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Published online by Cambridge University Press: 13 December 2011
This article analyzes the evolution of the Philadelphia Stock Exchange (PHLX), America's oldest stock exchange, from 1950 through 2000. PHLX was able to compete against the much larger New York Stock Exchange (NYSE) because it exploited loopholes created by fixed minimum trading commissions prior to 1975. After the liberalization of commissions, the PHLX competed against the NYSE by offering automated executions that met the needs of discount brokers. It also moved early to trade equity options and developed the first exchange-based market for foreign currency options.
1 For a clear, nontechnical discussion of network efforts in trading systems and factors affecting competition among markets, see Harris, Larry, Trading and Exchanges: Market Microstructure for Practitioners (New York, 2003)Google Scholar.
2 For a theoretical discussion of sources of competitive advantage and the implications for business strategies, see Porter, Michael E., The Competitive Advantage of Nations (New York, 1990)CrossRefGoogle Scholar. Porter also provides numerous case studies from a variety of countries to support his theory of competitive advantage. One can easily apply the theory to competition among securities markets, but the factors emphasized in the theory should be modified in two ways to fit this industry more closely. First, where Porter emphasizes geographic clustering that can result from agglomeration economies, in securities markets it is the network effects that promote the clustering of trades within a single market center. Second, competition within securities markets and the structure of those markets are heavily shaped by government regulations.
3 Over the years, the Philadelphia Stock Exchange has had a variety of names and office locations. But it has always been located in Center City Philadelphia, with one exception. In December 1968, in response to a fiscal crisis, Philadelphia imposed a $0.05 per share stocktransfer tax for all transactions on the PHLX. On January 2,1969, the PHLX moved its trading floor to an office building just across the street from the city boundaries to avoid the tax. In February, a court ruled that the tax was illegal, and the PHLX moved its trading floor back to its headquarters in the city.
4 For data on the volume of trading prior to the 1850s, the types of securities traded, and the typical brokerage commissions, see Wright, Robert E., Hamilton Unbound: Finance and the Creation of the American Republic (Westport, Conn., 2002)Google Scholar. Prior to the twentieth century, bonds and preferred stocks were more widely traded on securities exchanges than were common stocks. Trading and ownership of equities were limited by poor accounting standards and confusion about how to value equities. For a good exposition of the evolution of securities markets generally between 1800 and 1940, see Baskin, Jonathon Barron and Miranti, Paul J. Jr., A History of Corporate Finance (New York, 1997)CrossRefGoogle Scholar.
5 Werner, Walter and Smith, Steven T., Wall Street (New York, 1991), 184Google Scholar.
6 For a rich account of how the telegraph influenced U.S. financial markets, see DuBoff, Richard B., “The Telegraph and the Structure of Markets in the United States, 1845–1890,” Research in Economic History 8 (1983): 253–77Google Scholar.
7 A contemporary financial writer explained, “In general the exchanges outside of New York City deal in local securities. In a sense they serve the New York Stock Exchange in somewhat the same manner as does the Curb in trying out new securities. Enterprises which at the outset appear as local in scope expand to national proportions and when they do so they gravitate to New York.” Atwood, Albert W., Modern Business, vol. 20 (New York, 1918), 32Google Scholar.
8 For an explanation of the relatively late development of secondary markets in industrial securities, see Navin, Thomas R. and Sears, Marian V., “The Rise of the Market for Industrial Securities, 1887–1902,” Business History Review 20 (Spring 1955): 105–38CrossRefGoogle Scholar.
9 The data in this and the subsequent paragraph are found in U.S. Securities and Exchange Commission, Report of the Special Study of Securities Markets of the Securities and Exchange Commission (Washington, D.C., 1963), part 2, 916–17Google Scholar.
10 In its 1963 study, the SEC explained that “since the disclosure standards of the new statute exceeded the equivalent standards of the principal exchanges, companies meeting these standards might well seek the greater publicity and prestige of a listing on the New York exchanges in preference to a regional listing.… The new statutory requirements… also tended to shift the trading of securities from the regional exchanges to the over-the-counter market.… [S]ecurities traded over the counter were free of the requirements now attached to securities traded on an exchange.” SEC, Special Study, part 2, 918.
