Institutional Design and Market Efficiency: Evidence from the New York Stock Exchange Ipo

Stephen Diamond (Santa Clara University School of Law)
Jennifer Kuan (Stanford Institute for Economic Policy Research)

Abstract: A well-designed market keeps a variety of “off the equilibrium” path behaviors at bay. Unfortunately, forgotten hazards, such as the classic “lemons” problem, can re-emerge and pose a special threat to market participants when institutional change weakens deterrence. We argue this is occurring in the U.S. capital markets in the wake of the 2006 IPO of the New York Stock Exchange (“NYSE”). The IPO was the central event in a complex process that undermined institutional features of the NYSE that had been the basis of its stability and success for 200 years, including an open-outcry auction, the monopolistic “specialist,” and the “clubby” membership system. Contrary to the conventional wisdom in the literature, which focuses on trading activity, we argue that these features all contributed to the efficient pricing of securities listed on the underwriter governed non-profit NYSE. Today’s for-profit, shareholder owned NYSE generates revenue from trading fees rather than the underwriting fees that underlay the pre-IPO NYSE and thus the Exchange now lacks the incentives to minimize volatility. Instead, we argue, the NYSE has come to resemble the NASDAQ, a venue long controlled by traders rather than underwriters. We use stock market data on the bid-ask spread of both trading venues to demonstrate this convergence and to highlight the difference in institutional design between a non-profit exchange governed underwriters and a publicly traded for-profit exchange.

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