Although the New York Stock Exchange (NYSE) and Nasdaq are the primary markets in which securities are bought and sold, few investors are thought to know much about their day-to-day operations. In fact, for many years, their inner workings were something of a mystery to economists, too.

It wasn't until the early 1990s that intraday data--data on every trade, time-stamped to the second--from the two markets became available for study. Since then, a new area of finance, called "market microstructure," has emerged.

"Market microstructure research examines the process and outcomes of exchanging assets under specific trading rules," Jay Coughenour, assistant professor of finance, says. "The research looks at how the actual structures of our financial markets affect outcomes such as prices, transaction costs and market volatility. With the advent of intraday data, we have been able to dig in and begin answering important economic questions about market behavior--for example, what determines transaction costs, what determines order flow and how prices come to reflect new information."

Recent work by Coughenour in this emerging field examines how the organizational form of NYSE specialist firms can affect transaction costs and other characteristics of stock trading.

Every stock listed at the NYSE is assigned to a specialist. The specialist acts much as an auctioneer, keeping track of all the incoming buy orders ("bids") and sell orders ("asks") and matching those orders when possible. A primary function of the specialist is to keep the difference between the highest bid and lowest ask price (the "bid-ask spread") as small as possible--because this spread represents a major cost to the public. To keep the spread small, specialists often transact with their "own" money.

For example, if a particularly large sell order arrives, a specialist may buy all or a portion of the shares with his or her own money if there are not enough public buy orders at that moment at the current price. By doing so, the specialist "provides liquidity" by stabilizing the price for the seller--not letting it fall to attract more buyers.

"Specialists at the NYSE are either employed by publicly traded firms, trading with money that ultimately belongs to those firms' shareholders, or are part of a privately held and often family-run firm, trading with their own money," Coughenour says. "Because specialists operate under so many rules mandated by the NYSE and the SEC, the literature, both academic and popular, has tended to view specialists as a homogeneous group.

"My co-author [Dan Deli from Arizona State University] and I investigated whether this belief is true or whether the organizational structure of the specialist firm affects how specialists manage their markets. We suspected that specialists employed by large corporations, such as Fleet Bank and Merrill Lynch, might behave differently than specialists from the smaller, private firms."

Coughenour and Deli compared a group of three firms whose specialists used their own money to manage their markets with three firms whose specialists used a corporation's money. Their findings soon will be published in the Journal of Finance.

"We discovered," Coughenour says, "that differences in specialist firm organizational form cause differences in liquidity provision." For example, the volatility of prices at the opening bell and the sensitivity of the bid-ask spread to the number of shares people wish to trade were both lower for stocks handled by corporate specialist firms.

"We attribute these differences to the fact that large corporations generally have greater access to capital than private partnerships do and to the fact that people--specialists included--tend to be more risk-averse when trading with their own money," Coughenour says. "That is, specialists employed by the corporate specialist firms appear more willing to place capital at risk when managing their markets."

Not all findings favored the corporate specialists, however. Coughenour and Deli also found evidence consistent with the idea that specialists who trade with their own money have a greater incentive and ability to distinguish trades based on private information from purely liquidity-motivated trades.

"If you think about it, this finding makes sense," Coughenour says. "If you are a specialist trading with your own money, you probably have a greater incentive to learn the motives behind trades that are proposed to you on the NYSE floor--which tend to be the larger trades."

In summary, Coughenour says, his work "suggests that future research consider these differences, that firms listing on the NYSE should pay careful attention to their specialist allocation decision and that policy-makers at the NYSE and SEC need to recognize that specialists may react differently to new policies and trading rules."

--Mary Jane Pahls