Working Paper No. 101
THE CARLO ALBERTO NOTEBOOKS
Liquidity and Competition in Unregulated Markets
LIQUIDITY AND COMPETITION IN UNREGULATED MARKETS
Despite reputedly widespread market manipulation and insider trading, we find surprisingly
high liquidity and low transactions costs for actively traded securities on the NYSE between
1890 and 1910, decades before SEC regulation. Moreover, market makers behave largely as
predicted in theory: stocks with liquid markets and competitive market makers (cross-trading at
the rival Consolidated Exchange) trade with substantially lower quoted bid-ask spreads and with
less anti-competitive behavior (price discreteness). Effective spreads, illiquidity, and volume all
improve monotonically over time. Notably, the asymmetric information component of effective
spreads increases in relative and absolute terms from 1900 to 1910.
* Johns Hopkins University. http://www.econ.jhu.edu/people/fohlin/index.html
† University of Freiburg and CEPR
‡ University of Freiburg
We are grateful to Richard Sylla for help and advice on the institutional details of the NYSE as well as to
participants at the BETA Workshop at Strasbourg (May 2007), the Collegio Carlo Alberto in Moncalieri, Humboldt
University, and the ASSA meetings in New Orleans (January 2008). We thank particularly Giuseppe Bertola,
Elroy Dimson, John Latting, Monika Merz, Giovanna Nicodano, Albrecht Ritschl, Filippo Taddei, Harald Uhlig,
Andrey Ukhov, and Marc Weidenmier. We are indebted to Seth Friedman, Purvi Maniar, Michael Mueller, and
Frederic Rey for unflagging research assistance in gathering the daily stock data and to the U.S. National Science
Foundation (grants SES0137937 and SES0331009 to Fohlin) for financial support. Gehrig gratefully
acknowledges the hospitality of the Collegio Carlo Alberto in Moncalieri.
Copyright 2008 by Caroline Fohlin, Thomas Gehrig and Tobias Brünner. Any opinions expressed here are those of
the author and not those of the Collegio Carlo Alberto.
LIQUIDITY AND COMPETITION IN UNREGULATED MARKETS
Financial crises nearly always generate increased government involvement in the regulation of
financial markets and institutions. The collapse of financial markets and myriad banks between
1929 and 1933, followed as it was by a slew of new federal regulation, remains the most
significant example of the crisis-response pattern in the United States. While most would agree
that resulting institutions like the Securities and Exchange Commission (SEC) have provided
useful oversight and regulatory functions over the past 70 plus years, we actually know very little
about the functioning of US financial markets prior to the onset of government regulation.
Thus, in this paper, we examine liquidity provision and transactions costs—key
parameters of market performance—in the New York Stock Exchange between 1890 and 1910.
Using a newly-gathered database of daily closing prices, quoted bid and ask prices and trading
volume for all stocks traded on the exchange in those years, we calculate various measures of
illiquidity and transactions costs, in order to estimate the quoted and effective costs of trading.
In order to understand the sources of trading costs and market liquidity, we decompose the
effective spread measures into asymmetric information and order-processing components, based
on theoretical models of spread components. We then analyze the cross-sectional determinants
of the quoted spreads and market liquidity, including the impact of simultaneous trading on the
main competing exchange, the Consolidated Exchange.
Given the relatively early phase of development of equity trading in the NYSE, along
with the rudimentary communications technology of the pre-WWI era, we expect to find high
spreads by modern U.S. standards. Moreover, given the absence of regulation regarding insider
trading, one might be tempted to expect a relatively high adverse selection component in quoted
spreads and illiquid trading. At the same time, however, we expect that parallel trade on the
Consolidated likely increased competition (even if it also decreased efficiency via market
fragmentation) and therefore tightened spreads on the NYSE, particularly for stocks traded on
In fact, some of our hypotheses are borne out by the data, but there are many surprises.
Indeed, for the most heavily traded stocks, trading costs are roughly comparable to those in
developed markets at the end of the century. So we definitely have to revise our expectation that
markets operated with dramatically higher trading costs at this time. Likewise we find that
measures of market illiquidity for the highest volume stocks are comparable to the same measure
for stocks traded at the NYSE at the end of the 20th century. In the cross sectional analysis, we
confirm our hypothesis that stocks with liquid markets—those with a high number of trading
days and large volume—trade at lower cost, and those with simultaneous Consolidated activity
trade with significantly lower spreads. Over time, however, quoted spreads do not behave in line
with other measures of market liquidity and trading costs: while quoted spreads increase from
1900 to 1910, effective transaction costs and market illiquidity decrease monotonically and
trading volume of common stocks increases monotonically from 1890 to 1910. Preferred shares
show a different volume pattern, with the more actively traded shares increasing in volume from
1890 to 1900 and then dropping off again by 1910. Also of note, the asymmetric information
component of trading costs increases in relative and absolute terms from 1900 to 1910.
