from: http://www.aci.net/kalliste/ Click Here: <A HREF="http://www.aci.net/kalliste/">The Home Page of J. Orlin Grabbe</A> ----- Digital Society The Battle for Efficient Stock Markets First we eliminate the regulators. FIVE years from now, the business of trading shares will look radically different. Many old stock exchanges will be gone. The sense of revolutionary change is palpable. Hardly a week goes by without a new share-trading system being launched, or one exchange proposing to marry another. Last month, the London Stock Exchange and Deutsche B�rse announced a merger, together with a joint venture with America�s Nasdaq, now the second-biggest stockmarket in the world. Nasdaq has also formed affiliations with stock exchanges in Japan, Hong Kong and Canada, among others. More recently, Nasdaq�s great rival, the New York Stock Exchange, said it was exploring the feasibility of a global equity market that would link exchanges in several countries, including France and Japan. The goal of these exchanges is being urged on them by investors and companies alike: a single 24-hour market in which the shares of the world�s biggest blue-chip firms can be traded cheaply and efficiently. Tens of billions of dollars are directly at stake; and the indirect amount is far greater, since equity trading affects investment returns, corporate control and even the whole shape of economies. More and more countries are acquiring the cult of equity, since they have decided that the process of people putting money into the stockmarket and companies taking it out is the best mechanism for allocating long-term capital within their economies. At the same time, the long bull market has brought prosperity to investors, traders�and exchanges. So why is the New York Stock Exchange, the biggest in the world, said to face extinction? The death of the Big Board has, admittedly, often been predicted, by The Economist among others. Doomsters always point to its traditional trading floor, crowded with noisily jostling people, and say that electronic exchanges must offer lower-cost trading. Many of America�s most glamorous �new-economy� companies, from Amazon and Oracle to Intel and Microsoft, have chosen not to be part of the NYSE�s blue-chip roster, listing on Nasdaq instead. The NYSE has, until recently, retained many restrictive rules and practices that have protected it from competition; as they are scrapped, it will become more vulnerable. And it has been very slow to forge alliances or joint ventures with overseas markets, risking remaining an essentially national operation in a rapidly globalising marketplace. The reason for most of these failings is that the NYSE has refused to adapt as markets have evolved. And the main reason for that is that it is under conflicting pressures from its customers and its members. Some big financial institutions are investing in rivals, such as online trading systems, collectively known as electronic communication networks (ECNs). These firms are actively considering shifting some trading away from the NYSE, partly to make more money for themselves. Resolving these conflicting interests has been made especially hard because, like most stock exchanges until recently, the NYSE is mutually owned and largely controlled by those squabbling financial firms. A planned sale of shares in the NYSE, which might have given it a more effective management and governance structure, has been put on indefinite hold. Big Board blues Richard Grasso, the NYSE�s chief executive, is not complacent about the exchange�s current prosperity. He concedes that the Big Board is vulnerable, a fact he puts down to big strategic mistakes that it has made in the past. But he insists that these do not include the decision to keep the floor. Most other exchanges have, admittedly, scrapped their floors; no new stockmarket has replicated the NYSE�s people-oriented trading structure. And the Big Board�s plans to build a new floor across the street in lower Manhattan seem to have come unstuck�leading some to speculate that the floor may yet be allowed to die. Mr Grasso himself admits only to a concern that the visual image of the floor may not send the right message in today�s cyberworld, however good it looks on television. He recalls how, two decades ago, Seymour Cray, father of the supercomputer, suggested that the exchange should cover its floor with another, visible to the public, occupied by computers and serious-looking people in white lab-coats. Yet Cray still wanted shares in his company traded on the floor. And Mr Grasso is adamant that it is the floor, which hosts the exchange�s trading specialists, who make markets in particular shares, that makes the NYSE the most efficient trading system in the world�albeit one, he stresses, that is augmented by billions of dollars� worth of new technology. So what does he think were the NYSE�s mistakes? One was its lengthy ban on initial public offerings, lifted only in 1984, which helped Nasdaq. The Nasdaq market