Here's ITG, but alas, No ASTN (it must not exist): "The Stock Exchanges, Long Static, Suddenly Are Roiled by Change
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
Companies newly listing their shares on the New York Stock Exchange
usually do so in a glitzy ceremony sprinkled with congratulatory remarks
and promotional trinkets. But the listing of Investment Technology Group
Inc. in April was subdued and almost awkward. "We didn't get too many
floor brokers coming up and shaking our hands," notes David Cushing,
ITG's research director. Most declined to don caps bearing its slogan.
That's because the slogan is "The future of
trading." ITG is one of the traders' biggest
competitors. It offers a system called Posit
that electronically matches stock trades for
institutions that want to bypass the exchange
floor. One day recently, Posit traded 30
million shares, equal to the combined volume
of three regional U.S. stock exchanges.
When Posit "prints" a big trade, floor brokers
have trouble explaining to an institutional client
why they weren't part of it, Mr. Cushing says.
At breakfast with ITG executives, recalls one
diner, Big Board Chairman Richard Grasso
suggested that ITG change its slogan to "The
future of Nasdaq trading."
Behind the joking, Mr. Grasso was already
pondering a radical response to the
encroachment of systems like Posit: turning the
Big Board into a for-profit company and
taking it public. Last week, Mr. Grasso said
he hoped the exchange could sell shares in
itself by Thanksgiving. Doing so would curb
the member politics that hobble responses to competitive threats, and it
would create a currency -- the exchange's own shares -- with which to
gobble up some of those electronic threats.
Historic Upheaval
There is a Wall Street siege going on: growing ranks of alternative trading
systems challenging the Big Board and Nasdaq Stock Market. Born of
deregulation and technology, the trading systems have produced the
greatest upheaval in the financial marketplace since the present structure
arose from the ashes of the Depression.
Traditional markets are big, bureaucratic and heavily regulated, and usually
have a middleman in every trade. By contrast, private systems are small,
quick to innovate, lightly regulated and free of human intermediaries. At a
swift pace, the alternative systems are driving down the cost of trading and
spurring innovations such as extended hours and lightning-fast Internet
trades. Traditional markets, their core franchises threatened, suddenly are
thinking the once-unthinkable, from going public to invading one another's
businesses to merging with the electronic systems now poaching on them.
The financial marketplace, virtually static for 25 years, may soon be
unrecognizable.
"I don't think there's ever been a period like this in the history of world
capital markets," Mr. Grasso marvels. "Everyone is in everyone else's
business today. Whether you sell stock or sell suits, the Internet has
changed the world."
A Big New ECN
That point was driven home just last week when three big online brokers
-- Charles Schwab Corp., Fidelity Investments and DLJdirect --
announced they were joining with Spear, Leeds & Kellogg LP, a big
stock-trading firm, to build a new electronic communications network, or
ECN. An ECN is a type of alternative trading system that functions much
like a stock exchange, collecting, displaying and automatically executing
customer orders.
Markets' Evolution
1792
New York Stock Exchange created
1934
Securities Exchange Act passed, SEC created
1970
DLJ is first Big Board member to go public
1971
NASD creates Nasdaq
1975
Fixed commissions abolished
1987
Reuters buys Instinet Corp.
1997
Nasdaq order-handling rules take effect; eight ECNs later register
1998
NASD buys American Stock Exchange
1999
SEC allows ECNs to become stock exchanges; NYSE, Nasdaq
propose to become for-profit
Given the volume of business done by this new ECN's owners, some
expect it to become one of the biggest venues for Nasdaq trading. It
wouldn't trade Big Board stocks, something that would compete with the
owners' other businesses. Nasdaq is in more of a competitive bind than the
New York exchange. ECNs are all regulated by Nasdaq's parent, the
National Association of Securities Dealers. But they increasingly act like
competitors of Nasdaq, which began as a network of dealers who trade
directly with investors and profit by buying and selling at different prices. In
response to the threats, the NASD hopes to spin off Nasdaq as a private,
for-profit company, with an initial public offering possible afterward. The
NASD board will consider such a proposal Thursday.
Established in '30s
"There's the enormous requirement for capital, the total globalization
question, and the need for flexibility," all of which are facilitated by a
spinoff, says NASD Chairman Frank Zarb. It would help in forming
alliances, as well as in countering Nasdaq's fragmentation into a collection
of submarkets. Mr. Zarb's previous efforts to address that fragmentation
have been stymied by the member ECNs and dealers who feared their
business would suffer.
Still, altering a structure that has served investors and the industry for
decades also carries risks, and Monday, Securities and Exchange
Commission Chairman Arthur Levitt sounded a cautionary note. In letters
to Mr. Grasso and Mr. Zarb, he warned that any restructuring of their
markets "must ensure that the self-regulatory role will continue to be
zealous, adequately funded, and imbued with the public interest."
