Rethinking Wall Street

What do a for-profit NYSE and Nasdaq mean for investors?

Wall Street is in turmoil these days--and it has nothing to do with stock prices. The big bourses are changing radically and rapidly. Both the New York Stock Exchange and Nasdaq plan to convert to shareholder-owned, for-profit companies, the better to meet head-on competition from electronic trading systems. On Sept. 23, Securities & Exchange Commission Chairman Arthur Levitt Jr. laid out his vision: He urged the NYSE and Nasdaq to merge their regulators and to build a central "order book" to link investors when stocks are traded in different markets. Washington Correspondent Mike McNamee sorts out the equity markets' revolution:

Q: What's driving the changes on Wall Street?

A: Two things: regulation and technology. After a 1994 price-fixing scandal at Nasdaq, the SEC and the Justice Dept. forced the market to admit new competitors. That move, by a fluke of history, came just as an electronic revolution was exploding in stock-trading. Powerful networks are taking over functions once handled by legions of brokers. Buy stock through an online broker, and if the broker's computer finds a seller in an electronic communications network (ECN), your order will be executed with no human intervention, at a fraction of the previous cost. And computers never sleep--opening the way for trading before and after the traditional 9:30 a.m.-to-4 p.m market day.

Q: What caused this historical fluke?

A: Greed. Nasdaq market makers--dealers who drive trading by posting quotes for stocks--were caught on tape browbeating competitors to maintain wide spreads between the bid [buy] and ask [sell] prices. In the scandal's wake, the SEC in 1997 imposed new rules to dictate how dealers should handle customer orders. Dealers who receive so-called "limit orders" to buy or sell shares at specified prices can no longer ignore them. And the SEC created a new option: Dealers can route limit orders to nine ECNs, where orders can be matched automatically. Computerized trading at ECNs--especially Reuters Group PLC's Instinet Corp.--has also gained favor with institutions, which like the anonymity it provides their big orders.

The next step: The SEC decided in April that ECNs could become stock exchanges. Two--Island ECN, owned by Datek Online Holdings, and Archipelago Holdings, backed by an all-star roster of Wall Street firms--have applied.

Q: What has this meant for investors?

A: Lower prices, faster trades, better service, and more competition. Spreads on Nasdaq stocks have fallen by 30%, says the SEC. Online investing has taken off: "In the past year, more than 3 million new online brokerage accounts were opened, and the average commission cost of a retail stock trade dropped to $77," says Frank G. Zarb, CEO of National Association of Securities Dealers Inc., which owns Nasdaq. That's down from $125.

Traditional brokers like Merrill Lynch & Co. are slashing their prices to compete with online rivals. Americans who invest indirectly--through mutual funds, pensions, and insurers--will also reap big savings. "Right now, if I try to place a limit order to buy stock in New York, there are eight people between me and the seller," says Harold Bradley, senior vice-president of mutual-fund adviser American Century Investment Management. Electronics will also make it easier for U.S. markets to draw foreign issuers and investors.

But proliferating trading platforms also tend to fragment the market. If your limit order to buy a Nasdaq stock isn't the highest bid at a market maker or ECN, your order won't be revealed to traders elsewhere--so it might languish or never get filled.

Q: How have traditional markets responded?

A: Nasdaq and the NYSE didn't worry much about ECNs until their big members started taking an interest. "By investing in an ECN, we're getting the [bourses'] attention," says the chief equity trader for a big Wall Street firm that has taken a stake in Archipelago.

Indeed they have. NASD's board is expected on Oct. 7 to firm up plans to "demutualize"--converting Nasdaq from a member-owned collective to a shareholder-owned, for-profit exchange. After first pledging to take the Big Board public by Thanksgiving, NYSE CEO Richard A. Grasso now says he'll be selling NYSE shares sometime next year.

Q: What do the bourses gain by going public?

A: Flexibility, better relations with their members, and capital. Both markets suffer from cumbersome structures. NASD's membership is dominated by 5,000 small brokerages. The NYSE is ruled by 1,366 members, 63% of whom are absentee landlords leasing out their seats. The result, Grasso says, is "strategic gridlock"--a problem that nimble, for-profit ECNs don't face.

