Why the Bourses Are Spooked
Electronic rivals gain on the Big Board and NASDAQ
Once upon a time, the New York Stock Exchange traded big-company stocks on a central trading floor at its marble-colonnaded building overlooking Wall Street. Its rival, the NASDAQ stock market, traded small-company shares through an electronic dealer network. Until a few years ago, the two exchanges were happy within their distinct market structures, each of which thrived because they satisfied the capital-raising needs of different corporations.
No more. Frustrated by its inability to lure high-tech behemoths like Microsoft, Intel, and Dell away from NASDAQ, the NYSE for the first time is considering trading NASDAQ stocks. As first disclosed by The Wall Street Journal, the Big Board is searching for a partner to help it elbow into that fast-growing market and reclaim lost market share to electronic competition. NYSE CEO Richard A. Grasso is in talks with several networks, such as Reuters Group's Instinet, that the NYSE might acquire or ally with."EYE OF THE STORM." The Big Board's move could fundamentally change the business of trading equities. Now, once a company chooses which exchange its shares will trade on, competition between NASDAQ and NYSE ends. But in the future, the two will vie for investors' orders, which could trade in either market. The result: lower trading costs and better service.
As the two major markets overlap, some experts think they could one day merge outright. In fact, the dramatic flurry of events and unprecedented pressure for change could force the two into each other's arms as they scramble to hang on to their traditional market share. Trustbusters would look askance at any such deal, but the appearance of new electronic and foreign players could allay competitive fears.
For now, the heat is on. NASDAQ's parent fired the opening salvo last year when it broke into the NYSE's auction-style trading system by acquiring the American Stock Exchange to battle for listings against the NYSE. The rapid rise of alternative trading systems, fueled by orders from Internet brokers, has eroded both exchanges' market share. Next month, a Securities & Exchange Commission rule will allow these so-called electronic-communications networks (ECNs) to become full-fledged exchanges, paving the way for them to eat further into the exchanges' franchise. Another threat looms in Europe, where exchanges are consolidating and seeking listings from U.S. companies.
The Big Board is in the eye of the storm. "The NYSE is extraordinarily concerned about not getting left behind," says Pace University's William C.
Freund, a former NYSE chief economist. True, it has a powerful brand as the bourse of choice for blue-chip Corporate America. The market capitalization of all NYSE-listed firms is four times that of NASDAQ-traded companies. But New York's system, crowding some 5,000 floor brokers, specialists, and clerks onto one trading floor, is costly.
While New York has adopted many electronic innovations to speed up the flow of orders to the floor, it still lags behind NASDAQ and most overseas exchanges in technology. The majority of its voting members are floor traders or specialists who oppose changes that would reduce the number of human intermediaries or even ditch the floor altogether. And New York's stodgy image doesn't appeal to Silicon Valley, whose largest firms grew up on NASDAQ and are staying loyal.
But NASDAQ has its problems, too. Its parent, the National Association of Securities DealErs, waged a fierce internal battle to buy Amex so NASD could become a "market of markets," offering the dealer-based market as well as Amex's floor-based auction. But Amex continues to lose listings.
NASDAQ's core business is also getting squeezed. Regulatory changes have reduced the spread between buy and sell quotes--the basis on which the market's 500 or so dealers make their money. Dealers, in response, have blocked changes that could further erode their profits.
Meanwhile, each market is taking on the characteristics of the other. NYSE's automatic order-matching system now handLes 48% of shares traded. And the SEC's 1997 order-handling rules, which made NASDAQ more transparent by requiring dealers to display all their orders, made NASDAQ's screens more like the Big Board's broad tape. Not all like the trend. Alan L. Davidson, owner of Jericho (N.Y.)-based Zeus Securities Inc. and a NASD director, thinks NASDAQ should return to its roots as a market for small companies. Otherwise, he says, "If everybody wants to be in everybody's business, why do we need two markets?"GOOD-BYE, SPREADS? "It's a legitimate question," Grasso admits. He believes there should be one national market--so long as it's called the New York Stock Exchange--that competes against pan-European or Asian markets that already are making moves in the U.S. Indeed, Grasso has indicated to NASDAQ his interest in discussing a joint venture of some sort. NASD President Richard G. Ketchum denies merger talks, but says he's willing to consider combining the two exchanges' regulatory functions. "A merger of the two largest markets in the world is problematic," he adds.
Before any exchanges disappear, the markets are likely to see new entrants mushroom. The explosive growth of online trading, driven by investors seeking lowest-cost execution, has fueled the rise of ECNs that automatically match buyers and sellers. Online brokers use them because they dispense with costly intermediaries. Instinet, the oldest of the eight active ECNs, caters to big institutions seeking to trade anonymously. Others, such as Datek Online Holdings' Island ECN, serve retail investors.
With ECNs now handling some 20% of NASDAQ volume, they are robust enough that the SEC wants them to become real exchanges, or else post orders on an exchange so all investors can see them. Island intends to apply for exchange status so it can start trading NYSE shares. Says Island President Matthew Andresen: "We want New York to open up its monopoly to our system."
The NYSE knows it is under siege. When one ECN, Brass Utility LLC, approached Grasso a year ago to talk about a deal, the NYSE perked up. The ECN, owned by computer-services company SunGard Data Systems and four securities firms, explained that it was struggling with NASDAQ's evolution from a system in which dealers profit from the bid-ask spread to one that pays on commission. "It stimulated our thought process," says Grasso, who has since opened discussions with Instinet and Bloomberg Financial Markets' TradeBook. Grasso hints he's looking to buy an ECN rather than form an alliance.
How would an electronic network mesh with the NYSE floor? The Big Board seems interested only in the top 50 or so NASDAQ stocks: Internet low-profit highfliers like Amazon.com Inc. or eBay Inc. don't fit its profile. Grasso says the ECN--it would have a brand separate from the NYSE--would continue to match orders on NASDAQ stocks as it now does. But orders it can't match would go to an NYSE floor specialist, not to NASDAQ. And Grasso insists that this new system, which could start as early as this year, would give investors a cost break. How? Most likely by getting rid of spreads and paying dealers the razor-thin commissions ECNs collect.
NASDAQ vows to fight back. Ketchum insists he has the better market. But the NYSE will test the loyalty of NASDAQ dealers. One carrot both markets may employ to attract orders is rebating some of the tape revenue--the hundreds of millions of dollars in fees exchanges collect for making quotes available. Grasso denies he'll share tape revenue, while NASD figures sharing is inevitable.
New York's raid on NASDAQ could be rough on the securities industry. But it's welcome news at the SEC, which for years has tried to inject more competition into equity markets. Investors should be happy, too. The Big Board's move will redirect exchanges' rivalry away from attracting corporate listings and toward cutting trading costs. Finally, the Sleeping Beauty of exchanges, after slumbering through 200-plus years with only token competition, is waking up.By Paula Dwyer and Mike McNamee in WashingtonReturn to top