Friday, April 29, 2005

Barbarians at the gates of the NYSE

On April 20, the venerable New York Stock Exchange announced a merge agreement with Archipelago, a company unknown to the general public, but well known to the NYSE. Archipelago started operations in 1997. Their goal: establish an electronic trade exchange that would avoid any human interaction in the process of trading securities. In 2001, Archipelago’s CEO Jerry Putnam offered the NYSE an opportunity to work together. The reply from the Big Board was a straightforward no: “We will never use your system”. So, what changed over the last four years to make this deal possible?

A monopolistic game. How do stock exchanges make money? They charge fees to the listing companies and to the people who trade the stocks. What do the final customers want? A fast, cheap and transparent transaction. In this sense, the product offered is basically a commodity. Why are there only a few exchanges in every country? It turns out that the shareholders of the exchanges are the very trading firms who require a platform, the stock exchange, to operate. Once a stock exchange is operating, the barriers to entry are significant: (1) the initial investment is huge, (2) the network effects are difficult to replicate: to sell a stock you need somebody to buy it, the more traders in an exchange, the more valuable it is to trade there.

Global competition. In the domestic markets, competition normally arises in a niche area due to some new financial need. For example, the major domestic competitor of the NYSE is NASDAQ. NASDAQ emerged as a trading platform for start-up companies that did not meet the requirements of NYSE.

Today, additional competition is coming from abroad. One main advantage of the NYSE was its access to financing in a deep market and in US dollars. With the emergence of the Euro area, there is an integrated financial market that can compete with the US in terms of depth and currency stability. Additionally, foreign stock exchanges with innovative products are trying to expand to other countries. For example, Deutsche Boerse has pushed into the U.S. by opening a derivatives exchange in Chicago. To make matters worse, the European exchanges have invested heavily in technology, while the NYSE continues to rely on floor trading.

Leadership change. Why now? The answer is twofold. First, the NYSE probably underestimated the potential threats of other exchanges: “Every company wants to be listed here. Why change?” would summarize their attitude. Second, the former Big Board chief, Dick Grasso, had been there for more than 35 years and was reticent of any change. Merrill Lynch, Goldman Sachs and Morgan Stanley tried to convince Mr Grasso to automate trading for the busiest stocks and were unsuccessful. Grasso’s successor, John Thain is more technically oriented having studied at MIT and managed operations at Goldman Sachs. Addressing the merger at a press conference he stated, “it is clear that we must do more.”

The movement by the NYSE has been followed by a rapid succession of reactions. NASDAQ announced days later intentions to merge with Instinet. On April 25, Mr. Langone a former director of the NYSE stated that the deal was not fair for the “seat owners” of the Big Board and started to meet other Wall Street financiers to put together an offer to buy the NYSE. And to give a conspiracy touch to the whole operation, some analysts highlight the invisible hand of Goldman Sachs: Goldman has interests in both the NYSE and Archipelago and advised both of them during the negotiations. A bad prelude for an institution trying to divest itself of unsavory behavior.

Analysis and Opinion

Four years ago when the NYSE, under Grasso’s leadership, rejected Archipielago’s technology they possibly thought they had an unbeatable positional advantage in the stock exchange industry. They also probably believed that only one leading market could survive in the US and that its company listings, trading volume and network of trading partners gave them an inimitable and unbeatable organization.

New technologies and the rise of alternate playgrounds (e.g. European Union) are changing the competitive rules of this industry. In years past, a company relied on the NYSE and its network to provide adequate financing. But today, as long as a company represents an interesting investment, it need not trade on the NYSE in order to achieve its financing goals. As transaction costs continue to drop, it may even be possible for a company in the future to switch to a new market whenever the need arises. This scenario represents a big threat to the NYSE supremacy.

On the other hand, it is possible that the NYSE is a unique organization with its network of floor traders that provides a superior value to it customers and partners. This vision suggests that NYSE listed companies will not be as well served in new, technically advanced exchanges. The fact that floor trading is not going away expresses managements opinion. Although this could be true in the short run, it is likely in the long run?

Our opinion is that the current positional advantage of the NYSE is only sustainable if they are able to maintain competitive quality (speed and transparency) and pricing (lower transactional costs) for their customers. If NYSE can leverage Archipelago's technology to support these goals, then their customers will be less likely to switch to other markets, thereby allowing NYSE to keep their positional advantage. If they cannot develop these capabilities through the synergies of the two companies, then the NYSE will gradually lose their leading position in the market.

While we cannot determine if the Archipielago deal is the best option for the NYSE, or whether floor trading is ready to change, this merger does look like a move in the right direction. One thing is clear: there is money to be made in the operation, and money is what only matters on Wall Street. The NYSE is right now under a take-over threat. The barbarians are pushing the gates. Will Mr Thain be ready?

Rafael Calderon, Jay Geiger, Joan Gelpi


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