How America Ceded Capitalism’s Bastion to German Boerse Seizing Big Board
Richard A. Grasso can now reveal the secret ingredients.
The clam-juice cocktails at the private Stock Exchange Luncheon Club, where brokers lined up three deep at the raw bar, contained tomato juice, cooled water from boiled chowder clams, ketchup, celery salt and the option of a freshly shucked clam. Add vodka and they called it a Red Snapper.
“Everyone for years tried to duplicate it, and it was dead wrong,” said Grasso, 64, who started at the New York Stock Exchange as a clerk for $81 a week in 1968, a year after the NYSE first accepted a woman as a member.
The clam-juice cocktails are long gone, along with the club, which closed in 2006. So is Grasso, who quit in 2003 as chief executive officer amid furor over his $140 million compensation.
The NYSE’s domination of U.S. stock trading is gone, too. Once it handled 82 percent of the share volume involving companies it listed, with most of those deals done by brokers in colored smocks shouting orders on the exchange floor. Now the NYSE and a sister exchange’s shrunken 35 percent share of those transactions is executed mainly by computer servers stacked in a brick building in suburban Mahwah, New Jersey, about 33 miles (53 kilometers) from Wall Street. What mostly remains at the neoclassical Manhattan headquarters is a TV stage where business executives and celebrities such as Miss USA or Snooki from MTV’s “Jersey Shore” ring open and close trading sessions.
The Big Board most of the world knows has been reduced to a server farm and a bell.
Symbol of Capitalism
The 219-year-old symbol of American capitalism, now called NYSE Euronext, is about to complete a $9.42 billion merger with Deutsche Boerse AG (DB1) that will give the Frankfurt-based firm 60 percent of what would be the biggest exchange company in the world. The deal is the culmination of a decade of scandal, regulatory mandates and a technology arms race that opened the industry to electronic upstarts and forced the old Wall Street boys’ club to become an international company that makes most of its money from businesses other than stock trading.
“When I started in the business, Deutsche Boerse was open for two hours a day and the New York Stock Exchange was THE NEW YORK STOCK EXCHANGE,” said Thomas Caldwell, chief executive officer of Caldwell Securities Ltd., a money-management firm in Toronto, who has worked in the industry since 1965. “You just have to stop and say, ‘Wait a minute here -- Deutsche Boerse, New York, equal partners? How did that happen?’”
Over the years, trading has gotten cheaper and faster, benefiting investors. Buying 1,000 shares of AT&T before 1975 would have cost $800 in commissions, Charles Schwab, who founded discount brokerage Charles Schwab Corp., told the U.S. Senate in February 2000. That’s about 100 times more than the fees paid by some retail stock-pickers today.
Even so, many of those same investors abandoned equities after the Standard & Poor’s 500 Index, the benchmark measure of U.S. stocks, plummeted 6.2 percent in 20 minutes on May 6, 2010. Though the NYSE was the only exchange that didn’t have to cancel transactions after the so-called flash crash, the plunge created the perception that markets in general weren’t safe because high-frequency traders, who buy and sell in milliseconds, are beyond the reach of regulators and enjoy trading advantages on exchanges, said Joe Saluzzi, co-head of equities trading at Themis Trading LLC in Chatham, New Jersey.
“We have a two-tiered market,” Saluzzi said. “Some traders have information and speed, and the exchange caters to them because that’s where it makes its money.” The merger won’t change that formulation, he said.
The NYSE is required to allow all customers access to all services, said Richard C. Adamonis, a NYSE Euronext (NYX) spokesman. Other markets don’t have that requirement, he said.
The deal with Deutsche Boerse needs the approval of half the NYSE Euronext shareholders, who are scheduled to vote tomorrow, and three-fourths of the German firm’s stockholders, who will decide by July 13. The companies have wooed shareholders by agreeing to pay about 620 million euros ($895 million) in dividends.
