A Power Shift on Wall Street
In a TV commercial now airing for a large online brokerage firm, a crowd of individual investors crashes through the locked doors of what is supposed to be the New York Stock Exchange and swarms toward the trading floor.
“The rules are changing,” a deep voice intones.
This may be one case in which Madison Avenue isn’t guilty of hyperbole.
The U.S. stock market is in the midst of the most wrenching structural upheaval since trading kicked off under lower Manhattan’s fabled buttonwood tree in 1792.
A 24-hour trading day is dawning. The NYSE and the Nasdaq Stock Market are scrambling to fend off new electronic rivals. Competition among securities firms for small investors’ business has never been fiercer.
Yet as dramatic as the changes in the last couple of years have been, many experts say they will pale next to what lies ahead.
The arrival of online investing, rock-bottom commissions and hordes of newcomers to Wall Street has so far mostly altered just the outward appearance of securities markets. These things have only begun to affect the critical inner workings of how, when and where shares change hands.
The transformation underway will be most visible in developments such as round-the-clock and, most likely, round-the-world trading. Also, sometime next year, U.S. stocks will start being priced in simple decimals rather than in fractions--ending an archaic tradition that dates to the era of the Spanish piece of eight.
But the next major shifts in the market are likely to reorder its basic makeup, in the process granting individual investors much more control over how their investment orders are handled and at what cost.
“The changes will greatly reduce the cost of trading, make it possible for individuals to get in and out [of stocks] quicker without incurring huge transaction costs and give them the ability to control their own trading,” said David Whitcomb, chief of Automated Trading Desk, an investment firm in Charleston, S.C.
The army of Americans with online brokerage accounts--more than 5 million and growing--stands to benefit first from the shake-up of the old securities regime. But all of the estimated 79 million Americans who own stocks are already being affected in some fashion.
The potential loser, ironically, is Wall Street itself, as unprecedented competition intrudes on long-protected institutions such as the NYSE--whose colonnaded facade is the very symbol of American capitalism.
“What we’re witnessing here is really the tip of the iceberg, and there’s likely to be a wholesale realignment of many of the most venerable U.S. markets in the next couple of years,” said Bill Burnham, a general partner at Softbank Capital Partners.
An end result, as Securities and Exchange Commission Chairman Arthur Levitt declared recently, may be what Congress asked for 25 years ago: the establishment of a “true national market” for securities, a market where all buyers and sellers can meet to exchange shares at the best possible prices and lowest costs.
The idea may have seemed simple enough, but until now it has been impossible to achieve. Some critics say that’s because the NYSE and Nasdaq have given the appearance that their markets were evolving when in reality they were protecting their trading monopolies.
Home to Nation’s Blue-Chip Stocks
The NYSE, of course, is home to most of the nation’s blue-chip stocks. Its system of trading, while now facilitated by computers, has changed little in more than 100 years: All orders for a given stock are ultimately brought to a specific location on the exchange floor, where a human “specialist” oversees transactions.
The Nasdaq market, established in 1971, isn’t a physical exchange. It is a nationwide network of brokerages trading stocks via computers. Created as an alternative to the NYSE, Nasdaq has become the principal market of the nation’s largest technology stocks.
The NYSE and Nasdaq are owned by their “member” firms--the nation’s brokerages. The markets say they have spent billions on modern technology to accommodate investor demand. Each claims that its system is the fairest way for investors to trade stocks.
But to critics, the two markets have long operated as private clubs intent on stymieing innovation that threatens their franchises.
Nasdaq was tarnished four years ago by a price-rigging scandal that resulted in its member brokerages paying more than $1 billion to settle a class-action suit. But these days, the harshest barbs are directed at the NYSE. In an era when trading could be entirely automated, critics say the NYSE has fought too hard to preserve the role of its human intermediaries.
What’s more, the NYSE is accused of unfairly barricading itself against competition, primarily with a rule that prohibits member brokerages from trading certain NYSE stocks on electronic markets.
