Analysis: Is the NYSE a gravy train?
By Martin Hutchinson
UPI Business and Economics Editor
Published 10/8/2003 5:01 PM
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WASHINGTON, Oct. 8 (UPI) -- In the wake of the scandal over its former chairman Dick Grasso's $139 million payoff, it has been assumed in many quarters that New York Stock Exchange membership must be a gravy train of such grandeur that $139 million simply became a rounding error. Tuesday, the American Enterprise Institute held a seminar to discuss the profitability of NYSE specialists, and determine the reality.
The premise of the discussion was that the NYSE was a public-sanctioned monopoly, very similar to the housing finance behemoths Fannie Mae and Freddie Mac, and therefore that monopoly "rents" should be easy to extract from such a situation.
The NYSE is now the world's only major stock exchange where trading is still carried out by open outcry on a trading floor; in all other exchanges, including NASDAQ, trading is carried out electronically, through computer screens. Trading on the NYSE is carried out through specialists, each of which has a monopoly on one or more of the 2,557 stocks traded on the exchange.
Remarkably, after two decades of consolidation, there are now only 7 NYSE specialists firms, 5 of which account for over 95 percent of the NYSE trading volume. It is to these firms, therefore that any monopoly profits resulting from the NYSE's unique position must accrue.
Brian Becker, President of Precision Economics LLC, a valuation consultancy, reported to AEI that, while finding information was difficult because only one specialist was itself a publicly quoted company, he had been able to examine .the profitability of 3 of the 5 largest specialists, representing 60 percent of NYSE trading volume. Their average pretax profit as a percentage of revenues was 47.5 percent in 2002, with profits for the three firms totaling $488.8 million on revenues of $1,029.3 million.
This is among the highest profit/revenues ratio Becker has seen, higher than Microsoft's 35 percent. It compares with an average of 9.7 percent for all firms in SIC code 6211 (security brokers, dealers and flotation companies) and 14.5 percent in firms in SIC code 6282 (Investment Advice) and is higher than the average of all SIC codes classified as finance and insurance. Becker also examined five publicly traded NASDAQ dealers (of which there are currently 200 -- NASDAQ trades more shares than the NYSE, but for a lower total dollar volume) which had pretax margins in the fourth quarter of 2002 ranging from 0.5 percent to 28.4 percent. Becker did not present results for any year other than 2002, but stated that from his examination the previous few years showed a similar levels of profitability for NYSE specialist firms.
As an alternative valuation method, Becker looked at the takeovers of NYSE specialists that have occurred in the past few years, and at the percentage of their value represented by intangible compared to tangible assets. Generally, it is impossible to earn above-market returns on tangible assets, but returns on intangible assets such as intellectual property and monopoly market position are often very high indeed. According to this comparison, intangible assets on average represented 81.2 percent of the firms' acquisition value, a very high level -- putting it the other way, acquisitions were carried out on average at 532 percent of tangible book value.
Finally, Becker compared revenues per share traded for the NYSE specialists on which information was available and for Knight Trading, a major NASDAQ market maker, showing that while Knight's revenue was 0.3 cents per share traded, the specialists' revenue varied between 1.3 and 2.4 cents per share traded. While NYSE shares tend to sell at higher prices than NASDAQ shares, that does not explain such a wide discrepancy.
At first sight, therefore, being an NYSE specialist appears to be an exceptionally profitable business. There are however caveats, which need to be explored:
-- Becker did not examine the level of capital employed in the specialist business. There are a number of businesses where operating margins are very high, but so is capital employed. However, the acquisition premiums paid for specialists over their tangible net worth suggests that this is not an important factor here.
-- Even though returns are higher for NYSE specialists than for NASDAQ traders, the cost to investors of the trading system could be less. Since trading volumes are comparable, it must be more efficient to have 7 firms in the business than 200; the higher profitability could simply be a result of this efficiency.