“There’s this sentiment out there that we’re not what we were, and that’s right, we’re not,” NYSE Euronext CEO Duncan L. Niederauer, 51, a former co-head of equities trading for Goldman Sachs Group Inc., said in an interview. “The NYSE doesn’t want to be what it was. The game changed. We’re obliged to get into new services, new products, new asset classes, new regions. If we do that successfully, that’s a great story, not a sad story.”
Niederauer is slated to be CEO of the combined NYSE Euronext and Deutsche Boerse. Reto Francioni, the head of the German company, will be chairman.
New products, namely derivatives such as options and interest-rate swaps, are what Niederauer is counting on to revive a company whose stock has lost almost half its value since it started trading in March 2006. NYSE Liffe, Europe’s second-biggest derivatives market, will join Eurex, the biggest, owned by Deutsche Boerse.
After doubling each year from 2005 to 2007, NYSE Euronext’s operating income has since slowed, falling 32 percent in 2009 and growing 3.7 percent last year.
Combined, Liffe and Eurex may earn $1.18 billion in three years, according to data compiled by Bloomberg, Credit Suisse Group AG and Macquarie Group Ltd. Applying the average valuation of its three closest derivatives-market competitors would result in a business worth more than the combined companies before they agreed to merge -- and that’s leaving out their other operations.
The old NYSE ran with the help of a group of stock traders called specialists. In 2002, seven NYSE-designated firms, including LaBranche & Co., had the job of stepping in and trading stocks when there were imbalances between buy and sell orders so that ups and downs could be smoothed. Specialists were also required to hang back as long as NYSE customers could trade with one another.
LaBranche, created in January 1924, became the first independent specialist firm to sell shares to the public in August 1999. With their central role in trading and their access to market information, specialists were a closed and lucrative club.
In papers prepared for its initial public offering, LaBranche disclosed that it regularly turned about 71 percent of sales into profit before paying its managing directors. Earnings before that expense climbed at least 25 percent every year from 1995 through 1999, almost doubling in 1998. That year, 34 managing directors split a compensation pool that gave each of them an average of about $1.7 million, according to regulatory filings.
Technology and the government would undermine the specialists’ profitability.
In 2004, the U.S. Securities and Exchange Commission charged all seven specialists, including LaBranche, with making $158 million from trading when they didn’t need to step in and filling orders at levels that were inferior to the best prices. Specialist firms settled with the regulator for $247 million.
The U.S. government’s pursuit of criminal charges against 15 individual specialists for securities fraud went nowhere. Some were acquitted while others saw their charges dismissed. One jury conviction of a Fleet Specialist Inc. employee was overturned by a federal judge, who said prosecutors hadn’t proved fraud. The guilty pleas of two others were set aside.
No More Peeks
After the scandal, the specialists’ role at the NYSE declined as trading became more automated and rules changed. LaBranche never posted annual net income after 2006, and it sold its NYSE market-maker business to London-based Barclays Plc (BCS) in 2010 and the rest of the company to Cowen Group Inc. (COWN), a New York investment bank, in June.
The specialists have been replaced by “designated market makers,” who no longer see all the orders coming into the exchange and don’t have to wait until others trade, though they must continue to smooth order imbalances and maintain what the NYSE describes as fair and orderly markets.
Grasso, who became CEO in 1995, defended the specialists, running interference for them with the media and the government at the expense of investing in new technology to make its market faster, said Alfred R. Berkeley, president from 1996 to 2000 of Nasdaq Stock Market Inc., the NYSE’s biggest rival for corporate listings.
The decline of the traditional NYSE reflected “regulatory policy, nothing the exchange management did,” Grasso said.
The NYSE was a men’s-only club until 1967, a place where brokers could leave their dress shoes on the stairs leading to the trading floor after they changed into sneakers for the work day. It was a place where paper orders, crumpled and discarded, would pile so high that cleanup workers looked like they were shoveling snow.