“They have these anti-competitive rules and they are doing their damnedest not to get rid of them,” contends Junius Peake, a former Wall Streeter who teaches at the University of Northern Colorado.
Even the chief of one of Wall Street’s blueblood firms, Henry Paulson Jr. of Goldman Sachs Group, recently criticized “vested interests” in markets that have blocked competition.
The attacks on the NYSE and Nasdaq are, at their heart, attacks on a staple feature of many markets throughout history: the middleman who stands between buyers and sellers, taking a cut of the action and benefiting from knowledge of what both sides are doing.
On the NYSE, the primary middleman is the specialist. Combined, NYSE specialists earned a record $265 million in profit in the first six months of 1999 from their trading.
On Nasdaq, many orders are filled not by matching with another investor, but by Wall Street dealers known as “market makers” who at any given moment are buying a particular stock from one investor at one price (say, $25) and selling it to another investor for a slightly higher price (say, $25.13).
That price difference is known as the “spread,” and it has historically been a huge source of profit for Wall Street dealers.
Transactions by E-Mail
Though many online investors today may assume that they’re sending their orders straight to “the market,” they are instead sending what is essentially an e-mail to a brokerage, which, in turn, sends another e-mail to a Wall Street dealer who completes the transaction.
The ostensible job of such intermediaries is to maintain order in stocks by functioning as the buyers and sellers of last resort. They are supposed to put up their own funds to trade with investors when no one else will, for instance when stocks are selling off sharply, or in the case of thinly traded stocks.
The heated debate on Wall Street today--even among large brokerages with their own middleman operations--is whether the intermediaries get in the way more than they help buyers and sellers.
After all, at any moment there are plenty of buyers and sellers of major stocks such as Microsoft and General Electric. Why should investors be forced to use expensive intermediaries? critics ask. Why shouldn’t buyers and sellers just meet directly--in cyberspace--and exchange shares at whatever price they agree on?
If the concept sounds like the stock market equivalent of online auction service EBay, it is.
The market of the future began taking shape about three years ago, when trading systems known as electronic communications networks, or ECNs, emerged as the most potent challengers ever to the NYSE and Nasdaq.
Going by names such as Instinet and Island, these electronic trading systems link stock buyers and sellers directly. ECNs charge per-share fees ranging from a fraction of a cent to several cents--costs that can total far less than those incurred by trading through the NYSE or Nasdaq.
The oldest ECN, Instinet, has been around for 30 years. Until recently, however, it catered exclusively to institutions and was best known as an after-hours trading venue.
ECNs got their biggest boost from market reforms in the wake of Nasdaq’s price-rigging scandal. The reforms in effect forced dealers to open the market to competing buy and sell orders, allowing ECNs to attract more business.
Over the last three years, ECNs’ growth has been torrid. The nine players have siphoned off more than 30% of trading volume in Nasdaq stocks at the expense of Nasdaq and Wall Street dealers. Because Nasdaq volume has surged with the bull market’s continuing gains, the pie has grown for all trading venues--though the ECNs are taking an ever-larger slice of a bigger pie.
Individuals may not realize it, but a fair number of their orders now end up on ECNs, matched against those of other investors.
So far, the ECNs’ share of trading in NYSE stocks is small, but growing.
Meanwhile, some online brokerages are moving quickly to extend to individual-investor clients the technology to see real-time price data--for example, various quotes for stocks depending on order size--that previously only dealers could view.
“We’re seeing a tectonic-plate shift where stress has been building on these plates for a very long time,” said Harold Bradley, an expert on trading at American Century mutual funds. “It’s just taken this long for the political systems to break down enough to allow for true competition.”
The NYSE and Nasdaq have acknowledged their vulnerability to the electronic interlopers. Indeed, both markets are planning the once-unthinkable step of becoming publicly traded companies.
