A painting of the New York Stock Exchange in its heyday, depicting men buzzing around trading posts, hangs in the Jersey City office of William O’Brien. An inheritance from his father, it represents a way of life the Direct Edge Holdings LLC chief executive officer has spent a career helping to dismantle.
Now that Direct Edge has completed its merger with Bats Global Markets Inc., the combined company will vie with NYSE to be the biggest operator of U.S. stock exchanges, with both using computer servers instead of all those floor traders. Responding to a Twitter post last month that recalled an 1829 NYSE session that ended with no trading, the 43-year-old O’Brien wrote, “Trying to make this happen again real soon!”
Meant as a joke, the tweet still underscores the ferocity of competition between companies that operate in a space dominated by the Big Board for two centuries where yesterday 9.6 billion shares worth more than $429 billion traded. Buyers and sellers of U.S. stocks are now matched on more than 50 electronic venues, lowering costs and boosting speed for investors while increasing the need for exchanges to adapt to ever-changing demands from computerized traders.
“There’s certainly a psychological boost” that comes with having the biggest market share, O’Brien said in an interview Jan. 16, wearing his wedding band on his left hand and his University of Notre Dame class ring on the right. “Does it inherently change the value proposition? I’m not sure. We can’t rest on that.”
The portrait of the market in which O’Brien operates is harder to paint than it was in the era of his dad, who was born in 1936 and a Big Board member in the 1960s and 1970s. Instead of a landmark building on Wall Street with its own raw bar and barber, stock trades are matched in data centers with few windows tucked away in places like Secaucus, New Jersey, where palm-print scanners and other security measures await the few humans who enter.
Instead of people crowding around open-outcry pits, trading firms bunch computer servers around exchange machines in a process known as co-location. While clerks and pneumatic tubes once ferried order slips to floor traders, today fiber-optic networks and microwave transmissions connect the data centers of various exchanges in the suburbs of New York and Chicago. It’s all in an effort to shave microseconds from the time it takes to move information and be the first to trade on it.
The emergence of a challenger to the NYSE shows how much high-frequency trading has done to reshape the industry. Rule changes over the last 15 years opened the business to competition and spread trading across more than 50 electronic venues. Even as the regulations cut costs, they alarm some investors, who say the market has become too complicated, ripe for abuse and prone to malfunctions such as the “flash crash” of 2010, when the Dow Jones Industrial Average fell 998 points.
While the merger of Bats and Direct Edge reduces exchange owners, it won’t reduce the number of exchanges. They plan to keep operating all four of theirs, missing an opportunity to reduce fragmentation in the market, according to Dave Lauer, a consultant to Verdande Technology.
“Almost everyone wants some reduction in complexity and fragmentation,” said Lauer. “And when you have two pairs of venues with identical business models and very similar pricing structures, why wouldn’t you merge?”
Academics have scoured market data to determine if the proliferation of venues and automated, high-speed trading has improved markets. Most conclude it has, according to Charles M. Jones, professor at Columbia University.
“Every time there has been a market structure change that results in more HFT, liquidity and overall market quality have improved,” Jones wrote in a paper supported by a grant from hedge-fund manager Citadel LLC. “Based on the vast majority of the empirical work to date, HFT and automated, competing markets improve market liquidity, reduce trading costs, and make stock prices more efficient.”
Direct Edge is combining with Bats at a time when the HFT firms that helped spur their growth are making less money. Profits in the industry fell to as little as $810 million in 2012 from $4.9 billion in 2009, according to estimates from Rosenblatt Securities Inc. HFT was involved in about half of trade volume in 2012, the most recent data available, compared with 66 percent in 2009, according to the firm.
Exchanges, which profit when buyers are matched with sellers, are carving up a shrinking pie. Bloomberg LP, the parent of Bloomberg News, operates a venue called Tradebook. U.S. stock trading has declined 28 percent, from an average of 9.8 billion shares a day in 2009 to 7 billion this year, according to data compiled by Bloomberg.
As with many questions he’s asked, O’Brien had an analogy to explain what happened.
“The way to build a business or wealth in the United States from 1650 to 1900 was a lot different than from 1900 on,” O’Brien said. “You just keep going west, and you can’t do that anymore. The land grab era is over.”
Technology also has pushed the debate about market fairness off the exchange floor and onto the Internet for all to see, said O’Brien, who relinquished the CEO title to Bats’s Joe Ratterman after the merger closed yesterday as the Direct Edge brand is slowly phased out. O’Brien’s advocacy for the markets “lines up with our DNA and is why this merger is a natural fit,” Ratterman said in a Jan. 24 e-mailed statement.