quickly became known as the place where America�s promising growth companies went to raise equity. (Mr Grasso jokes that, to secure Microsoft�s listing, he would be willing to walk across America from New York to Redmond, Washington.) The recent removal of rule 500, which made it hard for NYSE-listed firms to switch to other exchanges, might now increase Nasdaq�s threat. But the mistake Mr Grasso thinks may have cost the NYSE most has been its failure to recognise that its greatest assets are its data. The exchange gets a mere $130m a year from selling its tape of share prices to outsiders, who then reconfigure the information and sell it on, earning, by some estimates, over $20 billion. Imagine, says Mr Grasso, if the NYSE had capitalised on this data: it would have so much money coming in that it could let people and companies trade and list free, creating even more data to sell. He intends to make up for lost time: �We are in the data and media business.� This is an interesting way to look both at the NYSE�s predicament and its opportunities. Indeed, Mr Grasso claims, somewhat extravagantly, that the real threats to the NYSE do not come from Nasdaq, from foreign exchanges or even from the new ECNs, but from e-commerce firms such as eBay or Yahoo! that have become experts at data mining and manipulation. The exchange wants to regain ownership of its share-price data by withdrawing from the Consolidated Tape Association, a mutual organisation run by all America�s regulated exchanges, which sells their combined data. It is also looking for new ways to make money out of other data that it collects, including its �limit order book�, which includes all as-yet-uncompleted orders to buy or sell at a pre-specified price, and which is now available only to the floor specialists. Is the price right? Information is indeed what a stock exchange really deals in. When most investors come to the market, the first thing they want is the answer to a simple question: what is the share price? And much of the current battle over share trading is about how that question is answered. Every investor wants what the NYSE says it provides: �best price�. That is an ambiguous phrase, but it means, among other things, that the price should be as tight as possible. Traditionally shares in America have been priced in fractions, currently sixteenths of a dollar. This is hardly tight, which is why the Securities and Exchange Commission (SEC) wants both the NYSE and Nasdaq to move to price to two decimal places, starting this September. Some ECNs already trade in decimals. Best price also means a price that genuinely includes the choices of all buyers and sellers. In America, buyers and sellers on the NYSE are connected to their counterparts trading NYSE-listed shares on regional exchanges, such as the Pacific Exchange, by the Intermarket Trading System (ITS). This probably results in better pricing than for the nearly one in ten NYSE-listed shares that are traded outside the ITS in the fast-growing �third market�, made up of firms such as Knight Primark or Madoff Securities which are not members of the NYSE. Such third-market firms sometimes even pay brokers to send them their customers� orders, a practice that makes it seem less likely still that they will get the best possible price. On the other hand, the ITS is slow to integrate prices off the NYSE, which may mean that its prices are not in fact �best�. Indeed, the Big Board wants the ITS to be scrapped. It argues that this would improve the quality of the NYSE�s prices by removing a cross-subsidy (free use of price data) to regional exchanges, without which some would go bust, leading to more trading in New York. Whether regulators would need to impose a replacement for the ITS has become a big debate. The SEC is consulting on proposals to create a system that would integrate trading information from America�s separate exchanges. But critics of this plan reckon that it would stop market forces and competition among exchanges from producing the most efficient solution. As well as being offered best prices, investors also want to know that they will be able to trade at those prices: �instant execution�, in the jargon. But there is typically a delay of several seconds between an order being sent electronically to the NYSE and its execution. ECNs such as Island and Instinet claim to have no delay at all. Retail stockbrokers such as Merrill Lynch and Charles Schwab reckon that most of their customers would rather have instant execution than the small possibility that they might get a better price on the NYSE. Investors also want to know how many shares a price is good for: that is, how deep and liquid the market is. This is a big worry for institutional investors, which spend much time and money trying to minimise the risk that prices will move against them when they do a large trade (�price deterioration�, in the jargon). This is why ECNs, only a year ago regarded as a huge threat to stock exchanges, have often