Traders kept containers of talcum powder in their desks, said James Maguire Jr., 49, who first worked on the NYSE floor in 1979 as a college freshman on Christmas break. When famous visitors arrived, one trader would distract the celebrity or CEO and another would shake the talcum on their shoes. When New York Jets quarterback Richard Todd showed up in white shoes, they used cocoa, he said.
“It was good-natured fun,” said Maguire, who worked as a clerk, a broker and a specialist until 2004. “The idea was that you may be a big shot in the board room or in politics, but you’re on our turf. You’re one of the guys.”
The back-slapping extended to NYSE governance, according to a 2003 letter by William H. Donaldson, 80, chairman and CEO of the Big Board from 1990 to 1995, and chairman of the SEC, the exchange’s chief regulator, from 2003 to 2005.
Until 2003, the CEOs of 10 brokerages regulated by the NYSE sat on the exchange’s board, and half the NYSE’s 12 public directors, designated to protect investors’ interests, were presidents, CEOs or former CEOs of firms that traded on the exchange, such as JPMorgan Chase & Co. Chief Executive Officer William B. Harrison Jr.
The board allowed Grasso to pick the directors who set his compensation. One Grasso choice was Kenneth G. Langone, the co- founder of Home Depot Inc., who became chairman of the compensation committee. Grasso, in turn, sat on the board and compensation committee of Home Depot.
Grasso was hailed as a savior of Wall Street for his work to restore the NYSE following the terrorist attacks of Sept. 11, 2001, which halted U.S. equities trading for four days, the longest shutdown since 1933. When terrorists flew two hijacked jetliners into the World Trade Center’s twin towers, just blocks away, Grasso used the public-address system to urge staff and traders to remain calm.
“I saw their reaction to his voice, and I was impressed,” Bill Silver, a floor trader, said in an interview six days later. “He’s a respected authority there and they trusted his judgment.”
Grasso was “spectacular” in working to reopen the exchange, said Harvey L. Pitt, who at the time was chairman of the SEC.
“He called me the first thing every morning and the last thing every night, to check in with me, find out what I wanted, to offer suggestions,” Pitt said.
The attacks highlighted the vulnerabilities of concentrating so much of the U.S. equities market in one location.
The aftermath of the restoration also provided an early glimpse into the compensation issue that would result in Grasso’s ouster. He received a $5 million bonus in 2001, in part for his work in reopening the exchange.
$140 Million Package
Kurt Viermetz, a JPMorgan vice chairman at the time, praised Grasso at a dinner in June 2003 for his role in restoring the capital markets -- with one catch.
“For some, our American hero was a little overpaid,” Viermetz added.
Later in 2003, the NYSE board went further, awarding Grasso $140 million -- enough for almost 8,000 years of tuition at New York-based Pace University, where Grasso was given an honorary degree. As Grasso’s predecessor as CEO of the NYSE, Donaldson had received annual pay of about $2 million.
After he found out about Grasso’s compensation, which followed the specialist scandal, Donaldson, Pitt’s successor as SEC chairman, demanded an explanation. “Grasso’s pay package raises serious questions regarding the effectiveness of the NYSE’s current governance structure,” Donaldson wrote in a letter to the NYSE board.
“In my opinion, nobody did anything wrong except there were judgments made about compensation that people can debate,” Harrison, the former JPMorgan CEO, said in an interview. “A lot of people thought it was too much. Some people didn’t.” Harrison wouldn’t say which side he came down on.
Institutional investors trading on the NYSE, however, had few qualms about questioning the board for paying Grasso so much, and some called for Grasso to quit, which he did.
Grasso had previously lobbied the NYSE board to oust Donaldson, according to Charles Gasparino’s book, “King of the Club,” and “Donaldson had a long memory,” Pitt said. “This was his chance to get even.”
In an interview, Donaldson said there was nothing personal about his battle with Grasso over the pay package.
