Big Board Looks for a Way to Trade
Nasdaq Stocks, Likely Electronically
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
The gloves are coming off.
The New York Stock Exchange, the world's biggest and most prestigious market for stocks, has watched as the hottest technology stocks -- Microsoft, Intel, Dell and Cisco, among others -- have led the bull market upward from their perch on the Nasdaq Stock Market. In recent months, the Big Board has looked on from the sidelines as dozens of red-hot Internet start-ups listed their shares with Nasdaq. To add insult to injury, the rapidly growing community of online brokers has been sending many of its trades of Big Board stocks to Nasdaq dealers or regional stock exchanges.
The Big Board doesn't want to take it anymore. In a development that could potentially shake up the U.S. securities market, the exchange is exploring ways to invade Nasdaq's home turf and trade its rival's biggest stocks under the New York Stock Exchange rubric, according to people familiar with its plans.
The plans are preliminary, and the exchange may ultimately choose to do nothing. But if it proceeds, there are at least three possible routes: Build its own electronic trading network, buy or ally with an existing network such as Reuters Group PLC's Instinet Corp., or arrive at some sort of joint venture with Nasdaq itself.
Big Changes
Top exchange officials, including Chairman Richard Grasso, have had exploratory conversations with several of the so-called electronic communications networks, or ECNs, since last year. Among the ECNs contacted are Instinet, the market leader; Bloomberg LP's TradeBook; and Brass Utility LLC, nicknamed Brut, a venture in which several major Wall Street firms are partners.
ECNs arose to meet a demand from institutional investors to trade outside the usual operating hours of the Big Board and Nasdaq, and to do so anonymously to avoid tipping off other traders. In their most basic form, they serve simply as conduits to match a buyer and a seller willing to do business at a particular price. Since they aren't affiliated with any particular market, they can accept orders to buy or sell any stock, no matter where it is listed.
People following the Big Board's plans emphasize that it has examined numerous possible partners and options as part of its strategic planning since last year and has not decided which, if any, of the options to pursue. Furthermore, the Big Board is unlikely to proceed if it concludes it cannot gain a significant share of Nasdaq volume.
But whatever the outcome of the exchange's strategizing, the mere fact that it is considering such extraordinary moves is testament to the magnitude of changes sweeping through global financial markets. Technology is giving the smallest investor the trading tools and market access traditionally reserved for big institutions. Demand is growing to trade stocks in any venue and time zone, regardless of the market on which they are listed.
Under Strain
Nasdaq's dealer system is under strain from eroding profitability, extreme volatility in new stocks and regulatory change. The Big Board itself faces incipient threats from online brokers that don't do business on the New York exchange and from ECNs its own member firms are setting up. The pace and scope of change have reached the point where bold moves may be the only ones that will make any difference.
The implications of a Big Board alliance with or ownership of an ECN are far-reaching. Investors large and small would be able to trade the hottest tech stocks under the Big Board's respected regulatory umbrella. A Big Board electronic network would have both powerful brand-name appeal and the backing of the exchange's enormous technological infrastructure, which now funnels orders from around the country to the stock-exchange floor.
The New York exchange could pose such a competitive threat to Nasdaq that some speculate that the two might eventually seek a way to join their operations. That would be a move the securities powerhouses of Wall Street would applaud, though not government regulators, who would doubtless fear reduced competition.
Exploratory Talks
People familiar with the discussions say the Big Board's Mr. Grasso and Frank Zarb, chairman and chief executive officer of Nasdaq's parent, the National Association of Securities Dealers, have discussed how they might share some operations. Those discussions are purely exploratory, these people say, and aimed chiefly at cost savings. The NASD isn't contemplating getting out of the stock-market business.
Central to the importance of the Big Board's strategy is the difference between the Nasdaq market system and the Big Board's.
Nasdaq has traditionally been a "dealer" market, in which investment dealers quote bid and ask prices at which they will trade with their customers. They try to profit from the spread between those prices.
But at the New York Stock Exchange, brokers don't buy or sell stocks from customers; instead, they simply match buyers to sellers, taking a commission for their trouble. So-called specialists do occasionally act as dealers, to maintain orderly markets in specific stocks. Because Big Board brokers usually act as agents, the New York exchange is sometimes called an agency market.
ECNs are something of a cross between the two: They are essentially agent networks that trade dealer stocks. Thus, it isn't such a big leap for the New York Stock Exchange to conclude that it, too, can trade Nasdaq stocks in an agency format.
In a sense, the Big Board would be doing what the NASD has long been able to do to it. Longstanding rules permit NASD members and regional stock exchanges to trade Big Board-listed stocks without, themselves, listing these stocks. Thanks in part to the growth of online brokers, which send most of their business to NASD dealers or regional exchanges, the NASD now accounts for about 8% of the volume and 11% of the transactions in Big Board stocks.