failed to live up to expectations. Their prices have no depth, because they have little inventory. But the scrapping of another of the NYSE�s restrictive regulations, rule 390, which banned the trading of listed shares in any other market, may give the ECNs a chance to do better. How does the NYSE perform on liquidity? Currently, 90% of orders of 10,000 shares or more go through the Big Board, which suggests that it is a deeper market than any of its rivals. This also explains the paradoxical conclusion contained in a study of 100 large institutional traders conducted by Plexus, a research firm. This study found that, despite much bigger commissions on the NYSE than on Nasdaq, the total cost of a trade (ie, combining commissions with price deterioration) is on average one-third lower. Others dispute these findings; and the Big Board�s cost advantage has anyway declined since 1997, partly because Nasdaq has become cheaper thanks to new rules for handling orders, and partly because the liquidity of the NYSE has itself diminished. Waiting in line Big investors have a different complaint: that, because all orders on the NYSE go to a single specialist, other investors can take advantage of a big transaction before the order is completely filled. This increases price deterioration for large traders. They want strict time priority, meaning first come, first served. The NYSE says it plans to introduce strict time priority soon. Institutions are seeking alternatives such as crossing trades among themselves�a big reason for the growing popularity of crossing networks. To disguise big orders, Fidelity also uses hundreds of brokers and anonymous trading systems to execute trades in small parcels. The fact that a specialist on the NYSE floor has sole access to the exchange�s limit-order book gives him highly valuable information about the supply and demand for a share. This knowledge is probably the main source of the specialist�s profits. As part of realising its destiny as a data company, the NYSE says it will scrap this monopoly on information by opening up the limit-order book to the public. If it does this, which would not be easy, it would make the market far more transparent. But in doing so, it risks sacrificing the people who are said to have made the NYSE what it is: the specialists. Specialists do two main things. They aggregate buy and sell orders for a particular stock. And they intervene in the market, buying or selling to reduce price volatility: in other words, they provide liquidity. The first of these functions could easily be done by a computer, or a series of linked computers. Whether the second can also be replicated cheaply may decide the specialists� fate. Liquidity is, after all, the NYSE�s main competitive advantage. Yet it is not clear that this liquidity is due to the existence of specialists. People like to trade where they know other traders congregate. Once an exchange has a certain amount of liquidity, it is likely to attract more trading volume, even if there are more efficient, but less liquid, alternatives. This is why many economists, including Alan Greenspan, the Fed chairman, argue that stock exchanges tend towards natural monopoly. Liquid assets The NYSE may, in short, be the most liquid exchange simply because it is the biggest. On the other hand, some financial institutions are so big that it would take only one or two (a Vanguard or Fidelity, say) to switch to an alternative venue to do serious damage to the Big Board�s liquidity. As one of America�s top regulators privately admits, the NYSE could lose 30% of its volume overnight, and may soon do just that�and its dominant position, once lost, might never be regained. Without the economies of scale that the NYSE reaps, its overheads would soon turn it into a decidedly high-cost provider. Even rivals to the NYSE acknowledge that only a very few shares (perhaps 50-100 firms) are truly liquid, meaning that volumes are so vast that there is never any difficulty in trading. In almost all cases, at least some of the time an intermediary is needed to provide liquidity by putting his own capital at risk by taking the other side of a customer�s trade. On the NYSE, the specialist�s monopoly position in seeing the limit-order book is granted in return for the responsibility, at least in theory, of ensuring a liquid market in a share. Would changing to a competitive system of liquidity provision by opening up the limit-order book to all result in better prices�or, instead, put the specialists out of business, so that nobody guarantees liquidity? Competition might be a better bet than monopoly�though efforts to extend trading in NYSE shares after normal trading hours have produced poor prices, as Mr Grasso points out. The absence of specialists from after-hours trading is one possible explanation. There are no specialists on the Nasdaq stock exchange. For the largest Nasdaq companies, such as Microsoft or Intel, the market is as liquid as for any NYSE share. For the