11 Ibid., 919–24.
12 U.S. Securities and Exchange Commission, Eighteenth Annual Report (Washington, D.C., 1953), 37Google Scholar.
13 In some cases, brokers on the floor would execute large orders with each other, but they generally negotiated these trades off the floor of the exchange. Brokers would execute the prearranged trade, known as a “cross,” on the PHLX or another regional exchange rather than the NYSE, because there were far fewer limit orders on the books of the regional exchanges. The exchanges require that limit orders that offer better prices, or that were entered earlier with prices identical to the block transaction, be executed as part of the block transaction. A large backlog of limit orders can therefore fragment and complicate a block transaction.
14 Although the SEC did not provide data specifically for the PHLX, in discussing securities traded on the NYSE or the AMEX that were also traded on a regional exchange, it stated, “The specialist participates as a dealer in approximately 90 percent of all multiple trading on the regional exchanges.” SEC, Special Study, part 2, 932.
15 Ibid., 915.
16 Ibid., 934.
17 Ibid.
18 Members of an exchange pay a small commission to the exchange for all trades that they execute on the floor of the exchange. This commission helps cover the overhead costs of the exchange. Nonmembers who wish to trade on an exchange must ask a member to execute the trade on their behalf. The nonmembers pay the member a “public” commission for handling the trade. Prior to 1975, all of the exchanges required their members to charge a specified minimum public commission. Since this was higher than what a free-market commission would have been, all members charged the specified minimum commission and did not compete for orders on the basis of price. The minimum public commission was specified on a per share basis, so large-volume institutional traders paid the same commission per share as small retail traders. In addition, with only minor exceptions, all the exchanges specified identical minimum public commissions. SEC, Special Study, part 2, 299–300. An investor could avoid paying the minimum commission by directing a trade in a listed security to an overthe-counter dealer who made a market in that stock. But rule 394 of the NYSE prohibited member firms from routing trading orders for listed stocks to OTC dealers. They were not, however, prevented from routing trades to regional exchanges. Rule 394 also prohibited NYSE member firms from acting as OTC dealers for listed securities. The effect of these rules was to limit access to the “third market” to institutional investors with the necessary technology to communicate directly with OTC market makers and to compare the prices on the third market to those on the NYSE.
19 SEC, Special Study, part 2, 1086.
20 Ibid, 938.
21 In the late 1940s, the PHLX created a public relations committee to encourage Philadelphia-area financial institutions to direct trades to the PHLX in order to benefit the local economy. Apparently some institutions cooperated. The vice-president of a local trust bank stated, “We have encouraged our brokers to place as many of our orders as possible on the P-BSE [Philadelphia-Baltimore Stock Exchange].” Walter, James E., The Role of Regional Security Exchanges (Berkeley, 1957), 127Google Scholar.
22 Philadelphia-Baltimore-Washington Stock Exchange, Annual Report, 1962 through 1964.
23 For a detailed analysis of the economic forces behind the mergers of the regional exchanges between 1940 and 1960, see Arnold, Tom, Hersch, Philip, Mulherin, J. Harold, and Netter, Jeffry M., “Merging Markets,” Journal of Finance 54 (June 1999): 1083–107CrossRefGoogle Scholar.
24 In Figure 1, the data from 1950–53 combine the volume of the PHLX and the Washington, D.C. exchanges. As noted in the text, the two exchanges merged in 1953. At the time of the merger, volume on the PHLX was fifty times larger than that on the D.C. exchange.
25 Table 1 in the appendix presents the overall dollar trading volume of exchange-listed securities and the market shares of the exchanges at five-year intervals. In this article, I report market share as a percentage of the dollar value of trading, not the number of shares or contracts traded.
