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Exchanges Benefit from Record Volumes

As the markets have stumbled, the number of shares traded have hit all-time highs. What's behind all this activity?

Market volatility escalated and trading volumes set new record highs this week, totaling 10.59 billion shares on the three major stock exchanges on July 26 alone. That was 34% above the previous record from earlier this year and a sign of increasing skittishness among investors. The heightened volatility comes as investors digest mounting evidence of a credit crunch and deeper housing market woes that could spell trouble for the broader economy in the months ahead.

The 4.9% drop this week in the Standard & Poor's 500-stock index was its biggest decline since September, 2002, while the NASDAQ composite index and Dow Jones industrial average logged their largest losses since March.

However, bucking the downdraft were shares of major exchange companies such as Chicago Mercantile Exchange (CME), the New York Stock Exchange Euronext (NYX), and the InterContinental Exchange (ICE), which rose on July 27 on news of the record volumes.

Record-Breaking Activity

The New York Stock Exchange measures market activity by the number of investor messages it processes in any given day, as opposed to the number of shares traded. On July 26, the NYSE processed 695 million messages, a 27% jump from its previous record of 548 million messages processed a day earlier. The NYSE Group, which includes the Archipelago Exchange it acquired last year, traded 5.1 billion shares on July 26, its second-most-active day after setting an all-time record of 5.19 billion shares on June 22.

The NASDAQ Stock Market reported 1.7 billion messages processed on July 26, up 42% from the prior record on Feb. 27, and it entered a record 326 million orders, a 59% jump from the previous high in February.

Cleveland Rueckert, a research analyst at Birinyi Associates in New York, believes volatility was the key contributor to the record trading volumes on July 26. "With the whole subprime thing, and the financial sector sort of falling apart, you have people who are getting nervous," he says.

Corporate earnings are affecting trading decisions, as is the approach of the end of the month, when mutual funds disclose performance information to investors. That's likely spurring portfolio managers to lock in profits by selling stocks they think have topped out, Rueckert says.

The Changing Nature of Trading

The record volumes aren't an indicator of volatility alone since the Dow industrials and S&P 500 reached new all-time highs last week. They also reflect a sea change in the way trading is done—through online trading programs used by a growing number of large institutional investors including mutual funds and hedge funds in the past five years.

"The days when humans traded with each other are gone. Now computers trade with each other," says James Angel, associate professor of finance at Georgetown University's McDonough School of Business. "Computerized systems are capable of handling big spikes in volume with minimal problems."

For Chris Concannon, executive vice-president of NASDAQ Transaction Services, heavy trading volume is an indication of the increasing efficiency with which the market is now able to execute trades, whether through online brokers or institutional investors using algorithms and electronic trading systems to place orders. Much of that has to do with technology, but it's also a function of much lower trading costs compared with 5 or 10 years ago. "If you can trade for $5, you may be inclined to trade in and out of positions on volatile days. There are very low costs for brokerage fees," he says.

Investors' ability to get in and out of positions all day owing to electronic trading programs means that record volume doesn't necessarily point to broader participation in the market. "Bigger institutional players like hedge funds that have that capability can bang in and out of the market a couple times a second," notes Rueckert. "Even though the same computer systems are trading back and forth, it's going to drive trading volume through the roof."

The Evolving Exchange System

Georgetown's Angel credits the quality of the market trading systems, which were able to process 5 billion shares in a single day. "One of the great advantages of having multiple competing exchanges is it forces them to be on their toes to be able to handle volume when it comes in, or else they'll lose market share to their competitors."

In looking at other "bad market days," when the 30-stock Dow Jones industrial average is down 2% or more, dating back to October, 2002, Birinyi Associates found that trading volume topped the 50-day moving average only half of the time.

Chris Johnson, chief investment strategist with Johnson Research Group in Cincinnati, says he's not surprised by how few record-breaking-volume days there have been in recent years. That's because of the range of alternative trading venues that people have migrated to, siphoning off volume that previously would have been on the major exchanges.

Dark Pools Muddy the Waters

Big institutional players like brokerages, for example, that don't want to disclose their trades prefer to make a market for each other's bids and asks through internal networks known as dark pools. Johnson doesn't know how volume of trades done through dark pools compares with volume on the open market.

"A lot of institutional money is going through these dark pools. With hedge fund activity, dark pool activity has grown significantly," he says. "Hedge funds don't want to reveal trading strategies or holdings. If you're operating through the open market, that information can be pieced together."

No matter how the trades are done, if volatility stays strong as some experts predict, the major exchanges should benefit.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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