“It was a tough thing to do,” Donaldson said. “I felt this was a really bad situation, a self-regulatory agency was writing rules for corporate America and not having any guidelines for its own governance.”
Grasso’s compensation didn’t constitute a scandal, Langone said in an interview.
‘The Last Emperor’
“There was nothing illegal or criminal about it, or unethical, which is even better,” he said. “It was the members deciding how much Mr. Grasso was worth, and he was paid that amount of money. It was the members’ money. It wasn’t some charity.”
“Grasso was the one person who personified the institution, who knew everyone and knew where every body was buried,” said John C. Coffee, a securities professor at Columbia University’s law school in New York. “Dick Grasso was the last emperor.”
The Grasso compensation and specialists scandals reduced the NYSE’s political power and gave the Donaldson-led SEC more leverage to push through new rules that reshaped the U.S. stock markets, according to James Angel, a finance professor at the McDonough School of Business at Georgetown University in Washington.
Horse and Buggy
“You can’t have your monopoly and eat it, too,” Angel said. “In 2001 they were operating a horse-and-buggy market where humans screamed at humans. When you add the scandals, that led to a regulatory environment that made it easier for competitors to compete.”
In 2005, the SEC approved Regulation NMS, for national market system. The new rules were designed to drive down trading costs for investors and increase competition among exchanges, eroding the dominance of NYSE and Nasdaq’s exchanges by moving trading onto as many as 50 markets.
Reg NMS was the final nail in the coffin for the old New York Stock Exchange.
It altered and expanded the trade-through rule, which gave exchanges 30 seconds to fill orders sent by a rival. Critics said the rule led to delayed executions, cherry-picked orders and sometimes less-than-best prices for investors. Reg NMS gave a boost to faster electronic markets and increased competition for the NYSE. Prices on exchanges that weren’t fully electronic, like the NYSE at the time, could be ignored, the SEC said.
Bats, Direct Edge
Nasdaq, which had faced competition from electronic trading systems since at least the late 1990s, acquired the Inet electronic equity market in 2005 and consolidated U.S. equity trading onto the company’s platform within a year. The company had bought Brut, an early electronic communications network, or ECN, in 2004.
Since 2000, Bats Global Markets, based in Lenexa, Kansas, and Jersey City, New Jersey-based Direct Edge Holdings LLC, each of which now runs two stock exchanges, have grabbed 18 percent of a marketplace that used to be dominated by the NYSE.
The owner of the Big Board increased its commitment to electronic trading in 2005 when it announced it would buy Archipelago Holdings Inc., a Chicago-based electronic exchange operator.
Bloomberg LP, the parent company of Bloomberg News, operates Bloomberg Tradebook, an electronic trading system.
While all this market fragmentation drove trading costs down, it also has been blamed for the May 6, 2010, market free- fall. Between 2:40 p.m. and 3 p.m. New York time that day, a plunge in stock prices erased $862 billion of market value. Accenture Plc (ACN), a Dublin-based technology consulting firm, fell as low as a penny from about $41.
The decline was triggered partly by one firm’s trade in stock-index futures, according to a study released Oct. 1 by the SEC and the U.S. Commodity Futures Trading Commission. The trading algorithm employed by the firm, identified by two people with knowledge of the findings as Overland Park, Kansas-based Waddell & Reed Financial Inc. (WDR), sparked the rapid selling of stock futures because it took into account volume but not price or time, the report said.
Volume increased as high-frequency traders, who buy and sell based on split-second price movements, traded as stock futures fell, prompting the mutual fund to increase its sell orders to the market. Disparate rules across stock exchanges and delays in the dissemination of trading data, especially for companies listed on the Big Board, led to confusion in the equities market, the report said.
Creating a Vacuum
“What we learned is that there are so many venues that trade the same product and don’t have the same rules,” Grasso said. That created a “vacuum” on May 6, he said. “The institutional difference is profound.”
The flash crash highlighted a trade-off that continues. Buying and selling stocks is cheaper and faster, but can also be riskier.
