Hybrid Markets: A Migration to the Screen
By Ivy Schmerken
January 05,2005
With market regulation in flux, all eyes are on the New York Stock Exchange as it awaits approval from the U.S. Securities and Exchange Commission for its hybrid-market proposal. This proposal is a bold plan to overhaul the NYSE's traditional floor-based auction-model with a turbo-charged automated trading system.
The NYSE's hybrid plan is designed to blend the strengths of its traditional auction model with the speed of electronic trading by preserving a role for specialists and floor brokers to interact with the electronic platform. "What we're looking to do is blend the best aspects of the electronic platform and the auction platform in a way that broadens choices for customers through immediate access to NYSE liquidity," says Robert McSweeney, senior vice president for competitive position at the exchange.
At the same time, customers will have the opportunity for price improvement and the opportunity to have their large orders represented at the point-of-sale with an agent, underscores McSweeney.
But market observers say the NYSE is going hybrid mainly because of Reg NMS - a proposal for reforming the national market system that pushes floor-based exchanges to operate electronically or risk having their quotes ignored by electronic markets that offer immediate execution.
Even though large institutional players like Fidelity Investments have been calling for reform for years, Jodi Burns, a senior analyst at Celent Communications, says the NYSE's hybrid move is a response to Reg NMS. "If they did nothing and Reg NMS went through, and people could ignore their prices, I would see their market share dropping from 80 percent to 40 percent," says Burns. She sees the hybrid system as something that the NYSE needs to stay alive in the new world created by the SEC-imposed change.
But with the SEC publishing a new version of Reg NMS in December and putting it out for public comment until January, the NYSE could be forced to reshape its plan. The NYSE declined to comment for this article on what course of action it would take in response to the SEC's latest Reg NMS proposal.
Where Others Have Gone Before
The NYSE is not the first U.S. exchange to go hybrid. The NYSE plans to go hybrid and expand its ECN-like automated execution system Direct+ to execute trades of more than 1,099 shares, the system's former maximum. This could invite comparisons to the U.S.' largest futures exchange, the Chicago Mercantile Exchange, a pioneer in automated trading since 1992, when it launched Globex.
When NYSE CEO John Thain visited the Chicago Mercantile Exchange in November, rumors swirled that the NYSE was possibly seeking closer ties to the CME. Shares of the CME's parent company, Chicago Mercantile Exchange Holdings - which are listed on the NYSE - rose to a 52-week high of $204.50. Thain reportedly asked the CME what steps it had taken to support electronic trading.
"I think we've become kind of the model for how to do this successfully," says Craig Donohue, the CME's CEO, noting that the exchange's volume in November was 70 percent electronic, up from 50 percent in January. Though some industry sources say the CME has been running side-by-side markets because Globex doesn't interact with the open outcry floor, Donohue refutes that contention, insisting there is a tight interaction between the financial products that trade electronically and on the floor.
"Every one of our products trades electronically, and they trade at the same time - in effect we're competing with ourselves," says the CME's CEO. The CME has equipped the traders on the floor with the ability to trade on Globex workstations and handheld trading devices that interface with Globex as well as with telephonic head sets. "What this allows market makers to do is trade between both platforms - the open outcry and Globex," Donohue says. Floor traders arbitrage price differences between the screen and the floor, which keeps the two markets in line and creates price convergence so that it becomes a single market, he explains.
Options Exchanges Chase the ISE
Meanwhile, virtually every options exchange is rolling out a hybrid trading platform. Facing fierce competition from multiple listings - mandated by the SEC in 1999 - and facing payment for order-flow practices, the Chicago Board Options Exchange (CBOE), the Philadelphia Stock Exchange and the Pacific Stock Exchange (PCX), as well as the American Stock Exchange, are either adopting or are planning to put in place hybrid floor and screen-based trading models to compete with the International Securities Exchange (ISE).
"We have not given up open-outcry negotiation or liquidity found in open outcry for a screen-based trading platform," says Ed Tilley, vice chairman at the CBOE, which began rolling out CBOE Hybrid in June 2003. "Each plays off of one another because they are basically one net market," says Tilley. That's the key to a hybrid system. "There's only one place to get executed," adds Tilley, who contrasts this with a side-by-side market, in which the electronic market and the floor are separate markets that do not interact.
