Thursday, December 08, 2005

The NYSE’s First Step to the Future

Traders Online: The stock dealers and institutional traders complete interactive news and information service of Traders Magazine: "The votes sealed the future of the last major floor-based stock exchange, as the NYSE and Archipelago will become electronic-savvy units of a new NYSE Group. The for-profit company will soon join the Chicago Mercantile Exchange and several others in the hot new investment sector of publicly traded marketplaces.

By increasing its value 10-fold since its December 2002 IPO – the first by a U.S. exchange — the CME has fired up a “next-Microsoft”-like frenzy among investors who are snatching any market that comes to Wall Street. Nasdaq, which will soon close its acquisition of Instinet’s INET ECN, trades at about 130 times earnings on the view that CEO Bob Greifeld has brought the once-endangered market back to life.

The emergence of a whole new publicly traded sector, such as exchanges, in the mature U.S. economy is a rare feast for investors. This usually stems from new technologies (remember the Internet mania?) or new regulations (it’s a little harder, but remember the SILECs or small incumbent local exchange carriers created by telecom deregulation?).

In the case of the exchanges, their transformation from dodgy utilities into profit-hungry businesses owes a bit to both: exchanges are belatedly embracing existing trading technologies while new regulations, chiefly the Securities and Exchange Commission’s Regulation NMS that only protects electronic quotes, tend to encourage virtual markets.

Add competition to the mix and the result is a sea change that goes way beyond the disappearing floors, the shareholders’ ownership and the profit-minded model. Historically, exchanges have provided the most efficient venue for faithful members to meet and trade. In an electronic world of connected, competing markets, the universe of potential customers is virtually unlimited, but no longer guaranteed.

For the NYSE, the prospect that it will have to fight for liquidity may be more daunting than learning how to simultaneously operate two new trading systems, the enhanced Direct+ hybrid and Archipelago’s continuous auto-execution ArcaEx platform.

Nasdaq learned the hard way that going from a cool monopoly that gets all the order flow to a competitive business chasing whimsical customers amid a price war can be taxing.

In a bid to maintain or regain their dominant role and beef up their technology, both Nasdaq and the NYSE opted to buy their rivals. With INET, Nasdaq will add market share and inherit a cost-efficient platform. With ArcaEx, the NYSE will acquire a high-performance trading system and tap a new segment of market participants whose computer-driven strategies require an electronic medium.

These acquisitions are wise moves but they won’t take the markets back to the old days when captive participants traded IT stocks on Nasdaq and blue chips on the Big Board. Consolidation is not the end of the story because it breeds fresh competition. Since the merger announcements, a new ECN, BATS, was born and regional exchanges are forging alliances with broker-dealers who fear that a “duopoly” would lead to higher trading costs.

Reg NMS itself paved the way for competitors to challenge the “duopolists,” because it requires brokers to execute against the best electronic quote, whether it is posted on an exchange or any alternative execution venue. According to some analysts, this could lower the NYSE’s market share in its own listings to 50 percent from about 75 percent soon after the June implementation of Reg NMS.

To address the looming issue of market share erosion, NYSE CEO John Thain has endorsed product diversification, from options to exchange-traded funds and debt.

It is not clear at this stage whether trading a lot of different products in one place is what customers need or want. The model has been tried by the regional exchanges without a roaring success and the NYSE once offered options but exited the business.

Unless a market is confident that it can offer the best quote in most securities, most of the time, there is no great benefit in offering a plethora of instruments. Electronic brokers that can offer broadband access to multiple products and exchanges and operate under the best-execution mandate are actually more likely to answer the demand for multi-asset trading with best results.

The futures markets, which enjoy the comfort of exclusive trading in their contracts, have followed a different business strategy that may provide a few hints to markets competing in the multiple-listing arena. To grow their business, they focused on attracting a more diversified customer base, not on offering more products to the same clients.

The CME, for instance, has reached out geographically, by installing trading hubs in a number of countries, and across customer groups, with initiatives such as the special membership for hedge funds.

The NYSE’s strategy will certainly be more complex than adding options trading. It may launch penny trading for options, a plan first formulated by the Pacific Exchange before it was acquired by Archipelago. Regardless of the products traded, ArcaEx’s role will be crucial when it comes to innovation because the electronic market will be able to reach out to new segments of market participants that the 213-year-old institution never dreamed of serving.

In their past incarnations, utilities-type exchanges were betting on their products, or listings, to be successful. In a competitive, for-profit environment, the winners may not be those who offer every product but those who offer their best products to the most customers through the best range of services."

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