Market Lessons From Merck's Decline

How exchanges need to work in concert

When Merck & Co. (MRK ) announced the morning of Sept. 30 that it was recalling its Vioxx pain medication, it caused a huge headache for patients and investors. But they weren't the only ones reaching for the aspirin. The pharmaceutical giant also created an enormous task for Wall Street's stock dealers and brokers. In the scant 75 minutes between Merck's 8:15 a.m. announcement and the scheduled opening of the New York Stock Exchange, and the frenzied hours immediately afterward, traders had to field an avalanche of orders.

If the dealers and brokers couldn't match buyers and sellers quickly, or if they completed the trades at wildly divergent prices, their already-riled customers would be furious. They also knew that the Securities and Exchange Commission would be closely watching. The SEC is debating whether investors are best served by the NYSE's auctions conducted by "specialists" on the exchange floor or by rival electronic systems that use computer programs to automatically match up traders with buy and sell orders for many NYSE-listed stocks.

So what's the verdict? Essentially, a tie. Overall, both the NYSE and the electronic systems did their jobs. Both played key roles in piloting Merck's badly damaged stock to a relatively smooth emergency landing. The electronic exchange helped take down the price before the NYSE opened. And the NYSE completed the job with huge block trades throughout the day. Despite trading more than 144 million shares -- 20 times the normal daily volume -- volatility was essentially kept in check after a quick 27% plunge gobbled up $27 billion in market capitalization. The shares, after closing at $45.07 the night before, opened on the NYSE at 9:32 a.m. at $33 each and traded in a remarkably tight range of $32.46 to $34.02 for the next seven hours, before closing right back at $33.

The performance was so good that John A. Thain, CEO of the NYSE, is touting it as evidence of the superiority of the exchange's system of floor auctions. "The specialist was able to find a price that was fair for both the buyers and the sellers, which is what led to the market being fair and orderly," says Thain. In the opening trade, the specialist assigned to Merck, James J. Barry of LaBranche & Co., matched up buyers and sellers of 5.7 million shares. He bought about 10% of those shares himself for LaBranche, helping make up for a shortage of buy orders, according to the NYSE.

But the two big electronic systems, Archipelago Exchange and INET, say they also deserve credit for finding the $33 level that satisfied so many buyers and sellers and opened the way for the flood of trades. Indeed, the ECNs, already open when Merck broke the news, were the first responders. They traded about 10 million shares before the NYSE opened, walking the price down through small trades to the NYSE opening price. Archipelago President Michael A. Cormack believes key electronic trades came from savvy investors who knew Merck well enough to figure out it was worth about $33 without Vioxx. "Our clients essentially discovered the price long before the (NYSE) specialist became involved," he says.

Not surprisingly, Thain doesn't see it that way. He argues the specialist's ability to choose $33 as the opening price came from much bigger orders queuing up on the NYSE floor. But the pattern of steadily declining prices on trades that Archipelago posted to the public before the NYSE opened shows the electronic system was important. Those early trades helped chart the course for the stock price and the big volume that followed.

The NYSE rivals handled 35% of the shares and dollar value of Merck trading for the day, almost double their usual 20% share of the volume in NYSE-listed issues. That's because when stocks are under the stress of sudden news, buyers and sellers tend to turn to the electronic systems to quickly buy and sell in smaller volumes. "People crave electronic markets when things get tough," says Cormack.

Still, the NYSE carried the big loads. The average trade on the NYSE for the day was 11,000 shares, more than twice that on Archipelago, according to the NYSE. Amid that pressure, the NYSE specialist kept the average spread between bid and ask prices, a key measure of trading costs, down to just 3 cents. While both sides want to claim victory, the day showed that investors aren't best served by one system or the other. They're best served by having both.

By David Henry in New York

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