Fortune (Part II) To compete more nimbly, New York and Nasdaq both plan to shed
their cumbersome ownership structures by going public. Both proposed
IPOs were immediately greeted skeptically, and the NYSE's plan was
almost universally pegged as a lousy investment. "It's like Henry
Ford is making his assembly line, and the biggest buggy maker is
planning an IPO," says Harvey Houtkin, Attain's CEO.
Another potential breach in Fortress NYSE concerns the exchange's
Rule 390. Keeping with the spirit of the Buttonwood agreement, the
NYSE's collusive founding document, the rule forbids member firms
from making a market in a stock listed before 1979 except on a
registered exchange. "Rule 390 is the last vestige of the Buttonwood
agreement," scoffs Steve Wunsch, president of the Arizona Stock
Exchange.
SEC Chairman Arthur Levitt has hinted strongly that he wants Rule
390 junked, but NYSE President Richard Grasso says he has no
intention of doing so. The argument may be moot, however, because of
a 1998 regulation that allowed ECNs and, more important, Nasdaq to
become registered exchanges. So far, Island, Archipelago, and
NexTrade have begun the process, and Nasdaq will soon. "I think
there's the potential for this to explode," says National Association
of Securities Dealers President Rick Ketchum. Once that happens,
there is nothing to stop NYSE members from dealing Coke, say, on
Nasdaq.
Of course, the possibility that member firms may be allowed to
trade away from the floor doesn't mean they will. After all, they can
already go on Nasdaq to make a market in stocks listed after 1979,
but they seldom do. Sources disagree as to whether that reluctance
arises from exchange politics or just from the difficulty of
competing with the NYSE's awesome liquidity.
However well the NYSE staves off ECNs now, the electronic
marketplace in general may be too powerful an idea to resist forever.
Regulators clearly have not forgotten the National Market System:
Levitt has mentioned it in two recent speeches. "Basic economics
tells us that the greater the supply and demand that congregate in
one place, the more efficient the price setting," he said in one
speech, calling for a "virtual limit order book" that would display
all orders from all the markets to all participants.
That kind of marketplace could have less room for the middlemen of
Nasdaq and the NYSE. Indeed, the entire electronic communications
revolution is about nothing if not reducing the middleman's role.
Matchmakers will still matter wherever market participants have a
hard time meeting--for thinly traded stocks, for example. And as
institutions have grown larger, they need a middleman's capital to
help them complete trades. But otherwise, an NYSE specialist is not
indispensable. Middlemen often argue that their capital will add
stability, especially during market turmoil. But a specialist needs
only to have $1 million in liquid assets and be able to buy 22,500
shares of the stock they specialize in--30,000 if it is in the S&P
500. "It's ridiculously low," says one Street executive. "When this
freight train turns around, no specialist firm on the floor will be
able to stop it."
The traditional market structure was created of, by, and for
middlemen. For the past 25 years, technology, regulation, and
entrepreneurs have been chipping the edifice away. In the future,
even retail investors may learn that the instant gratification of a
market order sent through a middleman is expensive. "What is the
value?" asks former SEC chief economist Susan Woodward. "If the
market maker is not there, you might have to wait a little longer [to
see your order clear]. That's it. We're not talking about three
weeks, we're talking about 90 seconds." Woodward, now chief economist
for the Internet-based private-equity marketplace OffRoad Capital,
predicts that middlemen will stop committing their capital to make
markets in highly liquid stocks because they simply won't be able to
compete profitably. In that world, it seems safe to say, 55% margins
will be hard to come by.
[SIDEBAR]
Trading Options: How Your Broker Got That Price
When your broker gets your order to buy a stock at the market, it
is his job to give you "best execution." That legal term roughly
translates as the best price, but it also factors in speed of
execution and other considerations. It's not hard for him to find out
whose quote is the most attractive. If the stock is listed, the
Intermarket Trading System will know whether the NYSE, the regional
exchanges, or the third market has the best price. The Nasdaq Level
II screen shows which of the competing market makers or ECNs is
cheapest. But where your broker sends your order has nothing to do
with that.
Long before your order arrived, he designed a complex algorithmic
program to decide how to route your order. Generally, he prefers to
trade with you himself. That tends to be his most profitable option,
and if he makes a market in the stock, he'll use it. Otherwise, he
could send it to the floor of the exchange if it's a listed stock or
shop among market makers if it's on Nasdaq. But wherever it trades,
there's a good chance it just goes to the outlet that pays your
broker the most.
Doesn't that violate your broker's legal obligation to get you
best execution? Not really. Your broker sends your order only to
market makers that--regardless of their own posted quote--agree to
give you the "national best bid or offer," or NBBO. So you get the
best price available anywhere, and thanks to the kickback, known as
"payment for order flow," you may pay a lower commission. How else do
you think your online broker could afford those $8 commissions?
The SEC even makes sure that your broker tries to get you better
than best prices. "Everyone says 'best execution,' but I actually
call that [the NBBO] the 'worst execution,"' says Bill Harts,
managing director in equity trading at Salomon Smith Barney. "[A
broker] couldn't do worse, because otherwise the SEC would be
knocking at [his] door. The best is 'How often can you do better than
NBBO?"' Exchanges, market makers, and third-market brokers all keep
statistics on how often they give their customers a price better than
the NBBO. So if someone is offering "price improvement," your broker
has to consider those numbers in choosing where to route your order.