26 As of 1963, the Pacific Coast, Detroit, and Cincinnati exchanges permitted some discounting of commissions for nonmember brokerage firms. SEC, Special Study, part 2, 936. As noted below, by the mid-1960s the PHLX and other regional exchanges joined these three exchanges in permitting a form of discounting through commission-sharing with nonmember brokerage firms.
27 SEC, Special Study, part 2, 316–17.
28 Philadelphia-Baltimore-Washington Stock Exchange, Annual Report, 1965.
29 Other regional exchanges adopted similar give-up provisions. As Business Week reported, “[The regionals] raked in heavy trading from institutional investors because neither the Big Board nor the AMEX allowed give-ups of commissions to nonmembers.… Thus, whenever a mutual fund, for example, wanted to reward a small brokerage firm that sold its shares or provided research but which did not belong to any exchange, it could direct its broker to place an order through one of the six regionals that permitted give-ups to nonmem bers.” Business Week, 3 Jan. 1970, 74.
30 Philadelphia-Baltimore-Washington Stock Exchange, Annual Report, 1966.
31 Business Week, 3 Jan. 1970, 74.
32 Seligman, Joel, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (Boston, 1982), 396Google Scholar.
33 Elkins Wetherill, Testimony in Securities Industry Study, Part 1, Hearing before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 92nd Congress, 21 Sept. 1971, 217–18.
34 Philadelphia Stock Exchange, Annual Report, 1969.
35 Business Week, 3 Jan. 1970, 74.
36 United States Securities and Exchange Commission, 35th Annual Report (Washington, D.C., 1969), 193Google Scholar.
37 Business Week, 26 Feb. 1972, 22–23.
38 Competing on this basis became common for the regional exchanges and OTC dealers. As the SEC reported, “[Retail] orders are very rarely routed on the basis of quotations. Instead, order routing decisions are made on the basis of preexisting arrangements where service and costs are paramount and execution quality is eliminated as a factor because all markets guarantee execution at the BBO. Once the order is routed this way, it is rare that it will be sent to another market because the best quote will be matched instead of rerouting the order via ITS. Thus, market makers have little incentive to compete based on quotes. According to the Regional Exchanges, it is more effective to compete by marketing quicker and cheaper executions than by attempting to attract orders through displayed quotations.” United States Securities and Exchange Commission, Market 2000 (Washington, D.C., 1994), A VI 40.
39 The DOT system later evolved into SuperDOT. As with DOT, SuperDOT did not allow for fully automated executions since NYSE rules required the specialist to expose incoming orders to the crowd for possible price improvements. New York Stock Exchange Special Committee on Market Structure, Governance, and Ownership, Market Structure Report, 2000, 24.
40 Philadelphia Stock Exchange, Annual Report, 1977. Well into the 1980s, news accounts credited PACE with attracting significant retail order flow. Philadelphia Inquirer, 18 Apr. 1986, C12.
41 The buyer of a call option has the right, but not the obligation, to purchase a stock from the seller of the option at a predetermined price by a specified date. The buyer of a put option has the right to sell a stock to the seller of the put option at a predetermined price by a specified date.
42 Traders on the floor of one exchange could follow prices and transactions on another exchange by obtaining data through third-party vendors, but this capability still would not provide the traders with an intermarket order routing system.
43 Investment Dealer's Digest, 17 Aug. 1992, 14.
44 The PHLX supported this move: “The imposed options moratorium, temporarily at least, answers our request for the halt to dual option trading. Earlier in the year, the PHLX attempted to call attention to a so-called dual trading war which was occurring between the options exchanges in their attempts to capture increased order flow.” Philadelphia Stock Exchange, Annual Report, 1977.
45 Table 2 in the appendix provides data on the overall volume of equity options trading and the market shares of the exchanges.
46 This was also true on the currency options floor during its best years. In both cases, the PHLX was a primary market in which national prices were set rather than, as in the case of the equity floor, a secondary market that based its prices on those determined by another exchange.
