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.”
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.
Since 1992, Harold Bradley, a senior vice president at American Century Investments, in Kansas City, Missouri, has sent more than 30 percent of his trades to ECNs because of those advantages. And the more new networks, the merrier, as far as he’s concerned. “I think there’s room for 20 or 25,” says Bradley, whose company has investments in several ECNs.
Benn Steil, a securities expert at the Council on Foreign Relations, in New York, estimates that it costs less than $10 million for the hardware, software, and telecommunications equipment needed to set up an electronic trading platform capable of executing 15 transactions per second. It’s not surprising, then, that as many as 140 broker-dealers have notified the SEC that they may form ECNs of their own. These networks have low overhead and low variable costs. But the ECNs are doing more than just bringing down prices for trade executions in the industry. They provide a glimpse of the electronic future of the securities markets. Ultimately, they threaten to replace the Nasdaq market makers and NYSE specialists making their living between investors. “Nasdaq and the NYSE give specialists an advantage,” says Ed Nicoll, CEO of Datek Online Holdings Corp., which owns 85 percent of Island. “We think that’s an anachronism.”
Why are the ECNs so important? In a nutshell, they provide competition where little or none existed. The absence of competition became painfully apparent in 1995, when a number of studies of the spreads between bid and ask prices on Nasdaq suggested that dealers were colluding to fix wide spreads. The Justice Department launched an investigation, and NASD dealers eventually paid $1 billion to settle a class-action lawsuit. The SEC also imposed new order-handling rules on the market makers in early 1997. The rules force Nasdaq dealers to display customer limit orders–orders to buy or sell at a certain price–that are as good or better than the dealer’s own quote. Prior to the rules, market makers could let customer limit orders priced between their quotes simply sit in their books. Meanwhile, they used their knowledge of investor sentiment to increase their trading profits.
The ECNs have, in effect, helped enforce the new order- handling rules. Until they came on the scene, the only information about the supply and demand for over-the-counter stocks was in the hands of the Nasdaq market makers. But ECNs, by posting the size and price of customer orders on their networks, serve as giant electronic limit order books, making the true supply and demand for stocks more transparent to market participants.
The key to success for ECNs is capturing order flow. Liquidity begets liquidity, and without it ECNs, or any market for that matter, won’t last long. Several ECNs, including RediBook and Strike, were set up by big broker-dealers that will supply order flow to give the networks a leg up. Others, such as Archipelago, are selling stakes to Wall Street brokers to encourage them to send business their way.
This is all very much to the benefit of investors, says Bradley. Since the SEC imposed the order-handling rules in January 1997, various studies have found that spreads between dealers’ bid and ask quotes on OTC stocks have shrunk by more than 30 percent. To a large degree, that’s a result of competition from the ECNs
“Nasdaq is on its way,” says Bradley.
The Big Board’s Turn
The NYSE is another matter. Investors like Bradley now have their sights trained on the floor specialists who make markets in NYSE-listed stocks. They want the same competitive pressure changing the OTC market to be brought to bear on the listed market. Bradley and his fellow travelers think the ECNs provide a ready means for doing so by forcing the much-vaunted but underdeveloped Intermarket Trading System (ITS), which includes the NYSE and the exchanges in Boston, Chicago, Philadelphia, Cincinnati, and San Francisco, to live up to its potential. When Congress commissioned the SEC to foster a national market system back in 1975, the goal was as clear as it is today: an interconnected market, where all bids for a stock could interact with all offers to sell it, regardless of where the orders originated. Best bids and offers on the table first would get matched with each other.
But since the ITS was established in 1979, the NYSE has paid only lip service to the idea of competition with the regional stock exchanges, which trade listed stocks, and the dealers in the OTC market. And the SEC has acquiesced, says Peake of the University of Northern Colorado. The resulting ITS not only fails to deliver on the national market system ideal, says Peake, but worse, it has become a means for the NYSE to keep out competition and protect business practices that favor exchange members.
That is hardly surprising. As the dominant venue for trading listed stocks, as well as a mutual company owned by its members, the NYSE had little interest in seeing the development of a truly national market system. The ITS, which electronically links the NYSE with the five regional exchanges, has been little more than a regulated pie-sharing arrangement among the exchanges. In effect, there is no competition. “The SEC made the decision to have the industry compete based on place, not price,” says Peake.