The CBOE remains the largest options exchange in the U.S., though its market share has been declining since the ISE burst onto the options scene in 2000. CBOE market share fell from 62 percent in 1990 to 31 percent in 2003, according to a report on equity/index options by Raymond James.
Market participants note that, after losing market share to the ISE in 2003, the CBOE recaptured market share in June, suggesting that the hybrid market is working. According to 2004 figures from the Options Clearing Corporation, in November, CBOE had a 25.02 percent market share, versus the ISE's 33.56 percent market share. Amex had a 16.65 percent market share; PHLX controlled 11.30 percent of the market; PCX captured 10.07 percent; and the Boston Options Exchange (BOX) registered 3.40 percent.
When equity index options are included together with the volume from equity options on single stocks, the CBOE's market share rises to 31.65 percent in June, versus the ISE's 30.48 percent market share. But in November, the CBOE fell back slightly to 30.95 percent, while the ISE captured 31.63 percent of the market.
To compete against the ISE - which is reportedly on track to earn $60 million in pre-tax revenue while awaiting an IPO that could pull in $750 million - "The CBOE has been making a concerted effort to halt its share decline by introducing new technology," writes Michael Vinciquerra, an analyst with Raymond James, in a report on equity/index options in May. "The CBOE came up with its hybrid systems, and that is to allow auto-execution for any options classes that are listed on Hybrid," says the report. In November, about 1,100 of the CBOE's 1,400 options classes were listed on the CBOE's hybrid system.
CBOE's new technology platform, CBOEdirect Hybrid Trading System (HyTS), allows in-crowd market makers, the specialist and, more recently, a new class of participant, remote market makers, to input real-time, streaming quotes into CBOE's trade engine. The trade engine takes the quotes in and publishes the best bid and offer, which it disseminates to the Options Price Reporting Authority (OPRA).
The CBOE's Tilley says streaming quotes have resulted in higher volumes and tighter bid/asked spreads. "We have now become the NBBO (national best bid or offer) more than any other exchange. From a customer-experience standpoint, we are the NBBO. You don't have to go to other places to find the best bid and the best offer," the CBOE vice chairman claims, though the ISE was the first exchange to offer streaming quotes, and all of the other options exchanges are now following suit.
In It for the Long Haul?
Yet Tilley is reluctant to predict whether or not electronic trading is the future. He says that when customers - firms, broker-dealers or remote market makers - route an order electronically to the options exchange, they can access the electronic portion of the exchange's hybrid market for immediate execution on CBOE Direct, the exchange's trading engine. Or, the customer can choose to hire a broker, who sees the market on the screen, to walk in the crowd and negotiate on its behalf, perhaps for more liquidity or a better price, says Tilley. "That's up to the user, not up to CBOE," he notes.
However, a spokesman for the Pacific Stock Exchange, which is migrating all of its options trading activity from the incumbent system POETS to the hybrid PCX Plus, says the P-coast floor has already shrunk and expects it will shrink some more as volume gravitates to the screen. "We have said that, so long as there are people who want to access the market by standing on a traditional trading floor, we will provide a facility like that," says Dale Carlson, vice president, corporate affairs, Pacific Stock Exchange. "Our expectation is that, probably at the end of the decade, there probably isn't going to be an exchange in the country that is operating a traditional trading floor," says Carlson.
The screen does offer benefits over floor-based trading, notes the CME's Donohue, including the immediacy of execution, the fact that orders are less susceptible to errors and the greater degree of anonymity. Another advantage is that an exchange can trade its products 24/7 and distribute orders across the globe, adds Donohue, who notes that the CME's products are traded in Asia while Chicago is asleep. That said, the main drawback in an anonymous trading environment is that firms lose the color they pick up on the floor, he adds.
Even though most European and Asian exchanges have moved, or are aggressively moving, to fully electronic markets, the debate over open-outcry versus floor-based trading is still raging in the U.S. "If we were to have a true hybrid market in the future of the U.S., it would be a rather unique American phenomenon," says Bill Cline, partner at Accenture, which has built many of the electronic markets overseas, including Eurex, the Swiss-German futures exchange. Accenture recently won a mandate to help the Shanghai Stock Exchange, China's largest stock exchange, build a new electronic trading system by adapting the Deutsche Borse's Xetra trading system to the Chinese market.
