Stock Market Fragmentation Raises Concerns
By Sandra Sugawara
Washington Post Staff Writer
Sunday, April 16, 2000; Page H01
washingtonpost.com
Four years ago, Lon Gorman was a mega-stock trader at Credit Suisse First Boston, handling the kinds of million-dollar deals that were the center of power in the clubby limousine world of Wall Street.
Today, Gorman is vice chairman of Charles Schwab Corp., ensconced in a modest office in low-rent Jersey City, where he oversees small trades for Schwab's millions of mom-and-pop investors. He is, he insists, at the new center of power in the stock markets.
Gorman's journey from the prestigious, monied moneyed environs of the Street to rundown run-down surroundings across the Hudson River says a great deal about the enormous changes underway in the Internet era of stock market trading. His tale illustrates how the millions of individual investors surging into stocks thanks to technology have helped reshape the markets. Although stocks of technology companies are getting trampled this month, technological innovations in how trades are executed has have sparked new levels of competition among Wall Street firms and stock exchanges themselves.
"The pace of this change has been mind-blowing," said the 51-year-old Gorman Gorman, 51. "And if you look at this on a continuum .?.?. I think we are still in the early innings."
These changes have created anxieties on Wall Street, disrupted trading and contributed to the stock markets' enormous volatility, according to critics. But they are the necessary evolution to more efficient, innovative markets, Gorman insisted insists.
For years, three major groups dominated the inner circle of Wall Street and they exuded the kind of invincibility that money and prestige can bring. One comprised such wealthy institutions as leading banks, mutual funds and hedge funds. They got the special deals, the early research, the choice tips. Then there were the major brokerage houses, which handled the big trades and pocketed millions of commission dollars each year. The third was the New York Stock Exchange, the world's largest and most successful stock exchange and the site of Wall Street's most important trades.
Schwab was a mere speck on the financial scene in the 1970s, a start-up that focused on the least sexy of the investment businesses ? retail investing. Retail investors, especially middle-class ones, were invisible. Their route to Wall Street was generally a phone call to their broker, who might pass on a research report or a stock tip but could never be expected to roll out the red-carpet treatment that large funds such as Fidelity and Putnam expected.
Gorman recalled that when mutual fund managers would come to him with a big order ? say, to sell a million shares of American Airlines ? he would hit the phones, negotiating with other institutional clients to take the deal. He'd wheel and deal, maybe offering a discount of up to 10 percent on the whole block so he could get the huge load of shares sold.
Once he'd found the institutional buyers, he'd send a message to the NYSE floor, announcing the discounted price at which the big block of shares was sold. If other investors had pending orders at those prices, those orders would be filled. If new investors wanted to jump in at the new, lower price, they were usually too late to act.
"Individuals might see the price going down, but by the time they had a chance to call their broker, odds were that the stock had already gone back up," Gorman said.
The vast majority of the mega-trades remained within the inner circle of institutions, as did the market intelligence generated by those trades. Gorman likens that kind of information ? intelligence about who is buying and selling, at what volume, and who might be interested in acquiring more ? to the navigational tools that pilots use to fly planes.
"A good broker would be able to give a great recommendation on a course of action for an institution ? whether to liquidate a block or dribble the sale out over a day or two," he explained.
To further cement ties between traders and institutional investors, brokerage firms often used their own money to help these prized customers complete a sale quickly. These brokerage houses would buy the stock from the client and then sell off pieces of the block of shares over the next several days, lessening the potential for the sales to cause the stock price to abruptly plummet. Market intelligence was critical for handling the risk in those transactions.
The investing world was beginning to change in 1996, the year that Gorman joined Schwab. Online investing was taking hold, although most in the Street's inner circle didn't seem to notice. When Gorman decided to drop his original plan of joining a hedge fund ? a private pool of money, generally from wealthy individuals, that is managed by a professional trader ? to head Schwab's trading operations, his best friends were concerned. "Why are you going to Schwab?" they asked him. "Schwab is not a factor in this business."
Gorman told them that he "sensed in some fundamental way that the same 50 or 60 institutions" that had controlled things in the stock markets were losing their control. The Internet was changing investors' behavior. With the click of a computer mouse, individuals could trade and get research and quotes. They were beginning to ditch costly brokers, who were often hard to get on the phone.
The finely balanced arrangement that had kept power with the club was unraveling.
That trend continued and accelerated. The number of customers at Schwab alone has more than doubled in the past five years, to 6.7 million, giving Schwab the brokerage some of the best data on the behavior of retail investors. ItSchwab also paid other online brokers to send it their trades, as well. Those payments helped many of Schwab's online competitors slash their commissions, but it added to Schwab's treasure trove of facts about how individual investors trade.
"You need a critical mass of order flows in order to have valid navigational tools," Gorman said.
Given the value of this intelligence, it is easy to see why Schwab hoards all of its trades ? a process known as internalization. Internalization is especially powerful in stocks traded on the Nasdaq Stock Market, which unlike the New York Stock Exchange NYSE does not have a central trading floor nor or a designated central dealer (otherwise known as a specialist) through which all trades must be funneled. In the Nasdaq market, competing dealers fight with one another on price. As long as Schwab always matches the best price quoted among all Nasdaq market makers, it can handle its orders by itself.
