Monday, May 16, 2005

Trading the pit for the bit?

On April 20, 2005 the NYSE announced plans to merge with Archipelago Holdings Inc., an electronic trading company. After years of trying to fend off the competition from foreign exchanges and electronic trading platforms, the NYSE is finally moving into electronic trading itself. The move will transform the NYSE from a not for profit organization into a publicly held company and change the dynamics of the intensely competitive trading environment.

Since its inception in 1792, the NYSE has benefited from several technical innovations to become the center of global financial markets. The introduction of the telegraph for example, allowed investors to place orders from all over the US and tremendously increased the volume and hence liquidity of traded stocks. Both the Wall Street Journal and Businessweek see the merger as tectonic shift and giant leap forward in the business of operating stock markets.

In the old days, investors would initiate trades by calling the broker. That broker would call the trader who would work with a specialist on the trading floor of the NYSE to fill the order. This open-outcry auction still dominates the floor of the NYSE. With the developments in information technology, computer based systems can handle the matching of orders and close the trade faster, cheaper and with better execution quality.
In the past decade, a new breed of electronic exchanges has been giving the traditional exchanges a run for their money by quickly gaining significant market share. Several traders and analysts, including Michael Panzner, head trader at Rabo Securities, expect the manual trading system to disappear.

While electronic trading systems have been around for several decades and has changed the trading, the NYSE has been reluctant to adopt the technology. The protection of the SEC to slow orders handled manually has let the NYSE get away with its reluctance to change. But the SEC is pushing the NYSE towards more electronic trading and has recently adopted the Regulation National Market System, a set of rules that require orders to be filled at the best price immediately. The Big Board has to adapt or face imminent losses in market share or even the risk of being wiped out. For sure competition will be fierce. As a response to the NYSE and Archipelago merger, NASDAQ announced to buy Instinet.

NYSE Chief Executive John Thain, who recently joined NYSE after John Grasso’s ouster, is a driving force behind the acquisition. Thain tries to break the NYSE’s reluctance to change and its tradition of preserving its structure and trading floor. The resistance to change can still be sensed in press releases: The NYSE and Archipelago have said they want to keep both markets separate - Archipelago's electronic exchange and the NYSE's trading floor. However, investors and analysts expect much of the volume to quickly migrate to improved and cheaper electronic channels. With the integration of Archipelago Thain also tries to give the NYSE culture a more entrepreneurial dimension.

The merger also means that NYSE members will get more value for their seats by going public. Seat prices on the NYSE have dropped from their peak of $ 2.7 million in 1999 to $ 1.6 million. The prices have come under pressure not because of the technology bust but due to the immense pressure the NYSE faced with concerns about its future. The deal which values a seat on the NYSE at $ 1.76 million will satisfy members who have been demanding that NYSE go public in recent years. Given the success of the Chicago Mercantile Exchange going public, it seems like the seat holders at the NYSE are poised to gain from this deal.

Goldman Sachs, where Thain previously was a president, also plays a key role in the merger. The investment bank not only advises both the NYSE and Archipelago in the merger, it also has interests in both entities. Goldman owns 30% of Archipelago and is a seat holder at NYSE and operates a "specialist" stock-trading firm at the NYSE. In the merger Goldman seems to strengthen its position in the new trading platform.

Investors are expected to benefit from the merger. Large investors will have the option of using the technology infrastructure for the simple and large volume trades. At the same time, they will have access to the floors of the NYSE for the more complex one-off trades that cannot be fulfilled by other electronic trading platforms. In addition the electronic platform would mean these players have access to stocks and other instruments listed on other markets. Smaller investors will not directly benefit, although the transformation of the NYSE and consequently of the industry will translate into lower commissions for these smaller players and eventually access to a variety of products that they currently cannot deal in.

The proposed merger will also have ramifications locally on the Chicago Board of Trade, Chicago Mercantile Exchange and Chicago Board Options Exchange. Along with the advanced electronic trading capabilities that Archipelago will provide to the NYSE comes the ability to target financial futures and options trading. Transforming the NYSE into a public company will also give them the financial leverage to buy futures.
The Chicago Stock Exchange may even be hit the hardest by the proposed merger. Currently the CSE acts as a trading alternative to the higher priced NYSE and Archipelago trading system may make the CSE irrelevant. This merger is going to cause these exchanges to change they way they are doing business or quickly grow to match the NYSE size.

The merger will give the NYSE a leg up in the financial markets of the future where speed and quality of execution will be key. The adoption of technology will also serve as a platform to branch into other instruments like options, exchange traded funds and exotic derivative products. The deal will cement the NYSE’s position as the center of financial markets. In any case the trading industry dynamics are bound to change. Only time will tell how the exchange of the future will look like.

Steven Coulembier, Daniel Groner, Vinod Iyer


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