entire wsj article:
July 27, 1999
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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.
Money Managers Need Selling on Necessity of Big Board IPO
Biggest Securities Firms Grab Lead in Online Bond Trading
* * *
Online Broker Gives Individuals a Taste of After-Hours Trading (July 26)
Big Board May Sell Own Stock to Public Within Four Months (July 26)
Four Stock-Trading Giants Will Form Electronic Mart (July 22)
Brokerage Firms Join Madoff to Offer Big Board Alternative (June 8)
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.
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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
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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.
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