rest prices are not quite as good, though they have improved considerably since order-handling rules were changed in 1997 after an antitrust investigation. For a sophisticated Wall Street firm, there is far more potential for profit in exploiting pricing disparities in a thinly traded Nasdaq stock than in shares traded on the NYSE. As an illustration, Merrill Lynch last week bought Herzog Heine Geduld, a market-maker with 8% of Nasdaq volume, for around $1 billion. By contrast, LaBranche, the largest specialist firm on the NYSE, with a 14% share of trading volume, has a stockmarket capitalisation of around $850m. Merrill�s purchase highlights another trend. Retail stockbrokers, most notably Charles Schwab, are increasingly looking to �internalise� by using their own market-makers to execute buy and sell orders from their own customers, without exposing them to the outside market and the chance of a better price. But this can benefit the brokerage at the expense of its customers. Some Wall Streeters think that Merrill may soon use Herzog to internalise orders for NYSE-listed shares, shifting lots of trading volume off the floor and badly hurting the exchange. Schwab is a big consumer of NYSE data. It stands to be one of the big losers if the NYSE can charge what the market will bear. If the Big Board does start to make more of its data, however, the users of the NYSE, whose orders are creating those data, might themselves want to be compensated. Sorting this question out should keep all concerned busy for many years. The urge to merge If there is life yet in the floor, the specialist system and the NYSE�s data�and these are all big ifs�what about its other big failing: the lack of a global strategy? Of late, the biggest news in exchanges has been not about floors versus screens but about international partnerships and mergers. But until its recent announcement of a vague linkage with several foreign exchanges, the NYSE seemed to have been left out of a powerful wave of international consolidation. Even now it is debatable how involved it really is. Alliances and mergers have never been much in favour at the Big Board. A few weeks ago, it was rumoured to be talking to its arch-rival, Nasdaq, about a merger; but the talks seem to have come to nothing. The mergers have been guided by the idea that technology overrides geography. If there is no longer a stock-exchange floor, nobody really cares where the matching and execution of orders takes place. A buyer could be in Frankfurt and a seller in Memphis. So maintaining separate trading operations in lots of exchanges represents hugely expensive, wasteful duplication. Rival ECNs, such as Instinet and Tradepoint, anyway threaten to make the old exchanges obsolete. The NYSE�s response to globalisation has been to seek to bring the mountain to Mohammed. �We aim to be the number two market for every major non-US stock,� says Mr Grasso. There are now 400 foreign firms listed on the Big Board. For a few firms, notably some from Latin America, the NYSE accounts for the largest part of the global trading volume in their shares. Unlike merging, which is fraught with business and human dangers at the best of times, this strategy of attracting foreign listings depends on doing what the NYSE should be doing anyway, but has done only slowly: providing liquidity, lowering costs, delivering best prices and extracting value from its data. But as the marketplace globalises, it is surely not going to be enough. The only way in which it might work is if all the world�s biggest companies were to come to the Big Board (and hence submit themselves to American accounting standards, as well as to SEC regulation). There is little chance of that happening. What is much more likely is that the big blue chips will hope to benefit from a network of stock exchanges, old or new, that can deliver global trading. By seeking now to link up with the French, Japanese and others, the NYSE is implicitly recognising this. But its cultural resistance both to change and to alliances may still prove a big obstacle. In the end, ironically, it may not be only its dogged adherence to a trading floor or its system of specialists that knocks the NYSE off its perch as the world�s leading exchange; it may be that it gets left behind by the rush to create an integrated world marketplace. The Economist, June 17-23, 2000 ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, All My Relations. Omnia Bona Bonis, Adieu, Adios, Aloha. Amen. Roads End <A HREF="http://www.ctrl.org/">www.ctrl.org</A> DECLARATION & DISCLAIMER ========== CTRL is a discussion & informational exchange list. Proselytizing propagandic screeds are unwelcomed. Substance�not soap-boxing�please! These are sordid matters and 'conspiracy theory'�with its many half-truths, misdirections and outright frauds�is used politically by different groups with major and minor effects spread throughout the spectrum of time and thought. 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