9/1/99 Upside (Pg. Unavail. Online)(SEE BOLD BELOW)
1999 WL 20543205
UPSIDE Magazine
Copyright (c) 1999 Upside Media Inc. All Rights Reserved.
Wednesday, September 1, 1999
Breaking the Rules
Loren Fox
As the securities industry struggles to accommodate Internet-era investors
by exploring extended trading hours, it also faces internal change. The
culprit: electronic stock-trading networks -- firms that are changing not only
when stocks are traded but also how. They represent the next generation in
electronic access, and their ascent is pushing the Nasdaq and the New York
Stock Exchange (NYSE) into uncharted territory.
Imagine this scene: On your way home from a late dinner, an e-mail on your
handheld computer notifies you that shares of that Hong Kong software company
you've been monitoring have dropped to your target price. Immediately, you log
on to your online brokerage account and put in a bid to buy at $35.50 a share.
You notice several sell offers, but none lower than $35.70. So you try bidding
on another stock exchange, and this time your bid of $35.55 is accepted.
The scene above is a fantasy. U.S. stock markets aren't open past 4:30 p.m.
Eastern time, let alone after a late dinner. And stocks are traded on one
market in cumbersome fractions of eighths and sixteenths, not on multiple
exchanges in precise decimal formats.
But within five years, if not sooner, every element of that scene will be
possible -- from 24-hour trading and pricing in decimals to stocks listing on
competing exchanges and widespread remote trading. The biggest stock-trading
revolution in decades is just around the corner. What's behind it?
"One word: the Internet," says Frank Zarb, chairman and CEO of the National
Association of Securities Dealers Inc. (NASD), the Nasdaq stock market's
parent. "The Internet," he says, "puts the spotlight on the antiquated system
that had been in place."
That antiquated system took quite a blow in May when the NASD voted to set
up a plan for a pilot evening session for trading the Nasdaq's 100 largest stocks. The session, which would run from 5:30 p.m. to either 9 p.m. or 10
p.m. Eastern time, could begin by the end of the year. The NYSE is also likely
to create an evening trading session. But its members voted in June to put off
any plans for extended hours until mid-2000.
Zarb and the NASD may think they're showing foresight in rolling out the
welcome mat, but in many ways they have no choice. Technology has opened the
floodgates of access and competition, and the stock-trading community must
figure out how to adapt. The Internet fired the first shot in this revolution
when it spawned online brokers, which made trading less expensive and more
accessible to individual investors. In turn, the explosion in online trading
fired the growth of all-electronic alternative trading systems, which look as
if they could one day supplant the existing stock markets.
"The markets are headed toward greater openness and easier access," says
Tom Bevilacqua, executive vice president of corporate development at Palo
Alto, Calif.-based E-Trade Securities Inc., one of the largest online brokers.
"The Internet is changing things in a way that's beneficial to investors," he
says.
And every layer of the securities industry will feel the ripple, affecting
when and how stocks are traded as well as the nature of the stock exchanges.
Not only did the Internet start the revolution, it has sustained it. Online
traders' ranks continue to swell. From fewer than 4 million online brokerage
accounts at the start of 1999, the U.S. industry is projected to grow to 20.4
million online accounts, handling $3 trillion in assets in 2003, according to
market research firm Forrester Research Inc. of Cambridge, Mass.
With computer access to their accounts and the ability to enter buy and
sell orders at all hours, online investors no longer want to wait until 9:30
a.m. Eastern time for their trades to be executed. On the exchanges, that
pent-up demand has created a morning trade rush that critics say can cause too
much volatility. The Internet's "always open" character makes the Nasdaq's and
NYSE's 6-hour trading day seem out of step.
"The notion that we close at 1 [p.m.] California time is absurd," says
Edward Nicoll, president and COO of Datek Online Holdings Corp., Edison, N.J.,
the parent of online broker Datek Online. "[About] 20 percent to 25 percent of
our orders come in when the market is closed," he says.
