This Draft: May 11, 2004 Preliminary & Incomplete Reputation Effects on the Floor of the New York Stock Exchange

A growing empirical literature suggests non-anonymous, floor-based trading venues provide lower trading costs for large, difficult orders than anonymous, electronic trading platforms. Theory suggests reputations, developed through repeated face-to-face interactions, allow floor-based trading venues to attenuate the adverse selection problem associated with large orders. We identify instances when stocks listed on the New York Stock Exchange (NYSE) relocate. Although the specialist follows the stock to its new location, many floor brokers do not. We use this natural experiment to determine whether reputation affects trading costs. We find a discernable increase in the cost of liquidity in the days leading up to and immediately after a stock’s relocation. The increase is more pronounced for stocks with higher adverse selection. Using NYSE audit-trail data, we find that the floor brokers that relocate with the stock obtain lower trading costs than those who do not move. Together, these results suggest the floor of the NYSE plays an important role in the liquidity provision process. Acknowledgments: We thank the NYSE, especially Katherine Ross, for providing data. The opinions expressed in this paper do not necessarily reflect those of the employees, members, or officers of the NYSE. For example, Tully (2003) notes in a November 10, 2003 Fortune article that,”Buyers and sellers sacrifice their anonymity by divulging their orders to the Wall Street middlemen. Most securities firms zealously try to protect that information. But Wall Street is famously a sieve-information leaks out from everywhere. And those whispers can dramatically move the price of the shares that the fund is in the process of accumulating. "When we're bulking up on a new stock," says American Century's Wheeler, "and we give the buy ticket to a bulge-bracket firm, they can trade ahead of us on a proprietary basis after they execute the first order. We might as well write them a check. "” There is a growing empirical literature that suggests non-anonymous, floor-based trading venues provide lower trading costs for large, difficult orders than anonymous, electronic trading venues. For example, see Chakravarty (2001), Venkataraman (2001), Garfinkel and Nimalendran (2003), Barclay, Hendershott and McCormick (2003), Waisburd (2003), Bessembinder and Venkataraman (2003), Theissen (1999), and Handa, Scwhartz and Tiwari (2003). Boehmer, Saar and Yu (2004), Madhavan and Papaganeshan (199X), Corwin and Lipson (200x), Coval and Shumway (2001) each present evidence that suggests the floor is informationally rich. Pirrong (1996) notes that “floor traders also argue that their ability to ‘look other traders in the eye’ also provides valuable information about the motives of their competitors, and that this (to some degree) limits their vulnerability to being ‘picked off’ by a more informed individual. ” Baker and Iyer (1992) examine trading crowds in a national option exchange and find that network structure influences price volatility and expected trading volume. They interpret their results as suggesting that the structure of the real communication network among investors may influence market behavior. 1 The rise to prominence of electronic trading venues in equities (Island, Instinet, and Archiepelago), equity options (International Securities Exchange), and futures (Globex) suggests that physical trading floors may soon be obsolete. Pirrong (1996) and Domowitz (2001) argue automated markets are attractive to investors because they are fast and because they are cheap to develop, operate, and monitor. American Century, a big mutual fund company, estimates the amount it spends on commissions would fall from $150 million to $25 million per year if all of its equity trading were done electronically (see Tully 2003). Perhaps more important, proponents argue electronic trading venues allow investors to reduce implicit trading costs associated with information leakage by giving traders direct control over their orders. Harris (2003), however, suggests that floor-based exchanges will not disappear as long as floors provide valuable services to traders. A large empirical literature suggests floor-based exchanges excel at handling large, difficult orders. Theoretically, Benveniste, Marcus, and Wilhelm (1992) and Weinstein (1993) argue the repeated dealings between floor brokers and specialists on floor-based exchanges allow specialists to penalize brokers who misrepresent their trading intentions (by providing less favorable prices in the future). Pagano and Roell (1992) argue that floor-based trading systems give participants “the opportunity to observe who trades what with whom, how urgently they seem to want to trade, etc.” These arguments suggest repeated, face-to-face interactions are one source of the floor’s comparative advantage in handling institutional order flow. We use