FEATURE-Going is tough for dealers in new trading world
biz.yahoo.com
By Mark Weinraub
NEW YORK, Jan 29 (Reuters) - U.S. share dealers are scrambling for ways to make money on stock trades.
New trading products, the shift to listing stocks in pennies rather than fractions, cutthroat competition among the newer alternative systems, a prolonged market slump and chilled investor enthusiasm are causing headaches throughout the trading community.
``A lot of these firms ... can ultimately only play the cards they are dealt,'' said Greg Smith, senior research analyst at J.P. Morgan. ``I think market conditions are still generally dismal. Customer activity levels are down on a year-over-year basis. There's only so much they can do with that.''
Traditional Nasdaq share dealers, known as market makers, face the biggest challenges. Knight Trading Group Inc. (NasdaqNM:NITE - news), which recently reported a 62 percent drop in quarterly earnings, is coping with a double whammy of decimalization and the onslaught of alternative systems.
But alternative systems like electronic communications networks (ECNs) Instinet Group Inc. (NasdaqNM:INET - news), The Island ECN, Archipelago and RediBook also face problems as they try to distinguish themselves and win stock orders.
Firms that offer unique ways to trade have had the most success. Investment Technology Group Inc. (NYSE:ITG - news), which lets traders move large blocks of stocks anonymously through its Posit share matching system, recently reported fourth-quarter profits that rose 57 percent.
MARKET MAKERS STRUGGLING
Market makers are looking for a way to fill stock orders for customers while still producing profits, said Scott Appleby, president of Appleby Capital.
``Right now, while they have great execution they can't make any money off of it,'' Appleby said.
Trading stocks in pennies rather than fractions forced Knight to overhaul its trading strategies, which had produced bumper profits for the firm during the bull run of the late 1990s.
``Our trading systems are no longer rule-based but reflect the diversity of individual stocks and situations,'' outgoing Chief Executive Kenneth Pasternak recently told analysts on a conference call. ``We are successfully moving from a one-sized fits all approach to a new dynamic approach.''
In other words, trading has gotten more expensive for dealers like Knight because it is now different for every stock. The firm, which acts as a middleman for many of the retail stock brokerages, also has changed the way it charges some of its customers.
Nasdaq share dealers used to make money by pocketing trading spreads, or the difference between what a buyer and seller are asking for a stock. But since the shift to decimals, which the U.S. Securities and Exchange Commission pushed for in bid to cut investor costs, spreads have narrowed by an average of more than 50 percent. Knight and other market makers are experimenting with charging commissions for the trades they carry out.
These new commissions could eventually lead to higher prices for consumers if brokers who send orders to these dealers feel it is necessary to pass these costs along to their customers. But the reduction in spreads is supposed to give consumers better prices for stocks, although some market watchers say this benefit is negated by increased volatility in the market.
SPECIALISTS COPE WITH DOWN MARKET
Share dealers on the New York Stock Exchange, called specialists, also are facing lagging profits. Specialists, who manage the buying and selling of stock on the Big Board's floor, do not pocket trading spreads but sometimes have to make unprofitable trades in order to ensure there is a market for the stock.
Since the shift to decimals, specialists have been forced to step in more frequently because the increased pricing points -- 100 between each dollar rather than 16 -- often lead to stock orders being spread out over a greater price range.
``The specialist is needed more often because the orders are thinner,'' said Michael LaBranche, chief executive of LaBranche & Co. Inc. (NYSE:LAB - news), the largest specialist firm. ``The role of the specialist has actually gotten a lot more important.''
The lagging market has also cut into the profits of specialists, who make their money by trading for their own accounts with their own shares. LaBranche's fourth-quarter profit fell nearly 20 percent.
Specialists also have lost a bit of an edge with the introduction of NYSE OpenBook, a product which displays certain stock orders to traders who are not on the floor of the Big Board. Previously, only specialists were privy to these orders.
ECN COMPETITION HEATS UP
But the problems with trading are not limited to the older, established share dealers.
New York-based Instinet, which operates a major alternative trading system, recently announced it laid off 150 employees -- its second round of job cuts -- in a bid to trim costs in a highly competitive environment. Instinet is majority-owned by Reuters Group Plc (quote from Yahoo! UK & Ireland: RTR.L) (NasdaqNM:RTRSY - news),
Instinet recently lost its title as the top dealer of Nasdaq stocks to rival Island, according to data provided by the Securities Dealers. Instinet also faces increased competition from a planned merger of competitors Archipelago and RediBook, a deal analysts say should enable the two firms to cut costs.
Island recently reported its Nasdaq trading volume surpassed Instinet's for the first time ever in November, a feat it repeated in December when it handled about 10.1 percent of Nasdaq's share volume, compared to Instinet's 9.2 percent share, according to data provided by the National Association of Securities Dealers.
ECNs handle about one-third of the daily volume on Nasdaq, which accounts for the majority of their business of electronically connecting buy and sell orders.
About two years ago, many market participants were calling ECNs the wave of the future. Goldman Sachs Group Inc. (NYSE:GS - news) Chief Executive Henry Paulson went so far as to call for the creation of a centralized electronic stock market, essentially a giant ECN. But then traditional dealers came back into vogue as many institutional traders expressed reservations about posting large orders on ECNs, where everyone could see them.
ECNs do not provide the same services that traditional share dealers do. Many market makers guarantee to fill orders up to a certain size, even if it means risking their own capital.
``We can't kill off market makers,'' Appleby said ``We really do need the liquidity.'' |