With stock to distribute, the markets can reward key players. Zarb says he'll give stock to big members so that ECN backers like Merrill Lynch and Goldman, Sachs & Co. will have a financial stake in bringing business back to Nasdaq. Both markets also face heavy capital demands to update their '70s-vintage electronic underpinnings.

Q: This is a sweeping change. Isn't it controversial?

A: Surprisingly, no. Not only do the NYSE and Nasdaq like the idea, but so do Republicans and Democrats. "There's clearly a consensus for demutualization," Senate Banking Committee Chairman Phil Gramm (R-Tex.) declared after a Sept. 28 hearing.

Q: Where has the SEC been?

A: Watching and waiting. Levitt wants to let markets set their own direction. But in his Sept. 23 speech, the SEC chief laid down some markers. To encourage innovation, he wants markets to vigorously compete for orders--rather than, say, allow the Big Board to enjoy exclusive trading in stocks of NYSE-listed companies. But competition has its limits: All markets must be linked, Levitt says, to ensure that investors get the best price on trades.

Q: How should the marketplace be regulated?

A: Since the SEC was formed in 1934, it has relied on exchanges and NASD to set their own trading rules, investigate customer complaints, and watch for market manipulation. That system has given the U.S. the world's cleanest markets. But can a market regulate itself when it's under pressure to deliver profits? Levitt is skeptical that exchanges' regulatory arms can function inside for-profit companies. "Strict corporate separation of the self-regulatory role from the marketplace it regulates is a minimum" in a for-profit exchange, Levitt says, adding that markets might also combine many supervisory jobs in one industrywide unit.

That's fine by Zarb, who is separating NASD's cops from Nasdaq and has long urged a "superregulator" merger for all markets. But Grasso disagrees. For the NYSE, he says, regulation is "an investment in our brand, building the confidence that inspires investors." Just as important, the NYSE's ability to audit big brokerages' books gives it leverage over Wall Street's powerhouses.

The regulation issue is shaping up as the key political fight of the markets' transformation. Levitt could hold up the NYSE's stock offer until it spins off its regulators. But several key lawmakers--including Gramm--are already lining up to back the Big Board.

Q: What will the shape of the future trading markets look like?

A: By breaking down exclusive franchises, the SEC hopes to promote competition between marketplaces. An investor could direct her order to buy stocks to an ECN for superfast execution. Or she could send it to the NYSE, where a floor trader might be willing to shave a few cents off the price per share. A mutual fund could spread its sell orders across several markets to avoid tipping its hand.

But competition invites fragmentation. To fulfill his goal of linking all markets, Levitt wants the bourses to create and share "limit order books"--electronic systems where limit orders from different markets can be shown. Investors in all markets could tap into these displays to ensure that they're getting the best prices.

The order book's design is critical. If every order has to go into a central book, the order book would supplant the separate markets. Result: Competition would wither. Nasdaq officials see that happening in Europe. SEC officials say they'll accept some inefficiency to preserve competition. So the SEC is likely to approve multiple order books specializing in different stocks. They'll also let ECNs continue to match orders internally. Nasdaq is expected to announce its own version of a central limit-order book by Oct. 7.

Q: Who will be the key players?

A: The NYSE and NASDAQ enjoy strong reputations and name recognition around the world. Both will remain central to the new markets.

Market analysts and SEC officials expect most of today's nine ECNs to consolidate or be swallowed by the major markets. Instinet, which commands 50% of the shares that trade on ECNs, is repositioning itself as a specialty broker for institutions rather than as an order-matching network. Island, with 20% of ECN volume, and Archipelago, with 8%, will thrive, thanks to strong links with brokers that send them lots of orders, says Octavio Marenzi of Meridien Research, a Newton (Mass.) technology consultant.

Q: How certain are all these reforms?

A: When change depends on the politics of stock exchanges, regulators, and Congress, nothing can be certain. Details of the new markets are still up for grabs. But stock trading's restructuring is being fueled by cheap electronic communications and steep global competition--forces that few businesses have been able to ignore. Stock exchanges aren't likely to be exceptions.