding a way to measure the effects of this hybrid market wouldn’t be easy.

“Market quality is endogenous, which means that it arises within the market, and when many things are changing at once one thing may not be causing the other,” she said. “For example, if you looked at long-term trends on the New York Stock Exchange and saw that the cost of stock trading fell as the amount of floor trading declined, it doesn’t necessarily mean that one decline is causing the other. They might both be caused by a third factor.”

Luckily for Moulton, the New York Stock Exchange (NYSE) decided in 2006 to allow more electronic trading. That created a fantastic opportunity for her to measure the effect that the reduction in floor trading would have on the market.

“Now we had an exogenous shock—something happened outside the market that directly reduced the amount of floor trading,” she said.

Moulton and a co-author approached the New York Stock Exchange, where she had previously worked as an economist, to request access to internal data that would help them analyze the hybrid market change. Using propriety information provided by the NYSE and publicly available data, they developed statistical techniques to study market quality as stock trading occurred.

Moulton found that, on average, the amount of time it took to conduct a trade sped up, but the cost of the transaction actually increased.

“It’s a surprising result,” Moulton said. “Reputation benefits apparently really did help the trading process, giving the market better prices.”

Moulton also found that volatility—the extent to which prices bounce around intraday—increased with the hybrid market changes.

“It’s probably because there aren’t as many people on the floor acting as buffers, stepping in at the last minute and saying, ‘I’ll buy or sell to keep prices more in line,’” she said.

Whether traders and investors prefer the speed of an electronic trade at a slightly higher price as opposed to the slightly lower price that comes with the “slower” transaction of a floor trade has yet to be determined.

“That’s something we can’t say definitively because it depends on the trader,” Moulton said. “If you were doing your own trading for your IRA, you probably wouldn’t care if a trade took an extra fraction of a second to execute. You might care much more if it costs you an extra penny or two.”

Yet time is of the essence to a large institutional trader, Moulton said.

“When you’re trying to do more complex strategies, time becomes a really important dimension to you,” she said.

The underlying theme of Moulton’s research is that market liquidity affects everyone—not just large institutional investment firms or day-traders.

“It matters to me,” she said. “I have a six-year old. Suppose 12 years from now he is admitted to college and I want to sell some assets to pay for his tuition. I’ll look at my portfolio but if I can’t get a good price right away for the stock I own, I might sell only some of my stock and borrow the rest of the money from a family member or a bank. In real life, people make these decisions. It’s about how they view the trade-off between price, time, and quantity.”

Moulton has been sharing her findings with those in the academic and financial communities. Her audience recently included NYSE leaders.

“It was tremendous. People were surprised to find that trading costs ticked up when floor trading decreased yet not surprised about the effects the loss of reputation benefits had on the market,” she said. “It was useful for them to see what we found and useful for me to hear this isn’t a pie-in-the-sky, ivory-tower research piece. This is real.”