Extant economic theories of markets and market microstructure may be
used to formulate a theory of of the price effects of exchange automation. Studies by financial economists such as Barnea (1974), Beja (1979), Amihud and Mendelson (1989) and others indicate that trading mechanisms affect price behavior especially with regard to short term components of price volatility. Further, theories of market automation proposed by Garbade and Silber (1979), Amihud and Mendelson (1990), Schwartz (1985), Miller (1989) and others all indicate that exchange automation changes the microstructure of the market. Based on these studies we deduce and test the theory that automation changes the component of price volatility that is generated by the trading mechanism.
To test this theory we study the implementation of the Electronic Display
Book on the floor of the New York Stock Exchange and postulate that the excess intraday price volatility that may be ascribed to trading mechanism will change when the EDB is deployed. Fortuitously, the EDB was deployed over a three year period using over 100 implementation dates to convert about a thousand stocks to the new technology. This allows the use of 'event time' methodologies to cancel out concomitant historical effects from the quasi-experimental design. Further, economic effects are factored out of intraday changes by using a regression technique which leaves residuals, termed 'excess intraday volatility'. This quantity is ascribed to trading mechanism effects and is therefore postulated as the appropriate response variable for measuring the impact of the information system.
Using trading volume and market movement as control variables, it is
found with 'intervention analysis' that at trading volumes higher than 100,000 shares per day and in cases where the daily price movement is at least three ticks, the excess intraday price volatility of stocks is lower after EDB implementation (see Figure 1 below). At lower trading volumes or when the price is not moving (by three ticks or more), no difference in excess volatility is detected. Volatility is an important property of markets. In particular, lower volatility is a desirable property in market design. This is because in a mean-variance world of risk averse utility maximizers governed by the efficient market hypothesis (Markowitz 1959, Sharpe 1963, Fama 1970) investors will demand additional returns to bear the excess volatility generated by the market mechanism. As a result the overall investment into productive assets in the macro economy would be less than it would have been had the stock market been frictionless. However, the only real function of markets is to provide liquidity and liquidity is related to volatility. Market design that lowers volatility is desirable only to the extent that this does not adversely affect liquidity. A test on liquidity is therefore performed and it is found that there is no evidence that at least one measure of liquidity is lower after the deployment of the electronic limit order book. We may therefore conclude as follows: The implementation of the electronic trading system has had a measurable impact on price behavior. Volatility has been lowered without also decreasing liquidity. The 'quality' of the EDB market is therefore considered to be higher than that of the manual limit order book market.
For empirical research the problem of low statistical power may be
addressed by tightening the functional definitions whose success is to be directly measured. For example, it may be difficult to measure the direct effect of a new accounts receivable system on the wealth of the shareholders but the measurement of the effect on mean collection time and percentage of the Receivables actually collected within a given time frame could be attempted. Such a measure can then be used to