-- Becker has examined only the last few years. While stock prices dropped in 2002, trading volumes remained remarkably high by historical standards. Specialist returns are undoubtedly more dependent on trading volumes than on the absolute movement of stock prices, and hence are likely to drop sharply in a quiet market.
-- Part of the returns earned by specialists may be remuneration to their top partners. Even though these are public companies, or subsidiaries of public companies, their senior partners may own a substantial portion of their equity, and hence receive remuneration through dividends or stock options. Neither such remuneration would pass through the operating data Becker has examined.
However, on balance it is likely that specialist profitability is indeed remarkably high, as a percentage of capital, and hence that, for the larger specialists, the NYSE is a gravy train.
The threat to the gravy train is that the SEC or some other body could determine that it was more competitive or efficient for the NYSE to cease floor trading and become a screen based market, like all other stock exchanges. This is after all what happened to the London Stock Exchange in 1986, when the "jobbers" (London's equivalent of specialists) were abolished and floor trading ended soon afterwards.
Such a threat is life and death to the specialists -- not only would their returns be reduced by a switch to screen trading, but, as London demonstrated in 1986, their skills based on decades of experience would be obsolete; they would be easy to replace by 25- year-old street kids with a fast finger on the video game joystick, or even by an "electronic communications network" trading system with minimal human involvement, such as Instinet. Accordingly if (eccentrically, in my view, in the long run) they felt that Dick Grasso, because of his media PR skills, would help them fend off the threat of NASDAQ-isation, $139 million would be cheap at the price.
Mechanistic believers in the free market, particularly those of the social democratic persuasion who take an ax to every "old boy network" but are happy to see government spending at 35 percent of gross domestic product, will claim that, if the NYSE specialists are so frightened of NASDAQ-isation, it must be a good thing for the market. However, this does not follow.
For one thing, London experience demonstrated that there was a considerable loss of intellectual capital in the abolition of floor trading. An experienced floor trader can tell from the auditory tone of the market, and from other traders' body language, which direction the market is about to move in, and can take advantage of that knowledge.
Since a high proportion of specialists' income (Becker was unable to discover how high) comes from taking positions, it is likely that a high percentage of specialists' exceptional profitability comes from this ability in their senior traders. This is "intellectual capital" in the same way as a research laboratory; it makes the market trade more smoothly, and it wholly merits being richly rewarded. In the same way, while the specialists' obligation to make a market appears to break down at times of really high stress such as the market crash of 1987 (though at that stage, specialists, then much more fragmented, may simply have been too undercapitalized to perform their function properly) the anticipatory skills of a senior trader will certainly help smooth the market in periods of normal difficulty, in a way that a screen based trading system cannot match.
It has been legal for several years now to trade NYSE stocks away from the specialist market, over an ECN. It is thus notable that 80 percent of trading volume in NYSE stocks still goes through the specialist, whereas in 2002 49 percent of NASDAQ stocks' trading volume had already been captured by the ECNs. This suggests that, whereas a human on a computer adds little trading value to the computer alone, a floor trader still has substantial advantages over the machine, with or without human assistance (the argument that the existing system gets all the order flow is self-perpetuating, and in any case applies both to the NYSE and to the traditional NASDAQ market.)
Policymakers seeking the best deal for the investor should not be too quick to sweep away the NYSE's specialist system in the name of modernization. However, like all oligarchic markets where much of the value is held in unwritten, un-codifiable form, the NYSE only works well when there is a high level of trust in the market, and where market participants act in their long term, not short term self-interest, dealing fairly with the public and exercising restraint in their attempts to reap extraordinary rewards. By and large, this restraint is achieved by selecting traders and Exchange officials from those of an established middle class or even monied background, and avoiding red-hot hustlers like the left-school-at-14 Dick Grasso.
In future, NYSE chairmen need to exercise restraint, and avoid $139 million payoffs. John Reed, at $1 a year, is doing just fine!
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