O’Brien, who is staying on as president of Bats, often points to the past imperfections of the market to bolster his case that criticism of its current state is overblown.
“There were bad actors in 1980, there were bad actors in 1880,” he said. “We really haven’t had to change the rules of what conduct is not allowed because of the rise of automated trading. But there are certainly new ways to break the old rules. And we have to be better, continually strive to get better, to make sure that the way we surveil, the way we deter, detect and punish the bad guys, is done more effectively over time.”
One of O’Brien’s sparring partners on Twitter is Sal Arnuk, the co-founder of Themis Trading, a 10-person shop in Chatham, New Jersey. Arnuk and partner Joe Saluzzi are among the most vocal critics of today’s market structure.
“Our biggest beef is how complex modern markets have become,” Arnuk said in a Jan. 21 telephone interview. Money managers have “to expend energy and cost into making sure that they are interacting properly and policing what’s going on.”
On a snowy day in January, the Themis trader has heard enough of O’Brien’s comparisons between today and the past.
“Bill,” Arnuk tweeted to O’Brien, “have to get past comparing versus 1987. Bogus argument.” Instead, he asked, why will the combined Bats and Direct Edge need to maintain four different exchanges? “Why not consolidate?”
O’Brien responded with six tweets about how each exchange is more attractive to certain types of customers, how different fee structures create different “eco-systems.” The free market will decide how many exchanges are needed, according to O’Brien.
“Any exchange operator has to prove the unique value of each platform,” O’Brien wrote, “or it will die on the vine.”
As criticism of electronic trading and the diffusion of the market grew, O’Brien said he saw a void that needed to be filled in its defense. His efforts included having lunch with Ann-Christina Lange, a Copenhagen Business School assistant professor. She arrived at Direct Edge headquarters on Jan. 16 with typed pages of questions and a Danish accent.
Lange is investigating what role crowd psychology plays in high-frequency and algorithmic trading. She asked about the techniques being employed: Is psychology written into the computer algorithms? And exactly how intelligent are they? What does Direct Edge do to supervise their use?
“The best-developed algorithms really understand how markets and regulation and technology combine,” he tells Lange. “It’s simply the automation of a decision-making process. Still human-driven, but machine implemented.”
While Direct Edge monitors the market and shares data with the Financial Industry Regulatory Authority, he said the company doesn’t review or certify algorithms used by trading firms.
Lange asked about Direct Edge’s order types, including its “hide not slide” option, which automatically re-prices orders to avoid “locked markets” where bids equal offers to sell. How many order types does Direct Edge actually have?
O’Brien offered another analogy.
“Ask someone how many models of cars does Toyota have,” he replied. While they offer only a handful of basic models, some customers want a better radio, bigger tires, leather seats or racing stripes. “You do all those permutations, you could say, well, Toyota really has 26,000 cars. Right? No, they don’t. We have a handful of basic order types,” he says, with a lot of permutations.
Regulators have been interested in exactly what kind of racing stripes exchanges offer traders.
The Securities and Exchange Commission was examining whether order types were being abused, Daniel Hawke, head of the SEC’s market-abuse unit, said at an industry event almost two years ago. The commission looked at issues such as co-location of computers and rebates that venues pay to traders to spur transactions, he said.
No actions have been taken, and O’Brien said he’s not worried that the SEC will fine his firm over order types.
“If we’ve broken any rule we should be held accountable to it, but I believe we really strive very hard to act and be perceived as a model exchange,” he said. “We have an active dialog with them on tons of issues.”
O’Brien didn’t always expect to follow his father into the business. After graduating from Notre Dame in 1992, he went to law school at the University of Pennsylvania, joining Orrick, Herrington & Sutcliffe LLP in 1995. He worked for attorney Sam Miller, a former partner at Paine Webber who focused on broker dealers and market regulation. Miller counted Instinet, one of the original electronic trading networks, as a client.
A two-year stretch as an assistant general counsel at Goldman Sachs Group Inc. followed. O’Brien left Goldman to become general counsel and later chief operating officer at Brut LLC, another of the original electronic communication networks, or ECNs, that traded stocks.
“He produced a competence in market microstructure for us, and a presence in that area, whether it was commenting on the SEC’s regulatory work or just helping us,” said Richard Schenkman, the former Brut CEO who hired O’Brien. “An ECN is all about market structure and making markets more efficient for clients, and Bill was integral to that.”
