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.