Some market participants eyeing the hybrid-markets trend say it's a transitional phase in an attempt to protect vested interests and retain market share. Chris Nagy, director of trading at Ameritrade in Omaha, Neb., says that hybrid markets are an evolutionary step to become much more electronic and to keep up with competitive forces.
"If you look back at the Merc and the CBOE and the NYSE, these are traditional trading floors. All those constituents have conducted business in sheltered and exclusive environments. As you find the technology hurtling forward, these exchanges are increasingly finding themselves in difficult roles to continue to pacify that historic membership structure," he says. Nagy says the hybrid plan is essentially a pacifier for the old-line regimes. "Lets face it, if CBOE were the only options exchange in this country, would there be a hybrid plan?" he asks. Competition is really the driver of technology, he contends.
This raises the question of whether hybrid markets are here to stay or whether they are an interim step being adopted to protect the interests of floor-based market makers and specialists from the inevitable migration to full-blown electronic trading.
McSweeney says the NYSE's hybrid plan is not a transitional phase. "Just the opposite," he says. "It is designed to preserve choice in a way that allows the customer to access liquidity through multiple paths and include both electronic trading and the ability to leverage the judgment and expertise of an agent at the point of sale," McSweeney explains. "I personally don't anticipate that this is a bridge to an all-electronic marketplace," he says.
"What we anticipate is that customers will choose, depending on the characteristics of the stock and the characteristics of the order, to migrate between the auction and the electronic platform," McSweeney continues. To make sure that liquidity can be accessed through multiple execution paths, the NYSE is developing additional technology and software applications so that agency floor brokers and specialists can function concurrently in the auction and in the electronic platform, he adds.
Specialists in turn will use algorithms to generate quotes and inject stabilizing capital to dampen volatility. They will represent their own interests and bring buyers and sellers together in the auction, while trades are occurring in the electronic platform.
NYSE's Hybrid Plan: the Pros and Cons
But several market participants familiar with the NYSE's hybrid plan say they have concerns over the human involvement of the specialists and how they will interact with the automated market. "I still feel that the updating of quotes is being controlled by the specialists. That's a fundamental flaw," says Andrew Fishman, president of Schoenfeld Group, a professional trading firm that backs short-term and long-term traders. "You're not going to have the automatic execution if the specialist can step in and referee or change the quotes," he says.
Overall, Fishman, who values speed and certainty of execution since he backs short-term traders, says the NYSE hybrid plan is positive because it's clearly a step away from what has been a human-controlled marketplace. Still, he notes, the plan has some fundamental flaws.
Some customers object to the Liquidity Replenishment Points (LRPs) - pauses that would stop electronic execution for a certain number of seconds so that the specialist could allow auction liquidity to dampen volatility. "I think it basically is set up to slow the stock down," says Steve Swanson, president and CEO of Automated Trading Desk.
When there is a liquid name, Swanson doesn't see the value in slowing the stock down. "I'm more of a free-market person - let the stock move. Let it go to whatever natural point it's going to settle at," explains Swanson, who questions the value human intervention brings to the model when liquid stocks like General Electric are being traded. "If you look at GE, I don't see what value a human trader is adding to a stock that is so liquid with so much volume," says the trader.
But, Swanson says with an illiquid stock with wide spreads and low volume, there is value in human intervention, because the specialist may slow the stock down and find liquidity for the order at the same time. Today, specialists make most of their money in liquid stocks like GE because there is so much more volume and trading opportunities.
But Swanson says he doesn't think that's what the NYSE's hybrid market is about. "I think they're trying to preserve market share and take small steps toward the electronic market," he says, adding that it's difficult and a conflict to manage the move toward electronic trading while preserving the human element on the floor.
Celent's Burns says that the NYSE is trying to balance two things with its hybrid plan. On one hand, it wants to move toward electronic trading. But, when trading happens in a faster market, volatility tends to go up. "In the New York world, where the specialist is involved in almost every single transaction, he can smooth out the edges," she says.
On the other hand, as the NYSE gets more comfortable with faster trading and finds that there is more than enough liquidity, it may get rid of the circuit breakers. "I see this as a temporary thing, and it's part of getting comfortable with electronic trading," Burns relates.