NYSE and Nasdaq OMX Group Inc., scrambling to keep up with the market’s switch to electronic trading, began buying up the original ECNs.
Nasdaq bought Brut in 2004 and O’Brien joined the second-largest exchange operator, raising some eyebrows when he hung his painting of the NYSE floor. It was a good gig: an office on the 50th floor of One Liberty Plaza overlooking the Statue of Liberty, trips uptown for the bell rings at Nasdaq’s MarketSite in Times Square, and a chance to go to the World Economic Forum in Davos, Switzerland.
Then the second generation of ECNs starting to take off. Bats was established by Ratterman and Dave Cummings, a software expert turned day trader at the Kansas City Board of Trade who founded HFT firm Tradebot Systems Inc. In Jersey City, Knight Capital Group Inc. had entered the ECN business and wanted to spin its Direct Edge product out to a consortium of investors. The ECN was handling about 1 percent of market volume at the time, O’Brien recalls.
It was time for another of the “educated risks” in his career, O’Brien said. He left Nasdaq to become Direct Edge’s CEO in 2007. “What excited me the most was that I felt like we had the potential to break that oscillating wave of competition and consolidation,” he said.
One source of growth was embracing rather than fighting dark pools which, unlike traditional exchanges, match orders without listing bid and offer prices for the rest of the market to see. Direct Edge offered what O’Brien calls “one-stop shopping” by connecting his exchanges with the alternative trading venues.
Direct Edge’s market share began to inch higher, and last month its two exchanges accounted for more than 10 percent of all U.S. stock volume. The Bats venues claimed another 10 percent. Combined, the two will jockey for the top spot among U.S. exchanges with the three platforms run by NYSE and the three venues at Nasdaq. It’s been a tight race so far this year, with NYSE’s daily average market share equaling 20.58 percent versus 20.1 percent at Nasdaq, according to data compiled by Bloomberg. Added together, Bats and Direct Edge have captured 20.62 percent, just ahead of NYSE.
At the time of its purchase by IntercontinentalExchange Group Inc. in November, NYSE had more than 3,000 staff across its operations, including its listings business, technology units and Liffe, the operator of commodities and derivatives exchanges. Bats operates with about 160 employees while Direct Edge has about 135, according to O’Brien.
Direct Edge’s owners included some of Wall Street’s largest broker-dealers, while ICE and Nasdaq are publicly traded. Direct Edge stayed away from a meeting with the SEC last year at which executives from NYSE, Nasdaq and Bats highlighted the increase of trading in dark venues and presented a case about why that hurts the markets.
“Bill is extremely bright and very passionate about market structure issues, but the question is: To what degree is he swayed in his opinion by his ownership?” said Christopher Nagy, president of KOR Trading LLC. “Will this be the path taken by the new entity?”
KCG Holdings Inc., which was formed when Getco LLC bought Knight, as well as Goldman Sachs and Citadel each owned almost 20 percent of Direct Edge and JPMorgan Chase & Co. held 4.9 percent before the merger. All the firms operate at least one alternative trading system.
“The value proposition of exchanges and broker dealers overlap but only overlap a little,” O’Brien said. “We’re really not in the same business. We shouldn’t act like we are and we shouldn’t try to advocate for policy on the basis that we are.”
O’Brien said he will eventually pack up his office -- his dad’s picture, the autographed Notre Dame football, the Direct Edge-branded rugby ball and various industry totems that line a shelf behind his desk. Many of his team won’t be making the move with him across the Hudson River to the new offices in Manhattan, he said. He didn’t provide more details on the number of positions that will be eliminated.
Direct Edge’s exchanges, which run on Microsoft Corp.’s Windows operating system, will be moved to Bats’s Linux-run technology. The merged company will be headquartered in Bats’s home of Kansas.
“I go back to what I came here to do, which is build something that can endure,” O’Brien said. “And this transaction guarantees that. I feel like the combined company is really just getting started.”
O’Brien’s father died in 1996 at age 60, just as computers started competing with the exchange floor. The younger O’Brien said he believes his dad would have been in favor of the changes. He recalled him spending Saturdays on the porch of their Long Island home, crunching data by hand on legal pads in search of technical stock-chart patterns like Kondratiev and Elliott waves. Today, trading programs execute statistical-based strategies that, if written out, would fill the house with legal pads every day.
“I always viewed him to be a futurist,” O’Brien said.
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