Automated Trading Makes It Cheaper For Companies to Raise Capital

Listed companies may want to push for automated trading of their shares as soon as possible. A new study co-authored by Ian Domowitz of Penn State's Smeal College of Business Administration suggests automated trading would make it much cheaper for companies to raise fresh capital.

"Although many factors enter into the choice of financial market structure, our results support the argument that stock exchanges should move to fully automated trading," explains Domowitz, the Mary Jean and Frank P. Smeal Professor of Finance in Penn State's Smeal College of Business Administration and immediate past-chair of NASDAQ's Economic Advisory Board. Domowitz co-authored the study, "Innovation in Equity Trading Systems: The Impact on Transactions Costs and Cost of Capital," with Benn Steil, the Linda J. Wachner Senior Fellow in U.S. Foreign Economic Policy at the Council on Foreign Relations. It will appear in the forthcoming book, Technological Innovation and Economic Performance .

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 (NYSE) and even the Nasdaq.

The co-authors report four major findings in the study.

"Trading automation-the use of nonintermediated electronic auction systems, such as Instinet-- has a significant impact on trading costs. Over the period 1992-1996, we estimated that savings from use of such systems, including both fees and market impact, averaged 28 percent on NYSE shares and 33 percent on Nasdaq shares," says Domowitz.

The second major finding is that trading costs have a huge impact on turnover.

"For every 10 percent decline in U.S. and European trading costs between 1996-1998, turnover rises approximately 8 percent," says Domowitz.

The third major finding is that trading costs have a highly significant impact on the cost of equity capital; however, the researchers found that higher turnover in blue-chip stocks (S&P 500 in the U.S) does not itself lower the cost of equity capital.

"That is, turnover does not 'intermediate' between trading costs and cost of capital, at least for blue-chip stocks," explains Domowitz. "Rather, declines in trading cost have a direct impact on cost of capital."

The economists report that every 10 percent decline in trading costs results in a 1.5 percent decline in the cost of equity capital to blue-chip listed companies. Over the period 1996-98, trading costs declined by 53 percent in the US, translating into a decline in the cost of equity capital to S&P 500 companies of nearly 8 percent. Trading costs in Europe only declined 17 percent over this period, resulting in a much smaller cost of capital savings of 2.6 percent to European blue-chip companies.

Approximately 30 percent of the Nasdaq market and 5% of the NYSE market can already be considered "automated."

"If mandatory intermediation of trades by exchange members were to be replaced by direct access to automated execution systems, trading costs would decline a further 30 percent on that basis alone, translating into a further 4 percent decline in the cost of capital to S&P 500 companies," says Domowitz.

The effect would be more dramatic in Europe. Even though European exchanges use automated auction systems, unlike in the United States, trades must still be funneled through exchange members.

"Our trading cost study suggests that brokerage intermediaries subtract value, on average, in the institutional trading process. So, conservatively, if we just considered commissions alone, these would decline 70 percent in Europe with full automation of trading," says Domowitz. "This translates into a total decline in trading costs of 50 percent and that's not even including further anticipated declines in market impact costs."

He notes that this would result in a substantial 7.8 percent decline in the cost of capital to European listed blue chips.

Domowitz is a consultant to various government and international organizations, as well as to various securities exchanges. He serves on the Scientific Advisory Board of ITG, Inc., on the Advisory Board of Tradebonds.com, and is also a former member of the NASD's Bond Market Transparency Committee.