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The Philadelphia Stock Exchange (PHLX), the nations oldest, has survived alongside much larger and more liquid securities markets. How has it managed to do so? In this article, John Caskey explains some of the factors that account for the PHLX's long life and how their importance has varied over time. Although Caskey focuses on the evolution of the PHLX, he also profiles some seismic shifts in U.S. securities markets in recent decades and illuminates the role of the largely overlooked regional stock exchanges.

Conventional wisdom holds that securities trading will shift to the most liquid markets. After all, all else being equal, people buying a security would like to direct their orders to the market with the largest number of sellers, and people selling a security would like to direct their orders to the market with the largest ,lumber of buyers. This maximizes the chances that buyers and sellers get the best price possible for their trades and that they will complete their trades quickly.

Market professionals have long acknowledged this effect and have succinctly captured it in the common phrase "liquidity attracts liquidity." This point has also been recognized by academic economists, who refer to it as an "order flow externality," or more generally, a "network externality." (1) It is an externality because when one person directs an order to a particular market, it benefits other people trading in the same market.

Over most of its long life, the Philadelphia Stock Exchange (PHLX) has survived alongside much larger and more liquid securities markets. This article explains how it managed to do so despite order flow externalities. (2) In brief, a number of factors played a role, including communication costs, membership standards on dominant exchanges, incentives to avoid fixed trading commissions, a differentiation of trading technologies, an unwillingness to permit markets to compete in the trading of equity options, and the development of new products that were not traded on other markets.

The importance of these factors has varied over time. While focusing on the evolution of tire PHLX, in the background, I will profile some of the seismic shifts in U.S. securities markets in recent decades and illuminate the role of the largely overlooked regional stock exchanges.

PRE-1960: COMMUNICATION COSTS AND NYSE MEMBERSHIP AND LISTING STANDARDS

The Philadelphia Stock Exchange dates its founding to 1790, making it the country's oldest stock exchange. (3) Although the New York Stock Exchange (NYSE) was founded two years later, it soon surpassed all other stock exchanges in trading volume. By the late 1830s, for example, the reported share volume on the PHLX was about 14 percent of that on the NYSE. Undoubtedly this reflected the fact that by the 1830s, New York City had become the major center for commerce.

Over the 19th century, an increasing share of the trading in financial securities, especially for the largest firms or public projects, migrated to the NYSE because of the liquidity and depth of that market. But relatively high communication costs enabled the regional exchanges to compete in the first half of the century. Philadelphians could not quickly discover the prices of securities trading in New York, nor could they quickly transmit orders to trade to that city. In other words, communication costs offset the tendency for the trading of securities to concentrate in one market center, and regional securities exchanges flourished.

The development of the telegraph in the 1850s and the ticker tape in the 1870s began to change this situation. The Philadelphia Stock Exchange, and other regional exchanges, responded by increasingly listing and trading the securities of firms that could not meet the listing requirements of the NYSE, such as an exchange-specified minimum aggregate market value of publicly held shares or an exchange-specified minimum number of public shareholders. The firms that were unable to meet the NYSE listing requirements tended to be younger and smaller firms little known outside their local markets. In addition, many states exempted any company listed on an exchange, including the regional exchanges, from their "blue sky" laws. These laws offered some protection against fraud by requiring that securities sold within a state be registered with that state. The exemption created a strong incentive for firms that were unable to meet NYSE listing standards but that did not want to incur the costs of registering their securities in multiple states to list on a regional exchange.

In the 1920s, the volume of trading on the PHLX, as on many other regional exchanges, increased dramatically. In the subsequent stock market crash and economic depression, many of the firms listed on the regional exchanges failed or were absorbed in mergers, and trading volume fell precipitously. In addition, states changed their blue sky laws to limit exemptions for securities listed on regional exchanges, and the newly created Securities and Exchange Commission (SEC) required the exchanges to impose stricter listing requirements. These developments greatly decreased listings and trading volume on the regional exchanges. Gradually, the over-the-counter (OTC) market (see the Glossary) replaced the regional exchanges as the location where newly issued equities would trade and become "seasoned" before the issuing firm might seek a listing on the NYSE or the American Stock Exchange (AMEX).

As the regional exchanges lost listings and trading volume, they responded by starting to trade securities listed on the NYSE and the AMEX. In 1931, for example, the PHLX allowed trading to begin in any security listed on the NYSE or the AMEX. Since these securities were generally not listed on the PHLX, this was called "unlisted" trading. By 1961, only 1.2 percent of the dollar volume of stock trading on the PHLX came from the 88 stocks that had sole listings on that exchange (SEC, 1963, Table VIII-76). The vast majority of stocks traded on the PHLX were ones listed on the NYSE.

As the PHLX evolved into an exchange that mainly traded equities listed on the NYSE, it also evolved to resemble more closely a dealer market rather than an auction market. In most cases, the only person buying or selling a particular stock on the floor of the exchange was the designated specialist (see the Glossary). There were no competing market makers on the floor, and it was rare for brokers representing buy and sell orders to interact directly. The counterparty to nearly all trades was the specialist. This was true for the trading of unlisted securities on the other regional exchanges as well (SEC, 1963, p. 932).

Over the 1950s and into the 1960s, brokers directed orders to the PHLX rather than to the more liquid NYSE for a variety of reasons. For one, specialists on the PHLX would generally set their prices to within $0.125 of the price of the last reported transaction on the NYSE, thereby guaranteeing brokers that their prices were nearly as good, and sometimes as good, as those on the NYSE. This practice was common on the regional exchanges. In addition, small and medium-size brokerage firms with their headquarters in the mid-Atlantic region were often members of the PHLX but not the NYSE, since membership in the PHLX required far less capital. If such firms received an order to trade a security listed on the NYSE and they directed it to the NYSE for execution, they would have to pay the "public" fixed commission paid by all nonmembers. Alternatively, if such firms executed the order on the PHLX, they could keep most of the public commission paid by their customers, paying only a minor member commission to the PHLX.

Firms that were sole members of the PHLX would direct some orders to the NYSE, either because the trade was too large to be executed quickly on the PHLX or because the security was not traded on the PHLX. Since a member's cost of executing an order on the NYSE was well below the minimum public commission, members competed aggressively to attract orders from nonmembers. The NYSE did not permit its members to discount public commissions or offer cash rebates to compete in attracting orders; however, the members could reward nonmember brokerage firms that were members of a regional exchange by sending them orders to execute on the regional exchange. Such orders were referred to as reciprocal order flow, and they accounted for a significant share of the trades directed to the PHLX and other regional exchanges during the 1950s and 1960s. In this way, the brokerage firm that was a sole member of a regional exchange could indirectly earn public commissions for handling orders that it directed to an NYSE member.