With the NYSE floor handling a dominant 82.5 percent of all listed stock trading, investors like Bradley are forced to grin and bear what they say is lousy service from NYSE specialists who make markets in listed stocks (one per stock). “The specialists have the information, and they can share it with whomever they want,” says Bradley. “There are always three or four people ready [on the exchange floor] to jump in front of me.” The recent Oakford Corp. case, in which 9 brokers were convicted of front-running in more or less this fashion, suggests that the NYSE’s vaunted self-regulatory toughness is not what it’s cracked up to be. Indeed, a 10th broker, John D’Alessio, who had the charges dismissed against him, has now filed a $22 million lawsuit against the NYSE and several exchange executives, including chairman Richard Grasso. The suit alleges that the exchange leadership turned a blind eye to the traders’ activities, and “agreed among themselves and others to permit illegal trading.”
What’s more, the consistently high profit margins at such specialist firms as LaBranche & Co. and Spear, Leeds & Kellogg suggest that the liquidity they add to the market may not be as dependable as advertised. “For the past 22 years, LaBranche hasn’t had a losing quarter,” says Bradley. That includes the bear markets of the early 1980s, the crash of 1987, and the wild ride in the fall of 1998–periods during which specialists, who are obligated to buy and sell stocks in good markets or bad, could be expected to suffer along with everybody else. “To me, that’s prima facie evidence that I give up a ton going through a specialist,” says Bradley, who wants the same kind of control over his trades in the listed market as he gets through ECNs in the OTC market.
The electronic revolution is by no means confined to Wall Street. In fact, the Chicago futures exchanges are holding on for dear life, as electronic exchanges from Europe expand their operations in the United States. Both the Frankfurt-based Eurex exchange–owned by Deutsche Börse AG and the Swiss Exchange–and the London-based LIFFE exchange are rapidly deploying terminals in the United States. Electronic futures trading outfits, such as Marquette Partners and TransMarket Group, are staffing late- night shifts to trade all manner of new products on Eurex and other overseas markets.
Both the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange have invested in their own electronic trading platforms, but they are far behind the European bourses. And even striking alliances with them (the CBOT with Eurex, the Merc with LIFFE) may only delay a showdown in the near future. If Eurex, which recently surpassed the CBOT as the largest futures exchange in the world, decides to list a copycat contract of the CBOT’s flagship 30-year Treasury bond contract, the local floor traders’ days could be numbered in Chicago. In Europe, when futures contracts have traded simultaneously on an exchange floor and on an electronic network, the liquidity has rapidly migrated online.
Furthermore, the Chicago exchanges’ membership structure makes it difficult for them to prepare for competition in cyberspace. Like the NYSE and the NASD, both the CBOT and the Merc are trying to convert to a for-profit structure in order to remain competitive. The floor traders are hobbling the exchanges’ electronic-trading initiatives, and may simply milk the open outcry markets for as long as they can. If that continues, the trading pits of Chicago–the ultimate venues for open outcry auction trading in the world–could soon be looking for new tenants.
The options exchanges are facing the same competitive threat. The International Securities Exchange (ISE), co- founded by the former head of E*Trade, Bill Porter, intends to open for business in March. It will cherry-pick the best contracts from each of the four established options exchanges and offer them on an electronic platform. Meanwhile, Goldman, Sachs and the Chicago Stock Exchange, a regional exchange that trades NYSE-listed stocks, are also in discussions to launch an electronic options exchange.
The threat has finally lit a fire under an industry that for most of its 25 years has been characterized by large spreads, fat margins, and virtually no competition for listings. Last March, the largest options exchange, the Chicago Board of Options Exchange, preempted the launch of the ISE by cutting its transaction fees by more than 50 percent. And, under pressure from the SEC, the four options marts have finally started to compete for listings. Since November 1998, when the ISE announced its plans to trade the top 600 options, the proportion of those contracts offered by only one exchange has fallen from 63 percent to 23 percent. And according to the SEC’s Levitt, spreads on multiple-listed contracts examined by the commission have shrunk by up to 44 percent.
Opening Up The Clubs
Thanks to technology and the SEC’s order-handling rules, the U.S. equity markets have become far more efficient in the past three years. An annual survey by trading consultant Elkins/McSherry LLC found that total trading costs (comprising commissions, fees, and market- impact costs) fell in 1998 by 25 percent at the NYSE and 23 percent at Nasdaq. Investors in listed and OTC stocks saved about $11.8 billion in costs compared with the year before. But skeptics doubt the markets will develop as positively as the ECN proponents expect, without the active encouragement of the SEC. While competition may be driving down costs across the industry, it is also raising new issues, such as market fragmentation and the quality of execution prices for investors. With growing numbers of unlinked trading venues to choose from, the duty of brokers to provide customers with the “best execution” is getting harder to perform. “The ECNs are Neanderthals,” says Peake, who testified before Congress in 1975 on the question of developing a national market system. “They fragment the market. What’s needed is consolidation.”