“People sometimes feel that the computers are too much in control,” John A. Carey, a Boston-based money manager at Pioneer Investments, which oversees about $250 billion, said of exchanges in general. “In the old days, at least you had specialists on the floor who could get a sense of what was going on and could calm people down.”
Since the May 6 crash, the SEC has instituted so-called circuit breakers for some of the largest stocks and almost 350 exchange-traded funds. If a security drops 10 percent or more in five minutes, trading in those shares stops for five minutes. The SEC is in the process of altering the curbs to limit price moves instead of halting stocks.
Investors Yank Money
That didn’t stop the acceleration of investors fleeing equity markets that began with the collapse of confidence in credit markets following the Sept. 15, 2008, bankruptcy of Lehman Brothers Holdings Inc. (LEHMQ) Retail investors pulled $96.6 billion from U.S. stock funds between May and December 2010, even as the S&P 500 rose 6 percent, according to data from Washington-based Investment Company Institute and Bloomberg. That represented 2.3 percent of the 2010 year-end assets in U.S. equity funds, ICI data show.
At the same time, bond funds were gaining, with about $121 billion in inflows during the same period. It wasn’t until the start of 2011 that investors returned to stocks, adding $11.4 billion in January, the most in 20 months. They withdrew more than $5 billion in March and have taken money out every week of May and June, ICI data show.
Under John A. Thain, who was president of Goldman Sachs before he became NYSE CEO in January 2004, the exchange went public by completing its merger with Archipelago in March 2006, making multi-millionaires of the specialists and brokers who owned seats on the NYSE. Thirteen months later the company paid 9 billion euros for Euronext NV, which operated exchanges in Brussels, Lisbon, Paris and Amsterdam, where it was based, and the Liffe derivatives exchange.
Derivatives offer NYSE Euronext’s biggest operating margin and are an increasing share of the company’s profit. As late as the first quarter of 2009, NYSE Euronext said stock trading and listings made up 61 percent of net revenue. In the first quarter of 2011, that unit contributed 48 percent, while 35 percent came from derivatives trading and 17 percent from its technology division, according to a regulatory filing.
After the merger with Deutsche Boerse, the derivatives business would account for 37 percent of the combined company’s revenue, while stock trading and listings would shrink to 29 percent, the company said at an April shareholder meeting, citing 2010 pro forma data.
Changes have swept out the industry’s clubby atmosphere, said Berkeley, formerly of Nasdaq and now chairman of Pipeline Trading Systems LLC in New York.
“There were WASP cliques, Jewish cliques and Irish cliques when I came into the business in the early 1970s,” Berkeley said. “Technology blew that away. Technology doesn’t care what color you are. It cares how much you know.”
Technology has also made the NYSE floor “way quieter” than it used to be, said Maguire, who told the talcum-powder story.
“When I walk in now, there’s that absence of the buzz,” he said. “The business is still out there, but it’s being done by computers.”
Those computers are located in a high-security building on a neatly landscaped 28-acre (113,300 square meters) former quarry in Mahwah, a northern New Jersey crossroads just south of the New York state border. Everything there is big. Pipes 20 inches (51 centimeters) in diameter bring water to cool the computers. The 20 surge protectors that guard against power outages are each as big as a Hummer H4. Generators on hand in case the facility loses utility power can keep cranking electricity on their own.
Brokerages and high-speed trading firms can pay a basic fee of $8,000 a month to have their computer servers hooked up to the trading grid, where orders are executed, according to the NYSE Web site.
The landscape is very different from the one Dick Grasso left eight years ago.
“You know what? You never look back,” Grasso said, wearing a black suit with a pink tie and a 9/11 lapel pin depicting an American flag on a New York Police Department badge, during a recent interview. “The tape goes in one direction.” He thrust out his hand and moved it slowly, following an invisible stock ticker. “Remember that. It only goes in one direction.”
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