When former Citigroup (C ) Co-Chairman John Reed assumes the helm of the New York Stock Exchange on Sept. 30, he'll have plenty of fires to put out. Investors are screaming for reforms in the way the NYSE manages its business. Powerful public pension funds that collectively oversee hundreds of billions of dollars -- and thus have huge clout -- have lodged protests over a system that paid just-departed Big Board chief Richard Grasso $140 million in current and deferred compensation, apparently without the full knowledge of the NYSE's bulky 27-member board. Reed has already announced that he'll push for a smaller, more independent board that will run a tighter ship.
That may not solve the most nagging problem the Big Board faces, however: the potential encroachment of a variety of electronic trading systems on the NYSE's turf. Perhaps the newest incarnation of these pretenders is the proposed Boston Options Exchange (known as BOX), which is currently seeking approval from the Securities & Exchange Commission to begin business. Why should BOX strike fear into the hearts of floor traders in New York? Because it has a computer program that's designed to replicate the auction process the Big Board has long touted as its primary and unique advantage.
Like the NYSE, BOX will expose offers to buy or sell a stock to a process called "price improvement." So, when an order is entered for the sale of an option at a set price, BOX will put that order out to an auction to see if anyone is willing to offer a better price. At the NYSE, this process takes place in the trading pit, the stereotypically chaotic den where traders vie to win better deals for their clients. That system distinguishes the NYSE from the NASDAQ and most other exchanges, which simply try to match offers between buyers and sellers with no negotiation and no attempt to improve the deal for either side.
MAN AND MACHINE.
The BOX version will have no pit and no floor traders. Instead, auctions will take place on computers -- "the first instance where the full auction process is replicated electronically," brags Ken Liebler, chairman of BOX's parent company, the Boston Stock Exchange, and a former president of the American Stock Exchange. What's more, "it could in theory work in the options or equities market," Liebler says.
The Big Board isn't exactly quaking at this prospect. "Technology isn't going to replace the function of humans in committing capital," says Robert McSweeney, senior vice-president for competitive positioning at the NYSE. And yet a vocal minority of the exchange's customers –- mostly big institutional investors, mutual funds, and hedge funds -- are frustrated with what they perceive as a technologically backward system that, in their view, caters more to the exchange's seat holders than to investors. Those disgruntled traders will be looking with interest at the BOX experiment once the SEC gives its blessing.
That's because BOX would be just the latest and most ambitious effort to rely on supercharged trading programs instead of people to match buyers and sellers. These already include regional options exchanges plus so-called electronic communications networks (ECNs) such as Reuters (RTRSY ) subsidiary Instinet and SunGuard (SDS ) subsidiary eBrut, as well as electronic exchanges such as ArcaEx. These volume-oriented transaction machines offer investors crystal-clear visibility into the trading process, speedy execution, the ability to buy and sell shares registered on both the NYSE and NASDAQ as well as other stock markets -- plus low, low trading commissions.
Investors also love the fact that several exchanges are competing to win their business -- and that the ability to switch from one ECN to another for order execution is no more than a mouse-click away. "My impression is that many brokers on Wall Street view the NYSE as a technical backwater compared with the NASDAQ," says Michael Kearns, a University of Pennsylvania computer-science professor who researches equities market dynamics and behavior. "The notion of the specialist -- the humans who manage the auction process -- introduces much less transparency," says Kearns.
That's because human agents often exercise subjective judgments in seeking out the best prices for customers. Specialists are allowed to buy and sell shares for their own account, ostensibly to keep order flows stable. But NYSE brokers often suspect specialists of trading on their own account not only to smooth out market ebbs and flows but also to profit through their advance knowledge of market action. The NYSE strongly prohibits this and has at least a dozen enforcement personnel on the floor at all times as well as a regulatory arm of 560 people to follow up on these types of allegations.
From a technology standpoint, the NYSE hasn't been standing still, of course. It says it has sunk $2.5 billion into upgrading its technology over the past decade to improve service for investors. The NYSE's DirectPlus system allows brokers to place orders for trades to be executed as quickly as possible with no floor involvement. And recently, it has introduced changes aimed at improving transparency in the trading process. For a variable fee the NYSE now offers data feeds that display all buy and sell offers on the books on any NYSE stock. This allows traders to see more deeply into market activity and make better trading choices.
Furthermore, the Big Board claims that its venerable auction process still gives both buyers and sellers better prices by allowing wiggle room for negotiatiation. Most important, the exchange claims, having so many traders in one place creates a fluid environment for buying and selling.
The ECNs see that as an advantage of the past, now that three of them plus the NASDAQ have created four separate trading pools that make liquidity crunches a distant memory. "Our clients aren't mom and pops in Albuquerque but sophisticated broker-dealers," says Andrew Goldman, executive vice-president for global marketing communications at Instinet. "Their level of sophistication has eliminated to a large extent the notion of fragmented national markets."
The ECN standard bearers also contend that the Big Board isn't top of the heap when it comes to executing orders quickly or at the best price for customers. "At the NYSE, you see a higher predominance of trades at worse prices for investors," says Chris Nagy, director of trading for broker-dealer Ameritrade (AMTD ) which has 3 million retail customers. Nagy also argues that NYSE trades often happen at prices other than what the customer requested. "Our clients say, 'I want the price I saw on the screen when I hit the sell button,'" Nagy says.
For now, the NYSE's human-centric approach continues to win out: The NASDAQ today executes less than 20% of trading volume in NASDAQ stocks (the rest takes place on ECNs or smaller regional exchanges). The NYSE, by contrast, still executes more than 80% of trading volume in Big Board-listed shares. "They have done a remarkable job of retaining that market share," says Nagy.
And no one expects the NYSE to shutter its trading floor any time soon, if ever. "As it stands today, 80% of NYSE trades never touch human hands," says Arthur Hogan, chief market analyst at Jeffries & Co., a Wall Street investment bank and broker-dealer that owns a floor-trading operation at the NYSE. "It's as close to a black box as you're going to get."
Still, Nagy and others question whether the NYSE can continue to hold onto such a high percentage of total volume as the leaner ECNs lead a race to the bottom on trading commissions. ECN eBrut, for example, uses only 58 employees to maintain a technology infrastructure that moves close to 200 million shares daily on average. By comparison, the NYSE uses 1,500 people to move 1.4 billion shares daily. Combine low overhead with low fees and fast execution of orders, and BOX and the ECNs could yet give the Big Board a run for its money.