How can brokers afford to pay for orders and still pay the best
price? Because it's worth it to trade with small investors like you.
An old trading strategy known as odd-lot theory, says it's profitable
to bet against small orders (called odd lots when they are less than
100 shares). When a market maker handles retail order flow, that's
essentially what he does: He buys what the little guys are selling,
and vice versa. Traders distinguish between informed (institutional)
and uninformed (retail) trades--less charitably, between smart money
and dumb money. In theory, big orders either have superior
information or move the market by their size. Individuals tend to be
the last in line for valuable information.
Third-market pioneer Bernie Madoff says the theory works because
retail traders buy and sell to meet their own financial goals, not because they've heard an inside tip. "Don't be on the opposite side
of a 100,000-share trade," Madoff explains, "because anyone trading
100,000 shares knows more than you do." Ken Pasternak, CEO of
Knight/Trimark, which handles about 40% of online orders, insists he
isn't betting against anybody. Like Madoff, he automatically accepts
orders. "They bet against me," he says, "because I don't choose."
Both Pasternak and Madoff make money by "managing their inventory"-
-essentially day trading, with the advantage of being able to see all
the traffic in their stocks. They do fine at this. Knight, for
example, makes $8.66 a trade and pays back brokers $1.63.
Market makers don't pay for limit orders, though--which suggests
that limit orders may be a smarter way for investors to trade. Knight
and Madoff may choose to execute limit orders if they like the price.
If not, either can send it to an ECN to wait for an automatic match.
There is a downside, though, to limit orders: If your bid is too low,
you may never get a match.
[BOX]
ECNs Creep Up on Nasdaq
Nasdaq market makers' percent of Nasdaq share volume: 80%
All ECNs' percent of Nasdaq share volume: 20%
Instinet 13.38%
Island 4.35%
REDIBook 0.80%
Tradebook 0.69%
Archipelago 0.61%
Others 0.21%
FORTUNE CHART / SALOMON SMITH BARNEY; FIGURES AS OF JUNE 30
[BOX]
The NYSE and Nasdaq Still Dominate, but Their Competitors Are
Multiplying
Founded Main Owners
1st & 2nd Market
NYSE 1792 Stock exchange members
Gimmick
Stocks are auctioned at specialist's post; one specialist per
stock
Nasdaq 1971 The National Association of Securities
Dealers
[Gimmick]
Competing market makers
ECNs
Instinet 1969 Reuters
[Gimmick]
International presence, brokerage services
Island 1996 Datek Online Holdings
[Gimmick]
Liquidity second only to Instinet among ECNs
Tradebook 1996 Bloomberg
[Gimmick]
Part of Bloomberg data network; targets Instinet's customers
Archipelago 1997 E*Trade, Goldman Sachs, Am. Century,
Instinet
[Gimmick]
Automatically routes orders to most-reliable trading partners
REDIBook 1997 Spear Leeds, DLJdirect, Fidelity, Schwab
[Gimmick]
Gets orders from its partners
Strike 1998 25 broker/dealers, and Sun Microsystems
[Gimmick]
Gets orders from its owners
Attain 1998 All-Tech Investment Group
[Gimmick]
Access for small investors ($200/month with All-Tech trading
software)
BRUT 1998 Sungard Data Systems, Knight/Trimark
[Gimmick]
Institutions can access only through broker/dealers
NexTrade 1998 Professional Investment Management
[Gimmick]
24-hour trading
Others
Bernard Madoff 1960 Privately held
[Gimmick]
Electronic automated execution; pays for small orders
Knight/Trimark 1995 Public shareholders
[Gimmick]
Handles about 40% of retail online orders; pays for some orders
OptiMark 1996 Am. Century, Dow Jones, Goldman, IBM,
SOFTBANK
[Gimmick]
Linked to ITS and Nasdaq; automates complex trading strategies
FORTUNE TABLE/SOURCE: PUTNAM LOVELL DE GUARDIOLA & THORNTON
TABULAR OR GRAPHIC MATERIAL SET FORTH IN THIS DOCUMENT IS NOT DISPLAYABLE
COLOR PHOTO: PHOTOGRAPH BY ROBERT LEWIS COLOR PHOTO: RAIMUND KOCH THE NEW TRADING FLOOR: Island ECN's servers hum in a nondescript basement just down the block from the New York Stock Exchange. They handle 12% of the shares traded in Yahoo. COLOR PHOTO: JONATHAN SAUNDERS THIRD MARKETER: Broker Bernie Madoff challenged the NYSE in the 1970s by embracing technology and undercutting the exchange's surcharge on small orders. He now gets business by paying brokers to route orders his way. COLOR PHOTO: BRAD RICKERBY--SIPA THE OLD HUB: Screens at the specialists' posts link the floor with regional exchanges and the Third Market. The SEC wants to give full access to Nasdaq and ECNs too.
---- INDEX REFERENCES ----
NAMED PERSON: MADOFF, BERNIE
KEY WORDS: STOCK MARKET
NEWS SUBJECT: Stock Market News (STK)
Word Count: 3815
11/22/99 FORTUNE 251+
END OF DOCUMENT |