The question is whether competition or regulation is the best way to get there. Most experts outside the SEC advocate the former. “The biggest thing on the SEC’s agenda should be to introduce competition and to get rid of rules that preclude it,” says Wallman. And while the traditional exchanges play up the dangers of order-flow fragmentation, the benefits to corporate issuers and investors of a competitive market in trade-execution services outweigh those concerns. “When the NYSE and NASD talk about the market fragmenting, they’re really saying they don’t like the competition,” says former SEC director of market regulation Richard Lindsey, who is now a senior managing director of The Bear Stearns Cos.
Based on his recent speeches, Arthur Levitt appears inclined to let competition, rather than regulation, determine market structure. Take, for example, the plans of both Nasdaq and the NYSE to convert to a for- profit ownership structure. Despite unsettled questions about the self-regulatory functions of the two exchanges, the SEC chairman has given his blessings to the plans. In the case of the NASD, whose board recently approved the spin-off of the Nasdaq exchange, the restructuring would enable the exchange–currently handicapped by the disparate interests of its membership–to compete more vigorously with the upstart ECNs. “It would allow Nasdaq to introduce new trading structures without having to lobby in Washington, D.C.,” says Benn Steil. In all likelihood, that would mean a Nasdaq central limit order book–the mother of all ECNs. It would instantly dwarf the competing order books of the nine ECNs now operating, and probably force an industry consolidation that would solve the issue of OTC market fragmentation.
Granted, the SEC’s reliance on competition to create a national market system was not particularly successful when it came to the ITS. But that was because the NYSE was allowed to use its self-regulatory authority and political clout to skew the playing field in its favor. Much, if not most, of that authority has led to rules designed to preserve the privileges of NYSE membership and keep business on the NYSE floor. The exchange argues that it is simply out to improve liquidity on the Big Board and ensure that investors get the best prices on trade executions. Sounds nice, but the argument is getting old for dealers and investors who can get faster and cheaper executions on alternative trading systems.
The NYSE is under pressure to scrap its more outrageously anticompetitive rules. Rule 390, for instance, prevents stocks listed before 1979 from being traded outside the ITS, though these include most of the companies in the Dow Jones Industrial Average. These are the most liquid stocks in the world, and thus perfect candidates for the order-driven market of an ECN. There will always be opportunities for market makers and specialists to capture the price spread on less- liquid stocks–just fewer of them. And the opportunities may dwindle further when the market converts to decimal pricing this summer, as spreads could shrink still more. With Levitt breathing down its neck, the NYSE has agreed to scrap Rule 390, a first step toward competition in the listed market.
The bigger issues, however, are opening up the ITS and scrapping the archaic rules that protect NYSE specialists and keep business on the exchange floor. With more-robust links to the ITS, ECNs would undoubtedly seize a much larger share of listed stock trades than they currently have.
As with Nasdaq, it is the NYSE’s game to lose. NYSE chairman Grasso has talked of setting up an ECN at the venerable exchange. Such a system could become the central electronic marketplace for listed stocks that investors are clamoring for. But Levitt should force the issue. If he’s serious about competition in the financial markets, the exchanges will no longer be able to hide behind their regulatory authority to thwart the ECNs. Only then will bonus time for Wall Street really be a cause for celebration on Main Street. S
Andrew Osterland is a senior editor at CFO.
BRAVE NEW MARKETS
When Robert Greber, former chairman and CEO of the Pacific Exchange, prepared to turn the key on the OptiMark electronic trading system in January 1999, expectations could not have been higher. Here was the future of securities trading: the biggest and baddest technology in the new world of automated trading platforms. For high-cost, floor-based exchanges, OptiMark was the dreaded black box, offering cheaper, faster, and, most important, anonymous and nondisclosed trade executions. “It’s a fantastic mousetrap,” says Prof. Junius Peake of the University of Northern Colorado, who is a small shareholder in the company.
Co-developed by Bill Lupien, the CEO of Instinet in the 1980s and a specialist on the Pacific Exchange before that, OptiMark was backed by such heavyweights as Merrill Lynch; Goldman, Sachs; and Dow Jones. Some exchanges, including the Pacific Exchange, the Chicago Board Options Exchange, and Nasdaq, deciding to seize the electronic bull by the horns, announced they would adopt the OptiMark system for their markets. Last October, Nasdaq gave investors the ability to buy and sell 10 large over-the- counter stocks on OptiMark, with the idea of adding more stocks to the system in the future. Jersey City, New Jerseybased OptiMark says it has signed up about half of the 200 largest institutional investors in the country and 60 broker-dealers to learn the system.