While the Big Board could in theory trade Nasdaq stocks, it never has, preferring to try to persuade Nasdaq's biggest, most prestigious companies to list their shares with it. It has been fairly successful in this quest, but hasn't been able to lure Nasdaq's crown jewels, led by Microsoft and Intel.
By building, buying or allying with an ECN, the New York exchange could trade Nasdaq's big tech stocks without having to list them. In effect, it would be operating two separately branded markets under one roof. Nasdaq stocks would trade on a screen-based market. But the Big Board's core business would remain: listing new companies and trading its 3,100 stocks, names like IBM and GE, in a floor-based auction format.
The Big Board probably wouldn't try to trade all of the more than 5,000 companies listed on Nasdaq, but only the 100 or so largest, most liquid stocks.
The discussions come at a time when the Nasdaq's dealer-based model is under pressure from numerous sources. Customers and some member firms have pushed the exchange to become more like the Big Board. ECNs are eating into its market share from outside.
The ECNs take about 20% of Nasdaq's volume, even as Nasdaq itself is adopting new systems, including one called OptiMark, that would enable individual and institutional customers to trade directly and anonymously with each other outside the Nasdaq dealer system. (Dow Jones & Co., publisher of The Wall Street Journal and Interactive Journal, owns 8% of OptiMark's developer, OptiMark Technologies Inc.)
Narrowed Spreads
An important impetus comes from Nasdaq dealers, who have seen their profits eroded in recent years by the narrowing of minimum bid-offer spreads to one-sixteenth from one-eighth of a dollar; the introduction of new order-handling rules; and increased volatility. An informal survey by the Security Traders Association last October found that 70% of traders thought Nasdaq should move toward commission-type "agency" trading.
Given that the largest brokerage firms are both Nasdaq and Big Board members, they wouldn't lose an order by switching it from a Nasdaq desk to a Big Board-allied electronic network. Indeed, the biggest Wall Street firms routinely send many of their Nasdaq orders to an existing ECN, rather than execute them themselves.
When the NASD bought the American Stock Exchange last year, it said it could offer companies the best of both worlds: either a dealer market or the Amex's auction market. But while Amex's options business has been booming, its stock business has yet to see big benefits from the merger. Indeed just Thursday, its most important listed company, Viacom Inc., announced it was moving to the Big Board in April.
The Big Board also faces competitive pressures. The explosion in online trading has begun to eat into its share of trading in its own stocks, such as America Online Inc. Its overall share of transactions has averaged 72.3% since November, compared with 74.4% in 1997. (The New York exchange still trades 83% of the actual shares that change hands, thanks to its dominance of trades of 10,000 shares or more, called block trades.)
ECNs have taken some of that share. Indeed, Instinet dominates trading of Big Board stocks outside of market hours. Furthermore, some of the Big Board's biggest member firms are financing competing systems, such as Brut, Strike and OptiMark, which started operating on the Pacific Exchange a month ago.
Floor-Based System
But setting up its own screen-based network to trade Nasdaq stocks would carry risks for the New York exchange. It would in effect be conceding that there is a viable alternative to its centuries-old floor-based system.
Still, the Big Board's commitment to the floor-based system for its primary business appears unwavering. While the exchange has invested vast sums in technology in the last decade to make the delivery, processing and reporting of orders as fast and efficient as possible, a specialist on the floor must still execute every order to ensure that everyone gets the best price possible.
In its tentative plans to extend trading hours to as early as 5 a.m. and as late as midnight, the exchange has promised that it wouldn't adopt screen-based trading for its stocks. "In doing that, we cannibalize what makes us different from all other markets," Mr. Grasso told a conference on Tuesday.
Should the Big Board decide against building, buying or allying with an electronic network, it may look at some kind of joint agreement with Nasdaq itself. Member firms would be likely to support such a move, much as they have supported consolidation among other marketplaces, including NASD's purchase of the Amex.
"At the highest levels of these firms, you'd rather have one regulator, one exchange, one marketplace," says an executive familiar with the discussions. "You don't have to support two separate infrastructures."
Mr. Zarb, chairman of the NASD, has spoken out in favor of consolidating some regulatory functions of the NASD and the Big Board. "The NASD and the industry as a whole need to take a fresh look at ways we might better coordinate regulatory responsibilities to avoid duplication and save on ... costs," he said in a speech in November.
In recent months, the NASD and the New York exchange have discussed the concept of having just one major stock market in the U.S., but many hurdles remain and the talks haven't progressed enough to say how this might work, people familiar with the situation say.
The barriers to the country's two biggest stock markets drawing closer are formidable. This would almost certainly raise objections from the Securities and Exchange Commission and the Department of Justice over the concentration of so much of the securities business in one marketplace.
--Aaron Lucchetti and Rebecca Buckman contributed to this article. |