47 Loren Feldman, “They're in the Money,” Philadelphia Magazine, Dec. 1983, 189–218.
48 Securities Week, 12 Dec. 1983,11. The CBOE was the first options exchange to trade a stock-market index option. It initiated trading on a broad market index in March 1983. New York Times, 11 Apr. 1983, D9. The CBOE and AMEX began trading index options on narrower economic sectors in September 1983. Securities Week, 5 Sept. 1983, 9.
49 For an entertaining account of the efforts by the PHLX to develop and market foreign currency options, see Millman, Gregory J., The Vandals Crown: How Rebel Currency Traders Overthrew the World's Central Banks (New York, 1995)Google Scholar.
50 Financial Times, 6 Oct. 1983, 116.
51 In June 1998 the PHLX Board tentatively agreed to a merger proposal from the AMEX. It was reported that PHLX lagged in technology and thought it had to invest many millions of dollars to catch up. Investment Dealers Digest, 15 June 1998, 5–6. The AMEX, on the other hand, had state-of-the-art technology that allowed for electronic processing of orders, cancellations, and replacement orders. The desire of the PHLX to gain AMEX's technology and the desire of the AMEX to gain PHLX's options business apparently motivated the merger. Under the terms of the merger, PHLX's options business would have moved to New York City. The merger plans were aborted in April 1999.
52 Philadelphia Inquirer, 23 Apr. 1999, Dl.
53 A former official of the PHLX informed me during an interview that the PHLX and the other exchanges commonly faxed to each other copies of proposed routine rule changes so they could maintain a unified set of rules. According to this individual, an administrative assistant at the PHLX mistakenly faxed copies of PHLX's plans for the CIP to the other exchanges, enabling the other exchanges to immediately present the SEC with copycat proposals.
54 Philadelphia Inquirer, 19 June 1990, El. Nicholas Giordano, the president of the PHLX at the time, was obviously frustrated with the CFTC. One trade journal quoted him as saying, “The CFTC should stick to what it is good at… like regulating pork bellies.” Banker, 1 Jan. 1990, 3.
55 The PHLX had a futures exchange and could have reintroduced the CIP as a futures product, but it did not do so. In its view, the CIP could not succeed as a futures product, since far fewer brokers were qualified to trade futures contracts than spot contracts.
56 New York Times, 13 May 1985, D5.
57 Jane Sasseen, “Dirty Little Secret,” Forbes, 17 June 1985, 203.
58 The SEC announced in early 1986 that it would informally study the use of payment for order flow among dealers for listed securities on the exchanges. Securities Week, 17 Feb. 1986, 4.
59 Philadelphia Inquirer, 18 Apr. 1986, C12.
60 In interviews, two former presidents of the PHLX told me that Boston-area financial institutions have long supported the Boston Stock Exchange by ensuring that it receives some of their stock-trading orders. They lamented that, at least in the 1980s, Philadelphiaarea financial institutions were not equally supportive of the PHLX. This reminded me of the claim by the sociologist E. Digby Baltzell that the wealthy families of Boston have always been much more civic spirited than upper-class Philadelphians. Baltzell, E. Digby, Puritan Boston and Quaker Philadelphia: Two Protestant Ethics and the Spirit of Class Authority and Leadership (Free Press, 1979)Google Scholar. As indicated by the title of his book, Baltzell attributed this difference to the religious heritages of the two cities.
61 Philadelphia Stock Exchange, Annual Report, 1992.
62 Securities Week, 7 Jan. 2002, 4.
63 One recent study estimated that spreads narrowed by about 28 percent for NYSE-listed securities. See a report issued by Lehman Brothers written by Maureen Murphy and Luba Krayterman, “Trading Places: The Future of U.S. Equity Market Structure,” 11 Feb. 2002, 18.
64 PR Newswire, 1 June 1998.
65 By 2001, ECNs handled about 5 percent of the volume in exchange-listed stocks. Murphy and Krayterman, “Trading Places.”