Indeed, Schwab has created its own little private stock market. Anyone who wants to buy or sell the stocks offered by Schwab customers must send their trades to Schwab to get executed.
In the Schwab mini-stock market, about 25 percent of the time Schwab simply matches customers, pairing someone who wants to buy Intel at $50 with someone who wants to sell Intel at $50. In other transactions, it buys the stock for its own account and then sells it a bit higher. The difference is known as the spread. Spreads used to produce hefty profits for dealers, but competition and regulatory changes have pushed the spreads way down.
Many dealers, including Schwab, now make much of their profits "by increasing their risk quotient," Gorman said. Dealers make money by buying and selling stocks during prices swings. This requires significant market intelligence for traders to understand when the jumps and dips will come, market information that internalization has given Schwab. Thus, volatile markets can be extremely profitable for good traders but poison for those not plugged in.
Although the hoarding of trades has helped Schwab create a thriving trading operation, it has infuriated the large institutional investors. Schwab and another dealer which that internalizes orders, Knight/Trimark Group Inc., make up about 30 percent of the Nasdaq market.
"Some 40 to 50 percent of some major market retail orders are being traded and internalized, which means we can't interact with those orders that are being handled by Schwab or Knight/Trimark or others who pay for order flow," said Harold S. Bradley, a senior executive at American Century, a Kansas City, Mo., mutual fund group.
Institutional traders say other innovative newcomers, such as electronic communications networks, or ECNs ? which are computerized trading platforms ? are also splintering the stock markets. Significant numbers of trades are moving onto these electronic platforms, which are cheaper and more transparent.
The fragmenting of the stock markets into separate fiefdoms "has made my job a lot harder," Lisa Hansen, chief trader for Transamerica Premier Funds, said after a frantic trading session. "If Schwab is a buyer of stock I want to sell and I'm working with Merrill Lynch, I won't have access to that volume."
These days, Hansen said, she has to check several sites if she wants to sell off, say, 100,000 shares of Amazon.com, especially since the surge in retail investors means that the size of trades is much smaller.
"If I have to do 100 shares at a time, I will, but it's not a real effective use of people's time," she said. "You have to spend a lot of time going to a lot of different places, ECNs and other alternative markets. .?.?. The problem has increased dramatically in the last six to eight months."
The problem is compounded by the fact that the ties between large brokerages and institutional investors are not quite as tight as they used to be were just a few years ago. Brokerage firms are "reducing the amount of capital they are willing to commit" for purchases from institutional customers, said Henry Hermann, chief investment officer of Waddell & Reed, a mutual fund company in Overland Park, Kan.
"In the past, if I went to my broker and said I want to trade today," the broker was willing to use his firm's money to buy the stocks and then sell it off over a number of days. The trader knew that the spreads were wide enough that he could make a decent profit, he said.
"Now, spreads are so narrow and markets are so volatile. If I want to sell today, my broker just marks down the price of the stock until it is so depressed that a buyer is found," Hermann said. And that, he said, is contributing to even more volatility.
"The question is: What does the future hold if the markets continue to fragment?" asked Anthony Leitner, managing director of Goldman Sachs Group Inc. His fear is that buyers and sellers will have a tough time finding one another each other if they are cordoned off into increasingly isolated markets, making markets more volatile, a fear voiced by many larger institutions on Wall Street.
The Securities and Exchange Commission shares these concerns and has solicited comments before it decides whether to intervene. Goldman Sachs and other large institutional brokers and investors have been pushing the government to link markets so that, for instance, a Goldman Sachs customer could easily interact with a Schwab customer.
This would be considered a radical move, because it would force Schwab and the others, in essence, to open their books and give up the exclusive knowledge of what trades their clients want to make.
Indeed, Federal Reserve Chairman Alan Greenspan last week cautioned against too much government intervention to stop fragmentation. "Although fragmentation has some undesirable consequences, it is an inevitable part of the competitive process," he said in congressional testimony.
"Fragmentation signals the value that investors place on the services and functions offered by competing trading systems. In the long run, activity will migrate to the system that best meets the needs of investors, absent impediments to competition," Greenspan said.
Gorman said brokers that want to attract institutional investors will have to come up with new technology to help traders like such as Hansen track down the best prices at the desired volume more easily.
Schwab recently spent $488 million to buy CyberCorp, which has sophisticated technology that routes trades to the best markets. Schwab hopes to attract institutional investors with this technology, which Gorman insists is superior to anything a government committee could develop. Of course, to use that technology, investors must be customers of Schwab.
With little prospect that the government will impose links to curtail fragmentation, Gorman predicted that many major brokerages will soon mimic Schwab by setting up their own mini-stock markets. "I will promise you that most of them will be internalizing their trades before the end of the year," he said.
Executives of some brokerages privately agree, especially since rules expected to take effect this year will make it easier to trade stocks of companies listed on the NYSE off the floor of the exchange.
In an attempt to cope with the multiple pressures caused by increased competition, even the NYSE appears ready to join the fragmentation movement. It recently asked regulators for permission to blow up the bridges that link it to other markets and to pull out of the system through which it cooperates with other exchanges in the distribution of stock price quotes.
"Rules have changed," Gorman said.
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