This study contributes to a growing line of research into the microstructure and
performance of securities markets prior to government regulation. Few other works have
investigated the historical development of transactions costs and liquidity in U.S. markets,
particularly the NYSE. To our knowledge, the current paper is the first to study these
phenomena for the NYSE using high-frequency historical data. Most closely related to our work
is Jones (2002), which examines month-end quoted bid-ask spreads for the components of the
Dow Jones Industrial average between 1900 and 2000. Jones (2002) shows that transaction
costs—he considers bid-ask spreads and commissions—explain a small part of the equity
premium over this long period. Also, spreads seem to be good predictors for future returns. The
purpose of that study is to follow very long-run movements in transactions costs. Due to the
lower frequency of the data and the smaller sample (of mostly the largest firms), the results
cannot readily be compared with those presented in the current paper. Moreover, our results
suggest that quoted bid-ask spreads are not a good measure for comparing the relevant
transaction costs over time. Rather measures of effective transaction costs or market illiquidity
are more reliable.
Also related to our work, Brown et al. (forthcoming) argue that direct competition with
the Consolidated Stock Exchange between 1885 and 1926 reduced transaction costs at the
NYSE. While they identify the competition effect around structural breaks in the time domain,
our cross-sectional regressions measure the competitive impact of firms being traded both at the
NYSE and the Consolidated Stock Exchange. In this sense we can also measure the value of a
“cross-listing” on both exchanges. As with Jones (2002), Brown et al. (forthcoming) rely on one
trading day per year over an extended period for a small sample of stocks, as opposed to our
daily data on the complete set of traded stocks. Additionally, we find that price clustering at
whole and half dollar increments – a potential indication for non-competitive conduct – is less
pronounced for securities traded on both exchanges both in 1900 and 1910.
Davis et al. (2007), focusing on capacity constraints and their softening after the seat sale
of 1928, also produce quoted bid-ask spreads for a selected high and low volume days
surrounding the sale. Mean spreads range from .65 to 1.69 percent: far lower than the estimates
we produce for the full set of stocks traded in 1900/1910 but similar to the spreads on high
volume stocks in these years. Their cross-sectional results, however, produce similar predictive
factors as we find for the earlier period. Their study also has data insufficient to create the more
extensive measures of effective transactions costs and market illiquidity that we use.
More similar from a methodological standpoint, Gehrig and Fohlin (2006) study trading
costs in the Berlin Stock Exchange, using daily prices, for a similar time period (1880-1910).
Due to the nature of trading in that market, however, the data are also quite different from the
NYSE data: the Berlin market produced only one daily price quote and no reported bid-ask
spreads. The results of that study indicate that estimated effective spreads in Berlin ranged
between approximately 11 and 28 basis points, while round-trip transactions costs varied from 45
to 116 basis points. In both cases, the measures declined over time, but unlike the New York
Exchange they were already fairly low by historical standards and certainly a lot lower than the
average at the New York Stock Exchange at that time.
These findings are particularly interesting in comparison with recent developing markets
(Lesmond, 2005). Our estimates indicate that NYSE illiquidity at the turn of the 20th century
was roughly comparable to emerging stock markets of China, the Czech Republic and Mexico at
the end of the 20th century.
The rest of the paper is organized as follows: the next section reviews the historical
context of the New York Stock Exchange and key features of corporate finance practice in the
pre-World War I era. Section III describes the theoretical underpinnings of various measures of
transactions costs, while section IV introduces the newly created database on daily stock prices,
volumes, and spreads. Section V presents the quoted and estimated effective spreads and their
decompositions, and section VI investigates the cross-sectional determinants of quoted spreads.
The final section concludes.