For example, even if member firms no longer own the market, they should
still have input, to ensure that disciplinary and other processes are "fair and
equitable." Mr. Levitt added: "We may want to begin considering ... more
formally separating the self-regulatory role from the role of exchanges as
trading venues."
The pace of change is stunning for a landscape that was static for so long.
Today's market structure -- member-owned markets overseen by the SEC
-- was established in the 1930s. The next big changes came in the 1970s:
The NASD created Nasdaq, and Congress abolished fixed commissions.
Congress also mandated that all markets be linked together, keeping the
regional exchanges as viable competitors to the Big Board.
Today's swirl of change began two years ago, when in response to
criticism that Nasdaq dealers charged excessive markups, the SEC forced
dealers to start publicly displaying their customers' orders. Eight new
ECNs soon sprang up to exploit this, joining the oldest and still biggest,
Reuters Group PLC's Instinet.
The ECNs and other electronic trading systems have flourished thanks to
technology -- which has put millions of investors onto the Internet in search
of faster, cheaper and more innovative trading -- and to the SEC, which
under Mr. Levitt has leaned in favor of competition in most of its decisions.
This year, a new SEC rule commonly known as "Reg ATS" took effect
that allows alternative trading systems to actually become stock exchanges,
giving them many of the benefits and responsibilities of the traditional
exchanges. Fast-growing Island ECN Inc., which now handles an
estimated 6% of Nasdaq volume and whose principal shareholder is Web
broker Datek Online Holdings Corp., has been among the first to ask for
exchange status, seeing it as crucial to breaking into the New York Stock
Exchange's franchise. Ten years ago, the U.S. had nine securities
exchanges. Thanks to Reg ATS, it could theoretically have more than 20.
Almost everyone agrees that would be too many, and indeed there's an
argument that investors might be better off if they merged into one since
that would make it easier for a buyer to find a seller. Although the NASD
acquired the American Stock Exchange last year, membership politics
have regularly doomed mergers between markets. That could change fast if
the Big Board and Nasdaq convert to for-profit entities, possibly
unleashing a wave of mergers between marketplaces and trading systems.
Jaws dropped at a March conference at New York's Baruch College
when Instinet's chief executive, Doug Atkin, said, "Those of you who are in
ECNs, you better make your money in the next few years, because it's a
dead business model." Already, ITG and Bloomberg Tradebook LLC, an
ECN owned by Bloomberg LP, are forming a super-ECN to which they
are trying to add partners. The Big Board has also explored assembling a
super-ECN to trade Nasdaq stocks under its own name.
End Is Unpredictable
Similar trends are under way in other financial markets. Traders on
Chicago's futures exchanges are nervously eyeing electronic intruders.
Numerous systems are cropping up to trade bonds electronically. And the
expected arrival of an electronic options exchange was a key reason that
four options exchanges tried to merge into two in the past 14 months,
though they failed.
No one knows how the expected shakeout will end, but investors seem
sure to benefit. By the end of the year, at least two ECNs expect to offer
evening trading for individuals, something long the purview of professionals
only. The traditional markets intend to follow next year, but they might
never have acted without the competition.
Some long-established players face an uncertain future. The 117-year-old
Pacific Exchange, for example, has a healthy options business, but its stock
business is losing market share and last year lost money. Its board voted
last week to turn its stock operation into a for-profit subsidiary, enabling it,
if necessary, to merge with another exchange or an ECN.
The exchange also plans to close its San Francisco and Los Angeles stock
floors in a few years. Specialists -- those who, in auction markets like the
Pacific exchange and the Big Board, have the task of ensuring orderly
markets in individual stocks -- would trade from offices across the country.
Members generally support the plan, in contrast to 1978, when a plan to
close the San Francisco floor failed in the face of resistance from members
who saw their way of life threatened. "Most people find the idea so
attractive because the alternative is so awful," says spokesman Dale
Carlson. "The alternative is you shutter the entire equity business."
Traditional markets face several obstacles that private systems don't.
Besides membership politics that can paralyze efforts to modernize, these
include expensive infrastructure and a heavier regulatory burden. The Big
Board has had to ask for SEC permission just to change the way
terminated employees hand in their floor badges.
Traditional markets do have size in their favor; once trading volume
centralizes in one place, it's hard to dislodge. Even so, Nasdaq is losing
ground in that battle: ECNs' share of the tech-stock-dominated market's
volume is 30%, and growing.
The New York exchange, meanwhile, has so far resisted most incursions:
Despite the growth of ITG's Posit and of ECNs, the Big Board's market
share in stocks listed on it has held at more than 80%. Its biggest
competition remains the regional exchanges and NASD-member dealers
that compete with the Big Board's floor traders, often paying other brokers
to send them their orders.