Already, alternatives have emerged. In 1998, the Securities and Exchange
Commission (SEC) gave its blessing to the widespread creation of alternative
trading systems that electronically match buy and sell orders. So far, there
are nine such systems -- known as electronic communications networks, or ECNs
-- allowed to deal in Nasdaq-traded stocks. Several ECNs are open before and
after the Nasdaq's and NYSE's trading sessions. They're accessible only to
professional firms; individual investors can't use them directly.
For example, The Island ECN Inc. of New York, created and majority-owned by
Datek, operates from 8 a.m. to 5:15 p.m. EST. Roughly 4 million shares a day
trade on Island outside Nasdaq's operating hours, says Island President
Matthew Andresen, who wants to further extend Island's evening session.
The granddaddy of ECNs is New York-based Instinet Corp. It was created in
1969 and is now owned by Reuters Group Plc. Instinet, which serves
institutional investors, has long held preopening and post-close trading
sessions. The largest ECN by trading volume, Instinet is also the only one
that trades Nasdaq and NYSE stocks. There's even a new trading system called IndivEx that Eclipse Trading Inc.
created for the express purpose of evening trading. During the summer, the New
York-based company will launch a 6 p.m.-8 p.m. trading session aimed at
individual investors. Initially, it will trade the 100 largest stocks on the
Nasdaq and the NYSE. "We're trying to focus on when there's the greatest
demand in the [United States]," says Eclipse Chairman and CEO Michael
Sanderson.
In a quasi-Nasdaq system, Eclipse will allow individual investors to see
the "book" -- a stock's buy and sell orders. Certain participating securities
firms will also act as "market makers," which means they'll be able to use
their own money in trades to maintain trading flow, just as some securities
firms do for the Nasdaq and NYSE. Eclipse, which isn't an ECN, has signed five
securities firms, including Morgan Stanley Dean Witter & Co. and Salomon Smith
Barney Holdings Inc., to use its system. "Eventually, 24-hour trading will
come to every popular security," Sanderson says. "That doesn't mean one trader
has to stay up late. It means the same stock will be traded continuously in
markets around the world."
With all the competition, no wonder the Nasdaq is formulating plans for an
evening trading session. "This is a precursor to what ultimately would be
24-hour trading," says the NASD's Zarb. "Whether it's two to three years from
now or five years from now, I don't know."
As Zarb suggests, the move into evening hours will be gradual because of
concerns that at those times, there won't be enough "liquidity," or sufficient
trading volume, to ensure that stocks trade fluidly. While some traders fret
that evening sessions will simply drain trading volume from the regular
daytime session, Datek's Nicoll believes extended hours would quickly result
in 10 percent to 20 percent greater volume.
"If the exchanges stay open later, they'll get the trading volume; they
have the liquidity," says Bill Burnham, VP and senior research analyst at
Credit Suisse First Boston Corp. "This is a game where bigger really is
better."
Traders, however, are grumbling about the prospect of working longer hours
or later shifts. And the regulators worry that the lighter trading volume in
evening sessions will result in wider price swings, exposing investors to
greater risk. Acknowledging these concerns, the NYSE, the NASD and the SEC
together set up four panels in June to study evening trading, with the mandate
to deliver preliminary reports in September. Extending trading hours also
raises procedural questions. For example, which closing stock prices will
daily newspapers publish: those from 4 p.m. or those from 9 p.m.? "We're not
sure what we're going to do," says Richard Tofel, VP of corporate communications for Dow Jones & Co., publisher of the Wall Street Journal. "It
may differ from early editions to late editions," he says.
These issues must be resolved because 24-hour trading is the inevitable
result of a larger trend: the globalization of the equities markets. As
cross-border barriers give way, U.S. investors hungry for new opportunities
are increasingly seeking to trade foreign stocks, and vice versa. In a pilot
program, the Nasdaq and the Stock Exchange of Hong Kong will list 40 of each
other's stocks by the end of this year. And in June, Nasdaq and Softbank
Corp., the big Japanese tech holding company and distribution enterprise,
agreed to create a Nasdaq-type market in Japan at the end of 2000 that would
trade the Nasdaq's largest stocks in addition to Japanese stocks. For its
part, the NYSE has for years aggressively courted foreign company listings.