II. The Development of the NYSE before World War I
The New York Stock Exchange was created in 1792 when twenty four brokers and merchants
signed the Buttonwood Agreement. At this time, five securities were traded on the exchange
(nyse.com).4 In the first half of the nineteenth century, government issues comprised the bulk of
publicly traded securities. By 1860, the liberalization of incorporation law (Hickson and Turner,
2005) allowed for the creation of marketable securities to trade on organized exchanges. Within
a few years, railroads began issuing securities for trading on the large public markets in order to
satisfy their growing demands for capital. Around the 1880s, rail stocks made up a substantial
majority of the trading on the NYSE. Listings and trading on the exchange grew rapidly, and the
mix of securities changed, in the latter part of the nineteenth century and the first decades of the
twentieth. While railroad securities remained important, they lost some market share around the
turn of the twentieth century, as other sectors expanded more rapidly.5 By 1910, “non-rails”
outnumbered railroads on the NYSE for the first time since 1870 (Davis and Cull 1994). The
value of securities listed on the exchange exceeded $26 billion (about $500 billion in 2005
Rules and Regulation:
In the period of our study, the NYSE was owned by its members and largely self-regulated.
Among the key regulations were those dealing with membership. Joining the exchange was a
costly venture: a new member had to pay a membership fee and then buy the seat of an existing
4 See Michie (1986), p. 173 and Mulherin et al. (1991), p. 597, for surveys of the institutional development of the
NYSE. See also Baskin (1988).
5 Navin and Sears (1955) consider the 1880s the beginning of the shift to the widely-held industrial enterprise,
particularly due to the “trust” movement in the processing industries. The main trusts created in the 1880s involved
oil refining (Standard Oil), cotton oil refining, linseed oil refining, whiskey distilling, sugar refining, and lead
smelting and refining. They also credit the heavy demand for trading in trust certificates with New York’s rise to
preeminent exchange during the late 1880s.
6 Davis and Neal (1998) report a figure of 5.4 billion pounds, based on Michie (1987). The dollar values come from
using the calculator provided by www.measuringworth.com.
member. The exchange had fixed the number of seats at 1,100 in 1879, so that the prices of seats
varied with the market. These prices ranged between $4,000 and $4,500 in 1870 (approximately
$65,000 in 2005 values) and between $64,000 and $94,000 in 1910 (roughly $1-2 million in
The Governing Committee of the exchange held ultimate responsibility for exchange
operations and had the power to fine or even expel members for infractions against exchange
rules. The value of a member’s seat worked as collateral in these cases or in the event of
bankruptcy (Mulherin et al., 1991, 597-598). The courts upheld these powers as well as the
exchanges’ right to restrict trading solely to its members and to set other rules (Mulherin et al.,
The NYSE implemented relatively stringent listing standards and requirements, including
registration of all shares (to prevent stock watering), minimum shareholder numbers, and
qualitative assessment of risk. Oil stocks, for example, could not be listed in their early years, as
they were deemed too risky.
External regulation of exchange operations or of listed corporations came much later, and
corporate reporting law generally remained weak in the United States up until the Great
Depression. Private incentives, particularly the desire to access outside funds from investors,
encouraged more and more firms to disclose their balance sheets and income statements. In
1895, the NYSE began recommending that listed companies provide both a balance sheet and an
income statement in annual reports to investors. Such reporting became mandatory in 1899
(nyse.com).8 The content of these reports varied significantly in their breadth and accuracy, and
accounting standards and auditing practices took many more decades to evolve into what would
become the modern norm.
7 Michie (1986, p. 175), presumably reported in nominal terms.
8 See as well Archambault and Archambault (2005), who find that even as of 1915, listed companies—particularly
industrials that were not already regulated by the government—were significantly more likely to report an income
statement than unlisted companies. Similarly, listed companies were far more likely to report a balance sheet.
Organization of trading:
Though it started out operations using a call auction system, the NYSE moved to a continuous
auction method in 1871.9 Under this system, transactions occurred throughout the trading day at
whatever terms could be agreed upon by the parties involved, with no guarantee of a single
price.10 While the continuous auction method eliminated the problem of overcrowding and the
excessive time taken in the call auction, it created new problems of order imbalance—the
brokers interested in trading a given security may not arrive simultaneously at the particular
trading post for that security. In general, such random arrival reduces market liquidity, creating
greater order imbalance and price volatility compared to a call auction (Kregel, 1995).
The evolution of the trading method led to the creation of two distinct types of
intermediaries. The first type, brokers, traded on behalf of their customers and received set
commissions as their payment. The others, jobbers, bought and sold shares in order to make
markets in securities, and they received the spread between bid and ask prices as their
compensation. The increasing number and sophistication of jobbers then encouraged their
specialization in particular stocks, hence the term ‘specialist.’ These specialists made a market
in their stocks at a single trading post, and they traded on their own account as well as on behalf
of their customers.
