The NYSE: A Thousand Cuts

ECNs, regional exchanges, brokerages -- they're all taking a piece of the Big Board

After the New York Stock Exchange ousted Chairman and Chief Executive Richard A. Grasso on Sept. 17, it didn't take long for business to heat up at the stock-trading venue Liquidnet. As founder Seth Merrin puts it, institutional traders suddenly felt freer to bypass the Big Board and kick business his way with Grasso no longer around to hassle them. Since then, the three-year-old New York firm, which matches buyers and sellers via the Internet, has more than tripled its volume. Says Merrin about the NYSE: "Just because you own 80% of the trading volume now, doesn't mean you are going to keep it."

Could this be the Big Board's Waterloo? Without Grasso's hardball tactics to discourage traders from going elsewhere, players from tiny Liquidnet to Street mainstays such as Charles Schwab (SCH ), Fidelity Investments, and Citigroup (C ) are starting to eat the NYSE's lunch. Large institutions, unhappy with the lack of anonymity, speed, and sometimes honesty of the NYSE's human specialists, are sending more trades to electronic alternatives. And brokerage firms, less shy about angering the NYSE's brass, are boosting their profits by matching trades from customers in-house. "Under Dick Grasso, the NYSE's power to regulate was used as a competitive weapon," says Jerry Putnam, CEO of electronic exchange Archipelago, where trading volume has jumped by a third post-Grasso. "The old regime used to threaten fines and intimidate members to maintain market share."

Thanks to Grasso's chronic obsession with market-share statistics -- he pored over the previous day's figures for the top 100 NYSE-listed stocks before the market opened each day -- the NYSE's share of trading in its own listed stocks rarely dipped below 80%. But since he left, it has been below that for three months. "The furor over Grasso's compensation, combined with allegations of wrongdoing by specialists, has forced a rethinking of how investors get their trading done," says Rob Hegarty, a securities and investment research consultant at TowerGroup. "This is a watershed."

So priority No. 1 for John A. Thain -- the Big Board's new chief executive, who took over on Jan. 15 -- is to stop the bleeding. That's easier said than done: It could be difficult for the NYSE to win back the customers who used the four-month interregnum to shift business elsewhere, then found they like the cost savings and efficiency. Some customers are switching to rivals such as Archipelago, which began trading NYSE-listed shares in 2002. ArcaEx, as it is called, is a former electronic communications network, or ECN, that became an exchange after it acquired the equity-trading business of San Francisco's Pacific Exchange. It's owned by Wall Street heavyweights Merrill Lynch (MER ), J.P. Morgan Chase (JPM ), Lehman Brothers (LEH ), and others.

Like the NYSE, archrival NASDAQ has faced the same pressure from upstart rivals -- and suffered. It has lost 80% of the trading in its listed stocks, mostly since the Securities & Exchange Commission opened it up to competition in 1997.

But the chief problem for Thain, who declined to be interviewed before he took office, may be that the biggest players are simply trading NYSE stocks off the exchange floor. Brokers such as Schwab and Fidelity are sidestepping the floor and matching buy and sell orders from their own customers. That is a serious threat to the NYSE: In the fourth quarter of 2003, Schwab was the biggest trader in NASDAQ stocks, thanks to its in-house dealing. "When you go to the NYSE, it can take a considerable amount of time, even if it's done electronically," says Larry Leibowitz, co-head of equities at Schwab SoundView Capital Markets (SCH ) in Jersey City. "We can get a better price for our customers internalizing the trade."

Another big blow to the Big Board, at least in terms of public relations, is the Jan. 12 announcement that, for the first time, six NYSE-listed companies will add a second listing at NASDAQ. Already, Hewlett-Packard (HPQ ), Walgreen (WAG ), and Countrywide Financial have signed up, and NASDAQ is going after others, such as American International Group (AIG ). Robert Greifeld, NASDAQ'S president and CEO, says the new climate will be defined by multiple players. "What is irrefutable is that monopolistic structures, where trading is pushed through a single intermediary, are not viable long-term," he says. Corporate America agrees. "I think our move will open the floodgates for more companies," says HP spokesman Brian Humphries. "A tier-one company tends to get people's attention." Merrill Lynch & Co. analyst Colin Clark adds that "it's one more strike against the NYSE in the battle for market share."

For now, the pack of competitors nipping at the Big Board's heels is inflicting only minor cuts and scratches. The 211-year-old NYSE is still the dominant player, but the move to the exits could quickly turn into a stampede. Regulators are taking a hard look at the so-called trade-through rule, which critics argue protects the NYSE's turf artificially. The rule requires traders to route orders to the market offering the best price, which is frequently the NYSE. However, because trading on the NYSE is so much slower than on ECNs, often the best price is gone by the time the order is filled. "You can have the best electronic system, but the trade-through rule doesn't allow you to use it," says John J. Wheeler, senior manager for equity trading at American Century Investments in Kansas City, Mo., which manages $89 billion.

Wheeler and others are sure the specialists' days are numbered. "They're going to have to let go of the human-based auction market and replace it with machines," he says. "There's a growing understanding in our industry of what is actually going on down on the floor, and it isn't pretty." On Jan. 8, Merrill's Clark downgraded the No. 1 specialist firm, LaBranche & Co., to a sell. He says that if the NYSE moves toward an electronic order book, that would hurt specialists, who earn 80% of their profits by handling large, liquid stocks that are more easily traded electronically. But Michael LaBranche, the firm's CEO, has heard it all before. "The NYSE is always going out of business. It's just been going out of business more than usual lately." He says specialists "are the reason the public can interact in the market in a fair way, at a fair price."

BIG DEALS. Indeed, Plexus Group, a firm that researches securities transactions, finds that trading stocks on the NYSE is almost as cheap as on any other market. And it credits the specialist system for this. "Shopping the order has a negative connotation, but the function is to find the liquidity," says Plexus Chairman Wayne Wagner. "It's an art, and it's done very well on the floor of the exchange."

Yet that argument hasn't kept traders from defecting to Liquidnet and other similar venues. The average commission on a big-cap NYSE stock is 4.26 cents a share, vs. 4.01 cents for NASDAQ stocks, but the cost for an NYSE trade can average 45 cents a share if the market impact of delays and missed trades are taken into account, says Plexus. Liquidnet charges just 2 cents a share, and though it still does barely 1% of the daily volume handled by the Big Board, more than half of its trades are the largest deals of the day in a particular stock, according to NYSE statistics. "The NYSE has made a lot of mistakes in the last couple of years, and mistakes trigger change," says veteran investor Michael Price, who owns a piece of Liquidnet.

If the NYSE can't lick its newly aggressive rivals, it can't join 'em, either. Specialists who own a sizable chunk of the Big Board are unlikely to vote for their own demise. Thain's challenge is to find some middle road -- without getting run over.

By Mara Der Hovanesian in New York, with Ben Elgin in San Mateo, Calif.

— With assistance by Benjamin Elgin

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