But so far, at least, the trading mousetrap of the future hasn’t lived up to its advance billing. Since the Pacific Exchange turned the system on, share volumes have been far less than expected. And while Nasdaq has offered OptiMark only since November, trading volumes on the network have been similarly weak.
Why? “It’s always difficult starting a new system and a new market,” says Richard Lindsey, a senior managing director of The Bear Stearns Cos. and a former SEC director of market regulation.
OptiMark is a trading system that comprises very sophisticated software running on very powerful IBM supercomputers. It assembles orders, and every 90 seconds it conducts an auction that matches buyers with sellers. OptiMark also allows investors to rank the desirability of different trading outcomes.
For example, a manager of a big mutual fund who wants to buy a block of 50,000 shares might be willing to buy the whole lot for $10 per share. If there is no counterparty willing to sell the block, however, the fund manager might prefer to purchase smaller lots of stock at different price levels. The OptiMark software allows investors to plot more-elaborate trading strategies without tipping their hands to the market.
This kind of service should be attractive to institutions that struggle to control the market-impact costs of managing large portfolios. So far, however, few have been willing to invest the time and effort to learn how to use it. And with little liquidity on the system, there isn’t much incentive to figure out trading strategies if the orders won’t get filled. “There’s a perception that it’s too complicated,” says Benn Steil, a securities expert at the Council on Foreign Relations, in New York.
But Steil insists that OptiMark is not difficult to master. And the ability to trade a large block of stock before any intermediary can see it is something large investors will ultimately have no choice but to use. “The buy-side trading desks are lazy, and they aren’t held accountable by the portfolio managers,” says Steil. “Eventually, they will be forced to learn it, or something else like it.” A.O.
BARBARIANS AT THE GATE
Equity trading used to be the virtually uncontested domain of the New York Stock Exchange and Nasdaq markets. But in the past three years, low-cost electronic communication networks (ECNs) have taken the industry by storm. At latest count, there were nine ECNs that automatically execute trades of listed and over-the-counter stocks. And as a group, they supply either the buy or sell side of an astounding 33 percent of Nasdaq trades. Given that as many as 140 broker-dealers have notified the Securities and Exchange Commission that they may each form some kind of ECN, the number could rise still further, despite the fact that most of these electronic upstarts have yet to make money.
The impact of the ECNs on the securities trading business is simple: lower costs for retail investors and institutions alike. ECNs have no membership dues and charge very low transaction fees to users of the network.
There’s nothing particularly innovative about ECNs. They are simple electronic order-matching systems that anonymously display the limit orders of their subscribers on the network. The new entrants, such as Island and Archipelago, are using essentially the same technology as Instinet, the first and largest ECN, which began electronically trading stock for institutions back in 1969. When bid and ask prices on an ECN match, a trade is automatically executed. Otherwise, the best unmatched bid and ask prices are displayed on the Nasdaq SelectNet system.
Currently, Nasdaq simply consolidates and displays the best bids and offers from the ECNs. It doesn’t provide information about the size of supply or demand for stocks at various prices from either the ECNs registered as broker-dealers with the NASD, or from the order books of market-making dealers. The order-handling rules passed by the SEC in 1997 force dealers to display limit orders that are as good as or better than their own quotes, but the full order books are still the privileged information of the dealers. Investors have clearly shown a preference for trading on the above- board, but anonymous, platforms of the ECNs.
The NYSE has, for the time being, retained most order flow in listed stocks because the ECNs (regulated as broker- dealers, not exchanges) have yet to gain access to the Intermarket Trading System (ITS)- -the computer network that connects the NYSE and the regional exchanges. Without a fast means of executing orders against those elsewhere in the listed markets, the ECNs have managed to grab only a small share of trading in the listed market, despite their huge cost advantage. Several ECNs, including Archipelago and Island ECN, have applied for exchange status with the SEC, and if they pass muster, they should get ITS access and provide much more vigorous competition in the listed market. Expect the NYSE and the regional exchange members of the ITS to battle that eventuality every step of the way. A.O.
The following are the nine ECNs’ market share of total Nasdaq trade volume in Q3 ’99.
- Instinet 9.4%
- Island ECN 7.8%
- RediBook 1.4%
- Archipelago 1.4%
- Tradebook 1.3%
- Brass Utility 1.0%
- Strike 0.3%
- NexTrade .03%
- Attain .03%
Source: Hambrecht & Quist LLC