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An Empirical Study of the Effect of Rule 19c-3

THE extent to which all orders for common stocks should be consolidated (that is, sent to a single marketplace) and the effect of consolidation on competition in the securities markets have been the subject of much debate in the past quarter century. This debate has focused on offboard trading restrictions for member firms (for example, New York Stock Exchange [NYSE] Rule 390 and American Stock Exchange [AMEX] Rule 5) and on the institution of appropriate intermarket linkages (for example, the Consolidated Transactions Tape, the Consolidated Quotations System, and the Intermarket Trading system). While the Securities and Exchange Commission (SEC) has attempted to promote competition in the securities markets, the results of its efforts are uncertain. Consequently, the consolidation/fragmentation debate continues. In this article, we examine a very specific case in which the SEC tried to increase the degree of competition in market making. Rule 19c-3 allowed off-board trading of NYSE-listed stocks by exchange members. As we will show, this rule had both beneficial and adverse effects. Section I describes Rule 19c-3, the environment which led to its introduction, and the controversy surrounding it. In Section II, we examine the effect of Rule 19c-3 on over-the-counter (OTC) market-making activity; we find that for about 34 percent of the eligible stocks, the introduction of exchange-member market makers increased the total level and also the continuity of OTC market-making activity. In Section III, we find that Rule 19c-3 has had a statistically significant effect in reducing percentage bidask spreads which, ceteris paribus, is desirable. In Section IV, our analysis shows that Rule 19c-3 has led to an increase in returns variance which, ceteris paribus, is undesirable. Finally, our summary and conclusion are presented in Section V.