More international partnerships are on the way, and they're already
happening overseas. In May, eight European exchanges -- led by the London
Stock Exchange and Frankfurt's Deutsche Borse -- agreed to establish a
pan-European stock market. Like Eclipse's Sanderson, market veterans envision
the day, within a few years, when shares of a stock such as Intel Corp. change
hands around the clock: first in Asia, then in Europe, then in the United
States.
Just as ECNs' emergence has helped spur extended trading hours, it's also
changing the way trades are executed. When an online investor places a trade,
the online broker usually sends that trade to a third party -- either a
specialist at the NYSE or a market maker at the Nasdaq -- for execution.
Operating electronically, ECNs create a market where brokers and dealers can
execute clients' trades directly with each other rather than going through
middlemen.
An increasing percentage of Nasdaq stocks are traded in the electronic
market. In 1999's first quarter, the nine ECNs together accounted for 18
percent of Nasdaq share volume, up from 12 percent a year earlier, according
to estimates from E-Offering, E-Trade's investment bank.
ECNs traffic exclusively in "limit orders" -- orders to buy with a maximum
price or sell with a minimum price specified. Market makers can also execute
"market orders," which, as the name suggests, seek a sale or purchase at the
latest market price. With the growing use of limit orders, however, the need
for such pure trade-execution services is shrinking.
Island, the second-largest ECN, contends that doing away with the market maker leads to better prices for investors. That way there's no broker-dealer
in the middle that can trade against clients' orders or make money from the
spread between sell and buy orders. "Island is a pure auction market,"
Andresen says. The kink is that without market makers to take the other side
of trades, only about half the orders sent to Island result in a match.
Regardless, by enabling trades to be executed without them, ECNs are
speeding Nasdaq market makers' evolution. Competition from ECNs has
contributed to a narrowing of bid-ask spreads among Nasdaq stocks. This builds
on the shrinking of spreads sparked by a 1997 regulation that changed the way
limit orders are handled. Since that rule change, capturing spreads has become
a minor part of the business for most market makers.
New kinds of brokers and dealers are emerging, such as Knight/Trimark Group
Inc. of Jersey City, N.J., which was formed in 1995 as a dealer cooperative.
It's now the largest market maker in Nasdaq stocks and the NYSE's
over-the-counter market. Knight/Trimark, the holding company for Knight
Securities Inc. and Trimark Securities Inc., is a wholesale market maker,
executing trades on behalf of broker-dealers, institutional investors and
online brokers.
Unlike traditional market makers, Knight/Trimark charges no fees for its
trade execution. Instead, it earns its profits trading its own money around
the vast flow of transactions it executes. Its technological prowess attracts
that large flow. Knight/Trimark President and CEO Kenneth Pasternak believes
that to survive in the new Internet era, market makers must add more value
than just execution. "In the Nasdaq market, traditional dealers will be
challenged," he says. To keep its options open, Knight/Trimark has invested in
Brass Utility LLC of New York, one of the nine ECNs.
But Pasternak and others say the market still needs traditional market
makers that can commit their capital to provide liquidity. In down markets, it
becomes harder to match sell orders on ECNs, and their volumes slip. And small
stocks may always need traditional market makers, no matter what the broad
market's direction.
Could ECNs ever threaten the stock exchanges? The big-name securities firms
aren't waiting for an answer. Trading venues are changing, and the safest
course may be to spread their bets.
Many ECNs have multiple investors -- usually Wall Street firms looking for
a piece of the action. Waterhouse Securities Inc. of New York agreed in May to invest $25 million for a 12.5 percent stake in Island. Archipelago Holdings
LLC of Chicago, another large ECN, is 25 percent owned by E-Trade, 25 percent
owned by Goldman Sachs Group LP and 20 percent owned by J.P. Morgan & Co. And
Strike Technologies Inc. of New York is an ECN owned by more than 20 brokerage
firms.
Competition is causing such a scramble that Wall Street establishment icon
Goldman Sachs has acquired minority stakes in four alternative trading
systems, including a new one called Primex Trading NA LLC.
New York-based Primex, unveiled in June by Goldman, Merrill Lynch & Co. and
Bernard L. Madoff Investment Securities, seeks to complement the NYSE. The
goal is to create an electronic version of the NYSE's auction market, Nasdaq
and other ECNs, where participating securities firms can try to better the
prices of electronically displayed bid and ask orders. Primex hopes to launch
by the third quarter of next year, to coincide with the market switch to
decimals.
