Commentary: The Big Board's Big Compromise

Yes, it's making electronic trading easier -- but big investors may soon demand more

When New York Stock Exchange Chief Executive John A. Thain unveiled a proposal on Aug. 2 to expand electronic trading, he said the Big Board would provide more options for completing a trade than any other market, along with access to the world's deepest pool of buyers and sellers. Well, he got the second part right.

But the NYSE is still a long way from even matching the Chinese-menu array of trading styles offered by electronic rivals.

Not that Thain's plan isn't impressive. He balanced the competing interests of two main constituent groups -- traditionalists who work on the floor and institutions that want faster trades untouched by humans. And he did it at warp speed, compared with predecessor Richard A. Grasso's halting steps toward computer trading. But the plan is the product of a grand compromise. Trading will be faster, but mutual funds and pension funds may have to wait years for true electronic trading at the NYSE. "It doesn't go far enough," says Junius W. Peake, a finance professor at the University of Northern Colorado.

Most specialists and floor brokers who manage the NYSE's floor auctions will keep their jobs, though investors at times will be able to bypass them. But floor denizens now must prove that they can add value -- for example, by lowering trading costs -- or lose business. Judging by the market's reaction, that may be in the offing: On Aug. 3, a seat on the NYSE sold for $1.25 million, down nearly 11% from early July. And the shares of two specialist firms, LaBranche & Co. (LAB ) and Van der Moolen (VDM ), declined 3% and 7%, respectively, in the three days since the announcement.

The core of Thain's plan is to remove the handcuffs on Direct Plus, the NYSE's flawed e-trading system. No longer will automatic trades be limited to 1,099 shares at most. Nor will customers have to wait an interminable 30 seconds between trades. To sweeten the deal for institutions, which have threatened to take their business to faster and less-expensive markets, Thain will let them scoop up large blocks of stock by "sweeping the book." That means they can trade electronically not just at the best buy or sell quote but also at prices above or below that.

This mimics what NASDAQ, Archipelago, and other electronic rivals do. But only up to a point. The NYSE would install speed bumps by capping such sweeps at 9 cents above or below the best quote. This reduces the chance that prices would swing wildly. But it's also a tip of the hat to the 480 specialists who manage the floor auctions and the 400 or so independent floor brokers who could pick up business from customers wanting to trade at prices beyond the cap.

Thain nixed an important feature that most rivals have and big players wanted: the ability of institutions to disclose just a portion of a buy or sell order, trickling out the rest of the order automatically as sellers and buyers reveal their hands, too. This way, a mutual fund would be less likely to move the price against itself. An indication that Fidelity Investments is shopping for 500,000 shares of Citigroup (C ) drives up the price for Fidelity investors. While this feature would have helped big buyers remain anonymous -- and lower their trading costs -- it would have deprived floor brokers of even more business. So out it went.

There were other trade-offs. If a fund wanted to buy 50,000 shares of General Electric Co. (GE ) at $33.01, under Thain's plan it could "sweep the book" for GE sellers beyond the one offering the best quote -- up to $33.10. If there were GE sellers offering good prices at rival Archipelago, the order would be routed there, but only to the seller offering the best quote. This helps the Big Board retain its share of trades in listed stocks, now at 80% after slipping to 75% in recent months, but could cost investors a bundle.

As the old saw goes, politics is the art of the possible. With this plan, Thain, who until January was president of Goldman Sachs Group Inc. (GS ), is showing that he's a smart politician. His plan might be seen as a giant leap forward at the 212-year-old exchange, but it's more evolutionary than revolutionary. Still, as customers adapt to the new system, trading costs should decline and investor returns should increase, says James P. Selway III, managing director of brokerage firm White Cap Trading LLC. "It's what you would call a productivity gain in any other industry." If he's right, the pressure to change even more could become irresistible.

By Paula Dwyer

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