NPR talks about market changes

Here's an audio from today's NPR Marketplace - the segment was about the electronic transformation of the US Stock Market:
http://tinyurl.com/3tgsp

Barrons Cover Story: The Archipelago Factor

The cover story in today Barron's is about NMS and the transformation of the equity market structure in the US. Again, ArcaEx is becoming well recognized for their leadership position in the new era in stock market structure. Also, a reminder - the public comment period for Regulation NMS ends this Wednesday (1/26-2005). Here's a portion of the Barrons piece:

Meanwhile, the NYSE has its own plan -- dubbed the Hybrid Market -- to modernize itself. In essence, it would vastly increase the size of trades that could be routed for automatic electronic execution, bypassing exposure to the floor crowd. But some orders would still be open for specialist participation and "price improvement."

Importantly, Reg NMS and the Hybrid Market plan both involve tighter network links among the Big Board and other trading venues, thus giving every exchange or electronic-communication network (ECN) access to other markets.

Under either proposal, trading presumably would become more efficient, investors would be happier and transaction costs ultimately would tumble. Regardless of how a customer or broker enters an order -- via an electronic market or at the Big Board -- all venues would be polled for the best execution. Trades would be routed accordingly.

Under this scenario, the NYSE would open itself to the computer-driven order-routing systems that now largely govern traffic flow for over-the-counter stocks. Tabb Group surveys indicate that fewer than 50% of institutional orders begin with a phone call from trader to a broker. (One wonders if the propagation of off-color jokes has slowed.) Direct electronic links with brokerages and pipelines to electronic-trading networks predominate.

Very popular now are "aggregation" systems, which consolidate quotes from various trading centers on one screen. Big investment firms also rely on sophisticated "smart-order routers" and "algorithmic trading software" to analyze and implement the most efficient and stealthy means of completing a trade. Most algorithms are complex, designed to pursue fancy tactics and strategies. Algorithms account for some 7% of trades, though they are behind a fair amount of the activity the NYSE terms program trading, which routinely tops 50% of weekly volume.

Says Seth Merrin, CEO of LiquidNet, an innovative system that lets institutions anonymously trade with one another: "Reg NMS mandates connectivity....The ECNs and [the Archipelago Exchange] will tell their customers to place the order with them first, and, if they can't find a match [internally], they can send it to the NYSE."

Of course, this would put a huge dent in the Big Board's 80% share of trading in the stocks listed on it. And much of the loss would likely be in the largest, most active stocks where spreads are thin and a match is easily made.

But, in this new world of trading, the Big Board would remain vibrant; it simply will have to ensure that its prices are competitive. And its market makers would have to focus more on smaller, less-active stocks that can actually benefit from their services. Says Ed Nicoll, Instinet's CEO: "There will be traders providing liquidity to less-liquid stocks. There will be big swaths of stocks that are large-cap and trade like water; you'll be able to buy one million shares of Microsoft for a penny a share. And then there will be a bunch of stocks in between."

The NYSE may one day have the economic profile of Knight Trading, whose OTC market-making profits rely heavily on thinly traded "bulletin board" stocks. This may seem an irony for the ultimate blue-chip exchange. But it's a living, though perhaps a tougher one. The exchange realizes changes are inevitable. That's one reason why it's trying to expand its role in the trading of foreign stocks and corporate bonds.

Already, NYSE specialists are reaping much leaner rewards than they enjoyed in the fat old days. In 2000, specialists on average earned a lush 26% return on capital. In 2001, the figure fell to 12%, and then to 9% in 2002. But in 2003 and in the first nine months of 2004 (the latest period for which numbers are available), it was 0.1%. That's not a typo.

Lower volatility in recent years accounts for some of that decline. But a cynic might wonder whether the heightened scrutiny of specialists since the scandals were disclosed has them toeing the line more carefully. In a related trend, NYSE membership seat prices, which allow trading on the floor, hit a nine-year low recently of $975,000. Note that UBS has been an aggressive buyer of seats, in hopes the NYSE might one day go public.

Traditional brokerage firms also are being squeezed by lower commissions and by clients who use technology to get better deals. Many investors still trade via the big brokers to get research and to use the brokers' capital to get tough trades done. But they use these brokers only when they must. Already, the trading of stocks for institutional clients is a breakeven game for many securities firms, even in a good year.

Not all the changes in trading will be benign for individual investors.

Major Wall Street firms are reacting to the reduced profit potential in client-driven brokerage services by emphasizing more proprietary trading -- betting on market moves with their own money. To do this well, it helps to see a lot of client order flow, which can be executed on a loss-leader basis. This helps the sharpies get sharper, ultimately perhaps at the client's expense. Estimates of proprietary trading revenue in the industry run toward 10%, with heavier commitments by the likes of Goldman Sachs.

Wall Street as software vendor is one response to the changing trading landscape. CSFB, Goldman Sachs and Morgan Stanley are the dominant providers of trading-algorithm programs. And Citigroup bought Lava Trading, the biggest order-aggregation systems provider.