If these newer systems sound similar to stock exchanges, they are. In
spring, Island nailed that home when it filed with the SEC to become a
full-fledged stock exchange. As an exchange, it hopes to trade NYSE-listed
stocks as well as Nasdaq stocks.
Observers believe Island, and possibly Archipelago, could thrive as
exchanges that compete with Nasdaq and the NYSE. One advantage they hold is
the lower cost of being electronic. While the NYSE employs hundreds of people,
including floor traders, technical workers and support staff, Island's staff
numbers just 35.
The result is likely to be new exchanges that trade the same stocks. One
stock listed on two exchanges? That has already happened with stock options,
which may be traded at the American Stock Exchange and the Philadelphia Stock
Exchange.
No one is predicting floor traders' demise as a result of electronic
trading's growth. But some observers raise their eyebrows at the NYSE's plan
to build a new facility with more trading-floor space. Says Credit Suisse's
Burnham, "I have a hard time believing it'll be anything other than an
interesting museum in 10 years."
In other ways, though, Nasdaq and the NYSE are facing their potential
obsolescence straight in the eye. Nasdaq has invested in OptiMark Technologies nc. of Jersey City, N.J., which runs an electronic system for institutions to
trade blocks of stock. And the NYSE is considering creating an electronic arm
that would trade Nasdaq stocks, and it may even buy an ECN to do so.
That makes sense to some experts, as ECNs need to mature. "There [will]
have to be some consolidation among ECNs," says Dan Burke, a senior brokerage
analyst at e-commerce research firm Gomez Advisors Inc. of Concord, Mass. "And
they [will] have to broaden their liquidity beyond just tech stocks."
From the individual investor's point of view, in the near term the most
visible and personal changes to stock trading will be the switch to decimal
pricing from pricing in fractions and the increased use of remote trading.
Both are products of the new access the Internet has granted investors.
Although decimal pricing may seem trivial, it comes at the behest of the
SEC and the U.S. Congress, and the change may help strip away some of the
clubbiness that has surrounded the investing business. In addition, precise
decimal prices will further reduce bid-ask spreads.
The industry has targeted July 3, 2000, as the deadline for decimal
pricing, but it has yet to work out the details. For example, the NYSE and
Nasdaq haven't decided whether the new prices will be in increments of nickels
or pennies.
In practical terms, few developments embody the new access more than the
nascent business of remote trading. More brokerages are allowing investors to
buy and sell stocks from personal digital assistants, Web-enabled cellular
phones and other handheld devices. Among existing programs, Fidelity
Investments Institutional Services Co. of Boston has a well-known
InstantBroker service that provides quotes and trading through special two-way
pagers.
And E-Trade customers can trade via the Palm VII, 3Com Corp.'s new handheld
computer with limited wireless Internet access. "It's our strategy to make our
investing activities and banking available through all sorts of devices," says
E-Trade's Bevilacqua, who notes the company is even mulling a way to enable
trading through interactive television.
Of course, as more investors turn to do-it-yourself trading, the broker's
job is shifting away from entering clients' trades. New York's PaineWebber
Inc., for instance, renamed its nearly 7,000 brokers "financial advisers" in
March and is using the Net to better keep in touch with clients. "Putting in the trade is viewed as a clerical function," says Robert H. Silver, the
company's director of operations, service and systems. "We're in the advice
business."
From broker to investor and from greater access to new trading venues,
market players acknowledge that the ongoing bull market has accelerated the
changes taking place. Besides stimulating trading, widespread profits from the
market's advances have smoothed the public's acceptance of dramatic shifts in
stock-trading practices.
"It's wonderful that these changes are happening in an up market. Because
when an extended down market comes, it will test the public's trust in the
securities industry," Securities Industry Association President Marc Lackritz
told a packed house at the brokerage trade group's mid-June conference.
In the meantime, the industry is jumping to catch up with changes it never
anticipated. "Technology [has] again leapfrogged conventional thinking,"
Lackritz says. "The old rules are going by the boards." |