Competition from other Exchanges:
The NYSE’s restrictive membership and listing rules led to the repeated rise of competitors from
its inception.11 The most significant competition came with the creation of the Consolidated
9 Kregel (1995, p. 464) gives a number of reasons relating to inefficiencies of the call auction. Kregel finds
unconvincing Garbade and Silber’s (1979) explanation for the shift to continuous trading—that the Civil War
increased the arrival of new information to the market.
10 See Kregel (1995) on the evolution of securities market organization in London and New York.
11 See, for example, Garvey (1944).
Stock Exchange, formed out of the merger of several rival exchanges, in 1885. The
Consolidated included 2,403 members—more than double the number of NYSE members—and
many brokers also traded in the unorganized “curb” market. By 1908, the three exchanges
contained 424 million shares of stock, over half of which (53.5 percent) were traded outside of
the NYSE (Michie, 1986, 175-176).
Compounding the incentives to deal outside of the NYSE, the brokers of the New York
Stock Exchange charged a fixed minimum commission of 1/8 percent on trades.12 The
Consolidated Stock Exchange, by contrast, charged a commission rate of 1/16, thus encouraging
nonmembers of the NYSE to deal on the Consolidated using NYSE market prices (Michie, 1986,
p. 178). By using the NYSE quotes, brokers of the Consolidated Exchange saved on the costs of
creating a price discovery mechanism, and were thereby able to charge lower commissions than
the NYSE (Mulherin et al., 1991, 608).
The NYSE worked continuously but not altogether successfully to eliminate its
competition. It created an Unlisted Trading Department to trade in stocks of the Consolidated
(Mulherin et al., 1991, 609), tried to remove tickers from the Consolidated Stock Exchange and
from outside brokers, and later forbade phone links to the Consolidated Stock Exchange. The
latter efforts failed, however, because brokers with legitimate access to the NYSE would trade at
the Consolidated at NYSE prices (Michie, 1986, 178).13 In 1896, dealing in differences between
domestic exchanges was banned and in 1898 the exchange banned the transmission of
continuous price quotes (Michie, 1986, 179).
The anti-competitive measures proved difficult to enforce, but they still limited
transactions between the NYSE and other domestic exchanges and created price differentials.
12 A loophole in the rule, however, allowed commissions of 1/32 percent (and often as low as 1/50 percent) on trades
for members buying and selling from each other. This discount pertained to all partners of a member firm, and thus
fostered the growth of large brokerage firms (Michie, 1986, 177-178). The original Buttonwood agreement stated a
minimum commission of ¼ percent.
13 For a detailed description of the legal battle for exchanges to control their quotes see Mulherin et al., 1991
The restrictive rules of the NYSE therefore limited the market in some securities, but
simultaneously hindered access to current prices by traders in the Consolidated. As Michie
(1986) points out, the “New York Stock Exchange covered only part of the New York market
and prevented the remainder from operating as efficiently as possible.”
Transactions Costs: Information and Competition
Trading in securities brought with it numerous costs, relating to both information asymmetries
and order processing. Information discrepancies between insiders and outsiders raised costs that
could be only partially offset by corporate reporting. The use of continuous trading created
additional illiquidity risk, particularly in stocks with thin markets that often required specialists
to hold inventories in order to make deals. Specialists required compensation for bearing these
risks, and the resulting spreads added to overall transactions costs. Moreover, restricted
memberships, minimum commission rates for brokers, and specialization in securities
(effectively product differentiation) may have lessened competition and allowed some market
power in the setting of spreads by specialists.
On the positive side, the innovations of the telegraph, ticker, and telephone lowered the
costs associated with disseminating information and expanded the NYSE’s geographical reach
(Mulherin et al., 1991, 606). It also allowed competing markets to gain access to NYSE quotes
and facilitated competition between the NYSE and other exchanges. These effects should have
helped lower order processing costs. To the extent that the exchange limited the listing of issues
judged to be too risky, the resulting selection bias should have mitigated the asymmetric
information components of transactions costs.
III. Measuring Market Liquidity and Transactions Costs
The development of the microstructure of the New York Stock Exchange prior to World War I
provides a unique real world experiment on the evolution of trading systems and associated
market liquidity and transactions costs in an unregulated (or self-regulated) environment.
Trading costs further reflect information about information asymmetries and market power.
Together, these various measures, and their underlying explanatory factors, provide a wide-
ranging picture of market functioning.
It is useful first to differentiate quoted spreads from effective spreads. While quoted
spreads can be readily observed as raw data, effective spreads need to be estimated by statistical
methods. Typically, effective spreads are more informative about real trading costs, because
quoted prices often change soon after a transaction has taken place or because traders can
actually negotiate to trade at prices between the quotes. When quotes change frequently during
the day, the effective costs of a round-trip transaction is likely to be lower than the quoted spread
at any point in time, because a hypothetical trader could take advantage of the option value of
trading the second part of a round-trip transaction at a different more favorable points in time
later. Also price improvements in form of bilateral agreements between traders and market
makers are rather customary in so-called quote drive trading systems, (i.e. in trading systems
based on market makers.)