Another response probably will be the exit from trading by firms that lack the technological brawn or proprietary research to lure clients.

The bottom line: There will be fewer seven-figure stockbrokers working the phones, more computer-science PhDs carrying business cards from investment banks -- and quicker, cheaper trading for everyone's mutual funds.

And -- who knows? -- some funds might even share their savings with shareholders by cutting fees, just as they're now demanding that brokers slash theirs.

FT Report - AX and INGP

The Financial Times published a report this afternoon which says that Arca is the frontrunner in purchasing INGP. You can read that story here:
http://tinyurl.com/5duy8
See some posts from November/December here for info regarding the wisdom of such as merger. In a nutshell, Putnam has said that it's a race for market share. INET's share (both mind and market) would be immediately accretive to AX. In the wake of the PCX options bidness, it's starting to be clear the Putnam and his team are driving a NASCAR in what's traditionally been a school zone!

Stay tuned!

Digital markets overseas

Here's an article from Dealing with Technology which discusses the european bourses and their place in the evolution of efficient and fair markets:
http://tinyurl.com/484pw
and here's a link to the pan-European exchange: http://tinyurl.com/4p7w5

AIG Joins ArcaEx!

"AIG firmly believes in the benefits of electronic trading and our dual listing on ArcaEx is proof of our dedication to creating and supporting the best trading environments for our investors. AIG shareholders should benefit from the enhanced transparency that an ArcaEx dual listing provides.""
-AIG Chairman and CEO M.R. "Hank" Greenberg on January 11, 2005

Here's the scoop on AIG's decision to join ArcaEx: http://tinyurl.com/5lnj5

Today's announcement is good news on a couple of levels:

1) Management: During last quarter's earnings call, Jerry Putnam, Arca's CEO, told analysts and shareholders that Arca's short-term goals center around growing their listings SPECIFICALLY through "dual listings" between NYSE and ArcaEx. Today's news about AIG highlights management's ability to execute.

2) Revenue: As of last quarter, Arca's revenue from listings was ~.01% of total revenue. It's nice to see this line grow.

		    Three months ended               

                       September    June    September        

                          30,        30,       30,            

                          2004      2004      2003                  

Revenues

Listing fees                 118       117        24        

Total revenues            127,141   128,770   126,891   

NY Times Reports: Derivative market contemplated by NYSE

The NY Times ran a story on 1/10/2005 titled, "Cheap Seats Provide View of Troubles at Exchange". Here's a syndicated version of that story:
http://tinyurl.com/7yrbr

Highlights from this article (in case you're pressed for time):

(Keep in mind Arca's recent purchase of the Pacific Exchange's options business)
". . .Mr. Thain [the CEO of the NYSE] is offering new products, such as an exchange-traded basket of stocks of Chinese companies, and is contemplating ways to enter the derivatives and futures markets. . ."

Here's an excerpt from the NY Times article where the trading Pfizer on a heavy news day was halted on the NYSE while not missing a beat on ArcaEx:
On Dec. 17, at 9:20 a.m., Pfizer announced that Celebrex, one of its top-selling drugs, might increase the risk of heart attacks in users who take it for chronic pain. Hundreds of traders rushed to Thomas Shafir III, the auctioneer who manages the trading of Pfizer stock. For nearly an hour, the traders massed in front of Mr. Shafir, waiting to learn the opening price of the stock. By 10:09, Mr. Shafir declared that Pfizer would open at $23.52, down $5.26 from the previous day's close. Ultimately, he managed the trading of 202 million shares of Pfizer, worth more than $5 billion.

Still, electronic exchanges claim they can match the Big Board's performance. Archipelago, an all-electronic exchange based in Chicago, did not halt its Pfizer trading that day. Moreover, when the Big Board opened, ArcaEx, as the exchange is called, had already arrived at much the same price without using a specialist. "Being open and trading and allowing the market to discover the price is the key. When the market's not open, are you better off?" said Gerald Putnam, chief executive of Archipelago Holdings, the parent company of ArcaEx.

Thomas Peterffy, head of Interactive Brokers, an institutional trading firm, said hybrid models so far had been unsuccessful. "There has been an experiment on hybrid on the Chicago Board Options Exchange and I do not see it working well for the users, but it works well for the floor members," he said.

Fidelity Investments, one of the toughest critics of the model, is also skeptical. "The proof in the pudding in hybrid is whether it will eliminate the information advantage of the floor members that disadvantages institutional investors," said Eric Roiter, general counsel at Fidelity Investments.

Ex-Fidelity Capital Markets COO Says It All

Arca announced the appointment of Matthew Gelber today. Mr. Gelber with be a managing director in Arca's newly acquired options business. He's yet another champion jockey and the options business is an incredible horse!

