Fixing the odds in NYSE's casino economy
By John Dizard
Financial Times; Nov 17, 2003
Among the qualities John Reed brings to his job as temporary chairman of the New York Stock Exchange is a lack of venality. He's there to do the right thing and receive nearly nonexistent compensation for doing it.
That is probably why he does not seem to fully understand the people around him at the exchange. They are not, in his words, "customer-focused", and they want to be overpaid for performing an inefficient service.
They are like the Joe Pesci character in Casino, who tells the more restrained Robert de Niro character, "We're in Vegas . . . We're supposed to be robbing people!"
Mr Reed, in contrast, has brought the template issued in business school: if you can measure it, you can control it.
Much of the time, out there in America among the honest businesses, that is a good plan. The problem comes when an honest measurement of "it" would tell you that your shareholders, in this case the members of the exchange, should fold up their tents and figure out a new way to earn a living.
The NYSE will not disappear but, in a couple of years, it will turn into a bunch of servers in a windowless room, which may or may not be in New York City. The less ambitious members will get modest cheques mailed to them down in Boca Raton in return for the remaining brand value of the old franchise. The more ambitious ones will become proprietary traders in competition with the quantitative hedge funds. They will still be able to make money but, unlike their present deal, they will also be able to lose money.
From my conversations with various members, after hours and off the record, they know that. They just want to get what they can out of an inefficient system while the getting is good.
While the Grasso pay scandal led to many dead trees and exhausted electrons, the real reason for the NYSE's humbling is the greater sophistication of the institutional traders. Much of the Exchange's volume these days comes from index arbitrageurs, hedge funds, and other computer and math-literate professionals. They have a much better grasp of the real costs of the NYSE than did the retail customers, sleepy insurance managers and pension plan sponsors whose business used to dominate the floor.
They are particularly annoyed with the "trade through" rule, which is notionally intended by the SEC to give a customer of an automated exchange the opportunity to get a better price from a NYSE specialist.
In action, the trade through rule simply gives the NYSE specialist the opportunity to get a free option from the customer. A non-automated exchange, such as the NYSE, can post an artificially attractive, or out of date, quote to buy or sell a stock, relative to the prices posted by automated exchanges. The firm commitment to buy or sell held by the automated exchange must then be routed to the NYSE, to give the NYSE specialist the chance to execute the order. The NYSE specialist can hold this free option to buy or sell for 30 seconds to two minutes, a long time in a fast-moving market.
One of the trade through rule's public critics is Thomas Peterffy, a mathematician who is the founder and principal shareholder in Interactive-brokers, an online brokerage firm, and Timber Hill, a large securities, futures, and options market maker.
He has chosen not to buy an NYSE seat. "By virtue of the fact that their quotes are updated faster, the automatic execution market may often seem to be 'trading through' [showing disadvantageous prices] when in fact that other market is in the process of updating its quotes," Mr Peterffy says.
Not only are the ultimate customers forced to grant free options to buy or sell to the NYSE but they cannot necessarily get instant execution if that is what they want. As Mr Peterffy says, "The regulatory structure thus continues to reward the traditional exchanges for not being fully automated."
The trade through rule is not the only game played on the NYSE. The fundamental advantage for the members is that human intervention in the order handling and execution process inevitably creates an enormous number of small periods during which the members have an advantage in information and freedom to take action. There are rules governing this process, of course, rules that outsiders can never understand. The fines levied somewhat arbitrarily for the violation of these rules are really just shakedown money paid to the Exchange's managers for offering protection against competition.
The problem for John Reed's successor is that too many people are on to the game and there are too many better ways to trade equities. Increasingly, customers can measure execution, and they intend to control it in the future.
Mr Reed has said that "the most important issue is to reduce short-term volatility in the market". Even with an arm's-length, fully automated system regulated by public agencies rather than by themselves, NYSE members can help reduce volatility. They can quickly buy on dips and sell on pops. If the price trend line mean reverts the way they believe it will, they can make money. If it does not, they will lose.
Good luck in your new jobs, guys. |
