Abstract

How stocks are traded in the United States has been totally transformed. Gone are the dealers on NASDAQ and the specialists at the NYSE. Instead, a company's stock can now be traded on up to sixty competing venues where a computer matches incoming orders. High-frequency traders (HFTs) post the majority of quotes and are the preponderant source of liquidity in the new market.

Many practices associated with the new stock market are highly controversial, as illustrated by the public furor following the publication of Michael Lewis's book Flash Boys. Critics say that HFTs use their speed in discovering changes in the market and in altering their orders to take advantage of other traders. Dark pools—off-exchange trading venues that promise to keep the orders sent to them secret and to restrict the parties allowed to trade—are accused of operating in ways that injure many traders. Brokers are said to mishandle customer orders in an effort to maximize the payments they receive for sending trading venues their customers' orders, rather than delivering best execution.

In this Article, we set out a simple, but powerful, conceptual framework for analyzing the new stock market. The framework is built upon three basic concepts: adverse selection, the principal-agent problem, and a multivenue trading system. We illustrate the utility of this framework by analyzing the new market's eight most controversial practices. The effects of each practice are evaluated in terms of the multiple social goals served by equity-trading markets.

We ultimately conclude that there is no emergency requiring immediate, poorly considered action. Some reforms proposed by critics, however, are clearly desirable. Other proposed reforms involve a trade-off between two or more valuable social goals. In these cases, whether a reform is desirable may be unclear, but a better understanding of the trade-off involved enables a more informed choice and suggests areas in which further empirical research would be useful. Finally, still other proposed reforms are based on misunderstandings of the market or of the social impacts of a practice and should be avoided.

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