Natural Migration?
While market participants are uncertain about how the NYSE's hybrid market will work - because the outcome could depend on what form Reg NMS takes - their expectation is that more volume will eventually flow to the screen. Automated Trading Desk's Swanson predicts that more volume in liquid stocks will migrate to ECNs and Nasdaq.
"You will see ECNs and Nasdaq take market share away in liquid names," like GE and IBM, he predicts. Swanson also thinks the trade-through rule that the SEC is proposing will level the playing field and create more competition, since the NYSE will be violating an SEC rule if it were to trade through an ECN. It will also give incentive for firms to place orders on ECNs. "I would expect the ECNs and Nasdaq are winners in that respect," he says. "Today, the NYSE controls 80 percent of the volume - does that mean they go to 70 or 50 percent? I don't know," he says.
Though no one can predict the future, market participants who have experience transitioning floor-based exchanges to hybrid markets or all-electronic markets say that liquidity and price discovery usually do flow to the screen. "It's a natural migration," says Jim Johanik, senior vice president of U.S. technology strategy for Euronext Liffe, an electronic competitor to the CME.
Johanik, who formerly worked at the CME, saw this first-hand during the evolution of the e-mini contract - a retail-oriented contract based on the S&P 500 futures contract that traded exclusively on Globex. "When the e-mini was trading, it pulled the liquidity away from the floor and onto the screen," he says.
Even though the e-mini contract was one-fifth the size of the floor contract - which meant someone had to trade five lots to get the equivalent of the floor contract - despite the cost barrier, liquidity still moved to the screen as the global trading community realized the immediacy of the electronic trading system, Johanik notes.
In March, EuronextLiffe - which is owned by Euronext, the French and Dutch derivatives market that purchased Liffe in 2002 - launched a competitive Eurodollar futures contract on the Euronext LiffeConnect platform to the CME's flagship Eurodollar contract, which was trading both on the screen and on the floor. At that time, the CME was only trading 6 percent of the eurodollar volume on the screen, before the floor opened up, says a source. After EuronextLiffe launched its contract, liquidity in the CME's flagship Eurodollar contract moved to the screen, transaction fees decreased dramatically because it was no longer necessary to pay an intermediary when the contract trades electronically, and it became a more efficient market for the customers, says a source close to Euronext Liffe.
According to the CME's Donohue, the transition from hybrid market to the screen is accelerating. In stock index futures, it took seven years to become 95 percent electronic; in foreign exchange it took three years, and in eurodollars it took 12 months to become 75 percent electronic. "We've gotten better at it," he says, adding, "We've been able to shorten the time frames at shortening the hybrid model."
A competitive threat can also be a catalyst in causing an established market to close its floor and rapidly migrate to the screen. European markets like Matif and Euronext/Liffe had a cataclysmic forced migration from floor to screen, says Donohue.
In 1998, Liffe, the London derivatives market, closed its floor in eight months in response to a competitive threat from Eurex, which captured the volume in the German Bund - the government bond futures contract - away from Liffe, which previously had the lion's share of the volume. "It was the catalyst that caused us to become an electronic market, as a result of almost losing an entire franchise to an electronic market," says Johanik.
But the benefits of screen-based trading may be difficult to ignore, especially lower costs. "Electronic systems are just more efficient than trading floors, which are enormously expensive to build, maintain, to operate and to regulate," says the PCX's Carlson. "You can take the rules of the market and hard code them into the system so that the electronic systems will not let you break the rules," continues Carlson, who notes that that can save huge sums of money. Not being tied to a physical location is also an advantage. "After 9/11, the NYSE was closed, though it had no damage. It had water and power, but nobody could get there," says Carlson. Because it takes thousands of people to populate the floor, it had to shut down.
But in an electronic world, with multiple data centers, people can access the market through a backup data center, he points out.
At the end of the day, these hybrid market structures have to serve investors, says Accenture's Cline. That is what the debate is all about - whether it's worth having all of these sorts of features of a hybrid market to assure investors of best execution. "There has to be a differentiated value proposition, because maintaining the floor element of a hybrid market is a big expense," he says. "That expense has to be embedded in the total cost of trading." |
