FOR a company's bosses, listing shares on the New York Stock Exchange (NYSE) is a good excuse for a party, kicking off with the chance to ring the famous bell that starts, and ends, the day's action on the trading floor. Few bosses would want to see the noisy throng make way for silent computerised trading: no fun in that. Yet automated trading would make it much cheaper for companies to raise fresh capital. That, at least, is what two economists, Ian Domowitz and Benn Steil, conclude.*
The study examines share trading around the world in 1996-98, a period when computer-based systems known as ECNs (electronic communications networks) became important in the trading of listed shares on the Nasdaq market in America, and many other exchanges made better use of automation. The study found that on balance fully automated trading—where computers match buyers and sellers—was as much as one-third cheaper than traditional trading on the New York Stock Exchange and even the Nasdaq.
Thanks in part to computers, across 42 countries, trading costs fell by an average of 16.4%. This reduced firms' cost of capital by an average of 2.75%. There are reasons besides cheaper trading costs why the cost of raising capital may have fallen sharply during this period. Perhaps investors became readier to take risks. Across the countries studied, cheaper trading accounted for only about a quarter of the total decline, according to the study.
The results were much more dramatic for America, where trading costs fell by 53% during this period, compared with 17% in Europe. In America, for firms in the S&P500 index, the cost of capital fell by 9%. Messrs Domowitz and Steil reckon that at least four-fifths of the reduction could be down to lower trading costs.
In Europe, lower trading costs accounted for around half of the fall in the cost of capital, of up to 5.5%. Although European markets were more automated during this period than their American counterparts, their trading costs (including commissions, and taking into account the effect on price of the size of trades) were three to four times higher. The main reason was that European intermediaries were far less efficient than in America.
What would happen if all the world's markets were fully automated, and inefficient intermediaries were no more? The authors calculate that on the Nasdaq, where only 30% of trades are currently done through ECNs, full automation would lower trading costs by a further 23%—reducing the cost of capital to firms listed on it by another 3.6%. On the NYSE, and other American regional exchanges, where automated trades account for only 5% of volume, full automation would cut trading costs by 27% and companies' cost of capital by 4.2%.
As for Europe, removing inefficient intermediation and further automating trading would cut trading costs by 50% and the cost of capital by a further 7.8%. All of which suggests that listed companies should be pushing for automated trading of their shares as soon as possible. Ring that electronic bell!
* “Innovation in equity trading systems: the impact on transactions costs and cost of capital”, in “Technological Innovation and Economic Performance”. By Richard Nelson, David Victor and Benn Steil, Princeton University Press, forthcoming.