Wall Street Wired

Judging from last year's bonuses, Wall Street never had it so good. But times probably will never be better.

In the next 5 years, the businesses of raising capital and trading it in secondary markets will undergo more change than they have in the previous 200. And for the infrastructure of exchanges, brokers, and dealers that is Wall Street, it won't be pleasant. The U.S. capital markets are at "a point of passage between what they have been and what they will become," said Securities and Exchange Commission chairman Arthur Levitt in a speech at the Columbia Law School last September.

By all accounts, these markets have been the deepest and most risk-tolerant in the world--a place where foreign governments and businesses come to raise money their own markets can't supply. They have also supported the most-profitable middleman franchises in history. That, thanks to increasingly low-cost, sophisticated technology, is about to change forever. No intermediary making his living between corporate issuers and investors or between buyers and sellers of securities is safe. Not the exchanges where the stocks, bonds, and derivatives trade, nor the dealers who make markets in them, nor the brokers who direct the flow of customer orders. From here on out, the competition gets more intense, the margins get slimmer, and the easy money from overseeing transactions in the world's most active securities market gets a lot harder to come by. "The Titanic is going down and there aren't enough lifeboats to go around," says Junius Peake, a professor of finance at the University of Northern Colorado.

Wall Street's woes, however, will prove a windfall for investors and corporate issuers. For CFOs like Ilan Slasky, of Hackensack, New Jersey­based Net2Phone, the biggest potential benefit is in the underwriting business. When the Internet phone-service provider went public last July, it handed over 7 percent of the proceeds to its underwriters. "We checked around to see who really wanted our business, but the fee was always 7 percent," says Slasky. And it has been for decades.

The investigation of that standard fee by the Antitrust Division of the U.S. Department of Justice may shake up investment bankers, but the real force for change will be the Internet. Electronic road shows, simplified registration procedures, and, ultimately, Web-based share auctions will eventually help corporate issuers go directly to investors rather than through costly underwriters.

The floating of a couple of vineyards and microbreweries on the Web may not have bankers from Goldman, Sachs & Co. and Morgan Stanley Dean Witter shaking in their boots, but it should. For example, the IPO of Andover.Net Inc., a Linux Internet company, which raised $82.8 million in a Web-based auction led by W.R. Hambrecht last December, cost the company 10 percent less than a traditional underwriting. The competition will eventually break the standard 7 percent IPO underwriting fee. It will also, and probably more rapidly, reduce the 4 percent fee typical of secondary offerings for established companies.

In the meantime, the secondary markets for securities trading are providing the most dramatic example of disintermediation by technology yet seen in the U.S. economy. Here, the benefits of technological innovation and regulatory reform may not be as obvious to issuers as on the underwriting side of the business, but they are just as significant. An efficient secondary market not only lowers transaction costs when issuers buy back stock or invest their pension assets, but it also lowers the cost of raising capital. "We want a happy shareholder base and want to be able to easily access new capital," says Slasky. The bull market has obliged. Slasky took advantage of a market that has driven his share price from 15 to 54 since going public, by raising another $400 million in a secondary offering brought to market last December.

As buoyant and liquid as the U.S. equity markets are, however, there is plenty of room for improvement. "People say our markets are the best in the world, and they are," says Steven Wallman, a former SEC commissioner. "The question to ask is, if we allow for more competition, will we see more innovation? The answer is yes."

Enter ECNs
The catalyst for competition is the so-called electronic communication networks (ECNs)--computer-based order- matching systems that display the bids and offers of subscribers on the network. When bids match offers, trades are automatically executed. When they don't, the best prices are posted on the Nasdaq system to compete with quotes from market makers. The oldest ECN, Instinet, has been around since 1969, functioning primarily as an after-hours market for institutions. There are also several electronic networks designed to enable institutions to trade large blocks of stock automatically.

Since 1996, however, eight more electronic networks have linked up to the Nasdaq system. And along with Instinet, they have seized an astonishing 33 percent share of total Nasdaq trading volume. That share is growing by more than 1 percent every quarter. Why? Faster execution speeds, lower costs, and, most important, anonymity. On the Island ECN, a trade can be executed in less than a second and for an average of 7.5 cents per 100 shares.

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