66 McAndrews, James and Stefanadis, Chris, “The Emergence of Electronic Communications Networks in the U.S. Equity Markets,” Federal Reserve Bank of New York, Current Issues in Economics and Finance 6, no. 12 (2000)Google Scholar.
67 Securities Week, 12 June 2000, 1.
68 Other regional exchanges, most notably the Cincinnati Stock Exchange, also used business relationships with ECNs to bring trading orders to their floors. In 2002, the ECN Archilpelago took over the equity trading floor of the Pacific Stock Exchange, effectively gaining all the privileges of an exchange. Financial Times, 3 Apr. 2002, 4.
69 Philadelphia Inquirer, 26 Sept. 1990, E10.
70 Wall Street Journal, 27 Apr. 1999, B30
71 Data provided to the author by the PHLX.
72 Philadelphia Stock Exchange, Annual Report, 1994.
73 Wall Street Journal, 6 Oct. 1999, C20.
74 Investment Dealers Digest, 17 Aug. 1992, 14.
75 Philadelphia Stock Exchange, Annual Report, 1992.
76 Financial Times, 19 Aug. 1999, 28.
77 New York Times, 24 Aug. 1999, C3. Multiple listing occurred despite the lack of an intermarket linkage system. In October 1999, SEC chairman Arthur Levitt reprimanded the options exchanges for failing to comply with his request (made in February) that they link their markets. He gave them ninety days to come up with a plan for doing so, and they did. The plan was phased in between 2001 and 2003.
78 Wall Street Journal, 27 Apr. 1999, B30.
79 The PHLX also encouraged specialist firms that were not able to attract significant order flow to transfer their specialist positions to other firms that might be able to attract more business. It did this by levying a fee on all specialist firms. The fee was based on the assumption that the firms have 10 percent of the aggregate exchange-traded order flow in their option contacts.
80 Laura Johnson, “‘Payment for Order Flow’ Seeps into Options Markets,” Wall Street Letter, 25 Oct. 1999, 1–2.
81 Philadelphia Inquirer, 21 Jan. 2001, El.
82 SEC chairman Levitt reported, “In four of the five actively traded options we examined, effective spreads have fallen between 22 and 44 percent since these options went from single exchange trading to multiple listings.” Arthur Levitt, “The Future of Our Markets: Dynamic Markets, Timeless Principles,” Columbia Business Law Review (Winter 2000): 8.
83 American Banker, 24 Jan. 1984, 1.
84 Ibid., 17 Jan. 1985, 16.
85 Financial Times of London, 2 Oct. 1984, 113.
86 Journal of Commerce, 3 Aug. 1987, 7B.
87 When the CBOE stopped trading currency options, its president remarked, “History keeps proving that the first one there (in the market) is the most likely to succeed.” Chicago Tribune, 3 Aug. 1987, B7.
88 Nicholas Giordano, then the president of the PHLX, stated, “60% of our volume in foreign exchange options comes from overseas hedgers and traders.” New York Times, 13 May 1985, D5.
89 Financial Times, 5 Aug. 1985, 15.
90 Ibid., 28 July 1994, 25.
91 Philadelphia Inquirer, 18 Sept. 1992, A16.
92 Investment Dealers Digest, 7 Sept. 1992, 5. In 1994, the PHLX introduced customized currency options contracts in an effort to compete with the OTC, but these never gained much market share from the banks.
93 Financial Times, 11 Dec. 1985, III6.
94 Schinasi, Garry J. et al. , Modern Banking and OTC Derivates Markets: The Transformation of Global Finance and its Implications for Systemic Risk, Occasional Paper #203. (Washington, D.C., 2000), 64Google Scholar.
95 Author's interview with Arnold Staloff, 17 Sept. 2002.
96 In late 1993, the PHLX tried to prevent the fragmentation of large currency option trades by stating that orders of more than one thousand contracts could be required to execute at a single price. Securities Week, 15 Nov. 1993, 5. Unfortunately for the PHLX, by this time most block traders had already shifted to the OTC market or were planning to do so, and thus were not willing to return to the PHLX.