Depending on the availability of empirical observations, estimated spreads can be
decomposed into the various theoretical components, like information, inventory holding, and
order processing cost. Since this decomposition of the underlying cost components is largely
based on theoretical considerations, in the sequel we briefly outline the theoretical basis for the
subsequent empirical analysis.
Market makers in an asset market receive as their compensation the difference between the price
paid to sellers and the price obtained from buyers—the bid-ask spread. Empirically, the
difference between quoted ask and bid prices, normalized by the midpoint of bid and ask prices
of the asset, provides an estimate of the actual transaction cost. Transactions do not necessarily
take place at quoted bid and ask prices, however, meaning that quoted spreads are not necessarily
precise reflections of real transactions costs. Moreover, the quoted spread wraps up a range of
different transactions costs: order processing expenses, inventory risk, asymmetric information,
and potentially monopoly rents. A number of alternative methods have been devised to more
accurately depict transactions costs and to allow decomposition of the spread into various
Realized Spreads and their Components
In order to estimate realized spreads, we use the method proposed by George et al. (1991). This
method refines and extends the serial covariance measure proposed by Roll (1984). In that
denoting the transactions return on a security i in period t, where
is the natural logarithm of the price of stock i, the Roll measure
estimate of security i’s effective spread.14 Since trades often take place at prices between the
quoted bid and ask prices, the estimated effective spread is smaller than a quoted spread. The
underlying idea of this estimator is that, in informationally efficient and stationary markets,
variation in transactions prices results from the randomness of buy and sell orders plus positive
transaction costs. In liquid markets with low transaction costs, successive individual orders have
little impact on observed transaction prices. In thin markets, price effects of individual trades
14 The transactions return is based on observed transactions prices. Transactions returns typically differ from true
returns, because even in efficient markets transactions costs prevent arbitrage, when true returns and transactions
returns are close enough.
may be more pronounced. If transaction costs are higher, the deviation of transaction prices from
true fundamentals will not be immediately arbitraged, even in efficient markets. Therefore, the
covariance of successive price changes provides information about market liquidity, and hence,
effective transaction costs.15 In liquid markets the covariance of successive prices will be low as
long as the price changes are not caused by systematic factors such as new market information.
And even new information will be reflected in prices immediately. In less liquid markets the
covariance will be higher, both, because of a larger market impact of individual trades, and
because information revelation is slower. The effective spread therefore arguably offers a better
estimate of actual transaction costs than does the quoted spread.
The GKN measure corrects for positive autocorrelation in the expected returns, thereby
overcoming the problem that the Roll measure often produces negative spread estimates. In the
framework of George et al. (1991) the logarithm of transaction price at time t can be written as
m is the logarithm of the true value of the asset at time t, π is the proportion of the quoted
spread that is due to order-processing costs,
is is the quoted spread and
it q is an indicator
variable that equals 1 if the transaction at time t is at the ask price and -1 if the transaction is at
the bid price. The true value of asset i consists of the expected return prior to transaction t, the
asymmetric information component, which reflects information revealed by transaction t, and a
white noise term. The logarithm of the bid price after transaction t is
Subtracting the bid price from the transaction price and taking the first difference yields
it it itit it itit
15 See Madhavan (2000) for a more technical survey on the empirical estimation of transaction costs.
Note that equation (3) does not depend on the true value
m and hence any time series properties
that the expected return
may exhibit do not influence
itr . Taking the autocovariance
itr yields the spread measure
i it iti
Using the spread measure
one can infer the proportion of the order processing component
π by a cross-section regression of
According to equation (4) we expect
β = and
Since we do not have bid and ask quotes for the year 1890 to correct for the positive
autocorrelation in expected returns we also employ another measure proposed by George et al.
(1991). For this measure the returns of closing prices, itr , are regressed on the expected return on
the equal weighted market index
E rI− :
r E rI
Then the Roll measure is applied to the residuals of this regression:
i it it
Closely related to the cost of trading is the concept of market liquidity. While the spread itself is
a widely used measure of market liquidity, it cannot reflect quantity reactions to changes in
prices or spreads. Characterizing market liquidity in this manner requires alternative measures,
three of which can be calculated with our historical data: i) the number of trade observations, ii)