Friday, April 29, 2005

The War of the Worlds.

In 1792, twenty-four brokers and merchants gathered on Wall Street to sign the Buttonwood Agreement. Thus was formed the New York Stock Exchange – and it hasn’t changed much! It has grown, of course, but consider this: standard parlance on the trading floor requires repeated use of the word “thou”. Even as virtually every stock market in the world has replaced human traders with computers that electronically-match buyers and sellers, the “Big Board” has clung to its archaic ways and doggedly protected its monopoly "specialist" system -- a testament to the enormous political clout of the roughly 480 "specialists" who referee trading.

Why, then, would NYSE CEO John Thain acquire electronic-trading company Archipelago Holdings Inc., and plan to take the merged company public? Does he really expect his stodgy specialists to co-exist with the Archipelago techies while under the transparent roof of a public company? If the trading floor’s days are numbered, can the NYSE realistically survive such creative destruction?

Disregarding the role of Goldman Sachs in the deal, there are a few obvious rationales for Mr. Thain’s action:

· Investors want faster, cheaper execution of their trades, and that has enabled electronic upstarts like Archipelago to quickly build formidable market positions against the NYSE and Nasdaq.

· In teaming with Archipelago, the NYSE will have an electronic-trading platform that will allow it to move into new lucrative markets, including trading options and other derivatives as well as bonds and Nasdaq-listed stocks.

· Next year a new SEC rule will remove longstanding protections extended to slow orders handled manually on the NYSE and give other exchanges a chance to handle them. This rule has forced the NYSE to speed up – Archipelago is its answer.

· By embracing electronics and seeking to go public, the NYSE is attempting to follow in the footsteps of other exchanges like the Chicago Mercantile Exchange, whose stock has soared after going public.

The media’s reaction is almost entirely positive. Even our GSB colleagues state in an earlier blog that “the overall synergy created (by the deal) is more than worth the risk” associated with merging such disparate companies. We agree that the NYSE’s transition to electronic-trading – in whatever form – is necessary due to changes in the competitive landscape. However, we also expect that Mr. Thain’s plan will lead to Wall Street’s version of “The Real World”, as contrasting personalities within the merged company battle wildly for supremacy, in plain view of the public. Here’s why:

· The culture clash: With 213 years of history, the not-for-profit NYSE is one of the oldest institutions in this country. The traders have their own culture and language, and several traders' families have been working there for generations. Yet, Mr. Thain is merging it with a company that was founded by techies in 1996 for institutional traders. Will everyone get along? When employees of Archipelago visited the NYSE in 2001 to suggest the two firms work together, "they looked at us as if we were lepers," says Jamie Selway. "They said they would never use our system."

· The management clash: The combined firm, to be called NYSE Group Inc., will have three co-presidents, including Mr. Thain, who is described as “bookish”, and Archipelago co-founder and CEO Jerry Putnam, who is a brash entrepreneur used to calling his own shots. Mr. Putnam is combative; two former Archipelago partners have filed separate suits against him, and he was previously fired by two trading firms due to disagreements with superiors. Will Mr. Thain and Mr. Putnam be productive together?

· The ownership clash: The NYSE will bring its 1,366 seat holders, which include many of Wall Street's largest firms as well as small businesses owned by families that for several generations have worked at the NYSE. Archipelago's holders are dominated by General Atlantic Partners, a 25-year-old private-equity firm that will maintain a roughly 6% position in the new NYSE Group. How will this diverse group of owners shake out? Which sub-groups will attempt to exert the most influence over the direction of the merged company?

· The knowledge clash: The merger of the floor-based exchange and the online exchange will require the reconciliation of two fundamentally different ways of quoting stock prices, matching orders and executing trades. There has been no explicit statement of whether the companies intend to offer the best of both worlds, or to merely supply a choice of worlds. Mr. Thain insists there will still be a role for the traders, as he envisions a “hybrid market” where investors can choose to have their orders filled quickly on an electronic system or manually on the NYSE floor. Think this through, however. Apparently, the NYSE Group will offer investors a choice between the traditional auction system and an electronic one. Mr. Thain is advocating that the market decide which branch of the new company survives, and to what extent !

Presumably this will all be sorted-out before the merged company goes public! Indeed, these two companies are very highly incompatible. Electronic trading is all about narrowing spreads, while specialist trading is all about making money on them. The revenue generation systems are therefore quite different, as are the individual incentives. Where are the synergies here? With three presidents it seems that the merged company will keep all of the corporate overhead of both companies, and there is very little in the merger that would seem to increase trading volumes, which is how both of the companies make money. Given the inherent lack of synergies, this merger seems to be a case of wishful thinking.

Mr. Thain says he wants the NYSE to be more electronic and to trade more than stocks; he wants to get into the business of trading options, exchange-traded funds and other derivatives. Acquiring Archipelago will perhaps provide the NYSE with a means of accomplishing these goals. In the meantime, you can be certain that this acquisition will provide a lot of fireworks!

Patrick Brickley, Lindsay Lowe and James (Nick) Smith,


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