Goldman and Merrill
But the face of competition has turned more ominous for the Big Board
lately. Consider: Goldman Sachs Group Inc. and Merrill Lynch & Co. are
revered by floor traders as among their most loyal member firms;
Goldman's CEO was nominated in March to sit on the exchange's board,
along with Merrill's CEO. Yet three months later, Goldman and Merrill
announced they were building an electronic trading system called Primex. It
would open up the bidding on any particular stock order to any customer
on the Internet, whereas on the Big Board, generally only floor traders are
part of the auction.
Even more surprising, their partner was Bernard L. Madoff Investment
Securities, the dealer that had invented the practice of paying for orders to
draw business in Big Board stocks away from the Big Board. "Our
arch-nemesis!" groaned one floor trader, expressing the betrayal felt by
many members.
That wasn't the effect Merrill and Goldman were aiming for, and indeed
both have suggested that the New York Stock Exchange adopt Primex.
But loyal as they are, Goldman and Merrill can no longer afford to place all
their chips on the main marketplaces. Like Big Board specialists and floor
brokers, Goldman and Merrill have lucrative businesses -- particularly
trading and stock underwriting -- that are threatened by electronic systems.
The shrinkage in spreads between bid prices and asked prices that
followed Nasdaq's new order-handling rules, coupled with the explosion of
ECNs, has pinched most Nasdaq dealers' profits. Merrill has stopped
making markets in many Nasdaq stocks, and some smaller dealers have
stopped making markets altogether.
Goldman has put more energy into responding to the electronic threat than
any other Wall Street firm. The prospectus for its IPO in May, under "risk
factors," said: "A dramatic increase in computer-based or other electronic
trading may adversely affect our commission and trading revenues ... and
lead to the creation of new and stronger competitors." The prospectus
listed six electronic-commerce ventures in which Goldman has invested,
ranging from two ECNs to online investment banker Wit Capital Group
Inc. "Through these investments, we gain an increased understanding of
business developments and opportunities in this emerging sector," it said.
Persistent Gadfly
Besides technology and deregulation, the rush to electronics reflects the
dissatisfaction of certain prominent investors -- most notably Harold
Bradley. Though unknown to the public, he is famous on Wall Street for
strenuous advocacy of replacing specialists and dealers with electronic
systems. "Wall Street has created this deep, gray fog around the magical
and mysterious workings of the markets," Mr. Bradley says. "Markets
should work to establish an efficient clearing price. That's not what
happens, because intermediaries make too much money imposing rules."
While running the trading desk of Kansas City-based mutual-fund manager
American Century Investment Management in the early 1990s, Mr.
Bradley became incensed at how Nasdaq dealers would bar him from
trading between their wide bid-ask spreads, leak information on his orders
and trade against him. He became an early and regular customer of
Instinet. He produced reams of reports showing how market makers
appeared to manipulate prices and sent the information to the Justice
Department and the SEC, which were already looking into questionable
dealer practices identified in academic studies.
Mr. Bradley has been equally critical of Big Board specialists for allegedly
favoring floor brokers at outside investors' expense. And he has persuaded
American Century to put its money where his mouth is. Earlier this year it
took a small stake in a Chicago-based ECN, Archipelago Holdings LLC,
whose investors also include E*Trade Group Inc., Goldman Sachs and
J.P. Morgan & Co.
Advent of OptiMark
Despite all the sound and fury, investors like Mr. Bradley are still waiting to
see the promised changes occur. One of the most talked-about trading
systems was OptiMark, whose sophisticated computerized algorithm is
meant to match difficult institutional trades. Advocates like Mr. Bradley,
whose firm invested in OptiMark's developer, OptiMark Technologies
Inc., thought it would rock the Big Board. But in its six months of
operation on the Pacific exchange, OptiMark's volume has been
disappointing, according to the company. (Dow Jones & Co. Inc.,
publisher of The Wall Street Journal and the Interactive Journal, has a
minority stake in OptiMark.)
Mr. Bradley blames regulatory obstacles thrown up by the Big Board.
Others cite traders' resistance to new technology and satisfaction with the
exchange.
But OptiMark may have indirectly spurred the Big Board into action. The
fact that so many of its members, including Goldman, Merrill and
PaineWebber Group, had invested in OptiMark brought home with a jolt
how unpredictable the landscape had become. The Big Board's president,
William Johnston, in a speech at the Baruch conference in March, said
these are times "when your competitor today could be your partner
tomorrow and your challenger tomorrow could be someone who doesn't
exist today."
Clearly, such ferment helped Mr. Grasso conclude the Big Board could
best compete as a public company. "When one's largest customers begin a
proliferation of investments in alternative systems, it behooves management
to [ask] what best serves the customer base," he says." |