In the Arca press release Mr. Gelber says a mouthful: ""Archipelago is as progressive an organization as there is within the financial services arena. They have consistently driven positive, investor-friendly change in the equities market. With their announced acquisition of the Pacific Exchange, Archipelago is well positioned to make a similar impact on the options marketplace. I am very excited to be joining such a forward-thinking company at a critical time in the evolution of the company and the markets."

Could Philly Exchange be Next?

Here's an article from today's NY Times about ArcaEx. NY Times writer, Jenny Anderson writes that today's purchase of the Pacific Exchange could be the beginning of more Arca acquisitions. In this prose, Anderson mentions that the Philadelphia Exchange could help Arca grow market share in the options arena.:

(See the actual NY Times article here: http://tinyurl.com/3tzvw)

Market Owner Agrees to Buy Pacific Exchange

By: Jenny Anderson, NY Times News
Date: 01/04/2005

Archipelago Holdings, the owner of ArcaEx, the largest electronic stock market, confirmed late last night that it would buy the Pacific Exchange for about $50 million.

While the deal would be relatively small, it is a sign of Archipelago's ambitions, giving the company its first options trading business. The acquisition comes as electronic markets and the traditional floor-based exchanges are scrambling to diversify. It also comes on the eve of anticipated new rules from the Securities and Exchange Commission that could alter the business of every exchange and marketplace.

Many in the industry say that a deal with the Pacific Exchange may be just the first step in a larger strategy of consolidation by Gerald Putnam, Archipelago's chief executive. Other potential targets include the Philadelphia Stock Exchange, one of six players in the options trading business.

A deal with the Pacific Exchange, with which Archipelago has a longstanding relationship, would also give the company "self-regulatory organization" status, giving it more control over its regulatory arm.

Options trading is attractive because it commands higher margins and trading volume has surged.

"The margins on the cash equities exchange business are getting thinner and thinner, so I'm sure everyone in that business is looking for business lines that have less margin pressure," said William Harts, an independent consultant on best-execution and market structure issues. "If Arca can leverage the technology they have built for equities to trading options, there's no reason why expanding into another asset class wouldn't be a good business proposition."

More than one billion options were traded in 2004, a 30 percent increase from 2003. In comparison, trading volume of stocks rose only 7 percent in 2004.

There is a great deal of maneuvering among the exchanges and markets that trade stocks, futures and options. While the New York Stock Exchange has a virtual monopoly on trading its listed stocks, the trading of over-the-counter stocks is more fragmented. Major market players are trying to consolidate volume in an effort to squeeze profits from the notoriously low margin business.

At the same time, many exchanges are diversifying so as not to be dependent on a single financial product. Instinet, which is controlled by Reuters Holdings, is for sale, and Archipelago and Nasdaq are thought to have submitted bids for its electronic network business, called Inet, in the first round, people involved in the talks say.

In announcing the deal, Mr. Putnam cited the diversity that the acquisition offered.

Archipelago has a history with the Pacific Exchange. In March 2000, the two institutions announced they would form a new electronic exchange to trade stocks listed on the New York Exchange, the Nasdaq and the American Stock Exchange.

As part of that deal, Archipelago paid the Pacific Exchange $40 million in cash and gave it a 10.8 percent stake in Archipelago - a deal worth about $90 million - for the right to be a regulated entity, essentially allowing it to operate as an equity exchange.

Under the proposed deal, Archipelago is buying the rest of the Pacific Exchange as well as repurchasing the Archipelago stock that the exchange still has (about 3 percent).

The Pacific Exchange is the smallest traditional market in the options trading business. At the end of November 2004, the Chicago Board Options Exchange controlled 30.7 percent of all options contracts sold, compared with 30.5 percent at the International Securities Exchange. The Pacific Exchange had an 8.5 percent share.

The International Securities Exchange has had a meteoric rise as an electronic market for trading options. Started in 2000, it has at times surpassed the Chicago Board as the largest player in terms of market share.

Because of its electronic structure, the I.S.E. has much cheaper overhead. In 2003 the exchange controlled 27 percent of all option products (including equity options and index options). At the end of November that number was 30.5 percent.

A deal for the Pacific Exchange would be Archipelago's first acquisition since going public in August.

Archipelago has been a rare success story in electronic equity trading. Begun in the wake of the S.E.C.'s 1997 ruling on how Nasdaq stocks could be traded, Archipelago was one of the original four electronic exchange networks.

Early investors included a who's who of Wall Street: Goldman Sachs, J. P. Morgan, Merrill Lynch & Company as well as American Century and Instinet all invested in Archipelago before it went public at $11.50 a share. The shares have since risen 82 percent, closing yesterday at $20.30. For the first nine months of 2004, Archipelago earned $56.4 million on revenue of $402.6 million.

Regulation NMS - Insightful overview from Wall Street & Technology magazine

Wall Street & Technology magazine's writer, Larry Tabb published a good take on Regulation NMS on 12/21/2004. Tabb explains the enormity of these proposals and their impact on the US equity market structure. You can read it here:
http://tinyurl.com/47l6b