Their stock sales, tentatively planned for next year, would be aimed at re-energizing their franchises--and raising capital to develop ECN-like networks of their own. Despite the upstart ECNs’ challenge, the NYSE and Nasdaq expect that investors will see them as formidable long-term competitors.
Many Wall Street dealers whose middleman profits have been squeezed have already invested in ECNs. Such heavyweight firms as Goldman Sachs and Merrill Lynch & Co. have gobbled up stakes in several such networks.
For the brokerages, reduced profits from middleman trading functions have been more than offset by fees from investment banking, fund management and other businesses in the 1990s. And earning lower fees off ECN systems is better than giving up all stock-trade revenue by conceding the business entirely to rival networks.
Yet for all the upheaval they’ve wrought, ECNs may be just another step in the market’s rapid evolution.
ECNs compete not only with Nasdaq and the NYSE, but with one another. In the current structure, a buyer in one marketplace--be it an ECN or an established market--often cannot trade with someone selling at a lower price on another system.
Matt Andresen, president of the Island ECN, acknowledges that “if there’s a better price somewhere else and you can’t see it or you can’t do something about it,” the efficiency of using ECNs may be sharply lessened.
A National Market for Investors
The idea of a national market is to put all investors on an even footing by having stocks trade in open venues for all to see and join. Pragmatically, that would require an electronic link among disparate markets and ECNs so that investors could access one another fluidly.
The appeal of a national market for investors is similar to the lure of a shopping mall for consumers, said Bernard L. Madoff, head of the Wall Street firm that bears his name.
“The advantage of a shopping mall is that there are lots of stores and you don’t have to walk outside into the rain to get from one to the other,” Madoff said. “If I don’t like the price in one, I can walk next door to get a better price in the other. . . . I don’t have to start getting in taxis and riding 20 minutes across town to get to the other [store.]”
ECNs have taken the first step toward tying together their systems by agreeing in principle to let after-hours investors see the prices at which stocks are trading on all systems. In some--though far from all--cases, investors could trade with investors on other systems.
Goldman’s Paulson, the SEC’s Levitt and other key officials say the time is right to develop the national, unified electronic trading system that Congress envisioned. “We are at a unique moment in our markets’ history--a point of passage between what they have been and what they will become,” Levitt said.
Eight European stock exchanges have announced plans for a Pan-European system. But in the U.S., there is no such consensus in the brokerage industry. At leading discount brokerage Charles Schwab Corp., President David Pottruck recently asserted that a centralized market could ultimately be anti-competitive.
Levitt has ordered U.S. options exchanges to come up with a plan to link, but so far the rival markets can’t agree on how to do it.
For Levitt, the paramount issue is whether individual investors get the best price when they buy or sell a security. That issue--execution quality--is expected to come into sharper focus as investors’ choices of how and when to trade mushroom amid the markets’ upheaval.
“Everyone is sensitive to commissions,” said Andresen, Island’s president. “But as market information becomes better and more immediate, very quickly [individuals] will become more sensitive to execution quality.”
For example, the benefit of a cut-rate $10 commission on a trade is obliterated if an investor sells 500 shares at even 25 cents a share less than he could have, thus giving up $125 in profit.
Attention to execution quality will become more crucial if investors embrace the seemingly inexorable march toward globalized 24-hour stock trading.
Though institutions have long been able to trade after traditional hours, that prospect seemed remote for individuals as recently as a year ago, when the NYSE and Nasdaq showed no inclination to operate outside their traditional hours of 6:30 a.m. to 1 p.m. Pacific time.
But many online brokerages have recently begun offering after-hours trading through ECNs--until about 5 p.m. Pacific time.
Extended Trading Catches On
Extended trading has caught on slowly amid concerns about light share volume and stock-price volatility. Nevertheless, many observers say a 24-hour trading day could be a reality in a year or two.
“Right now, in every other field except securities trading, you can buy online 24 hours a day, seven days a week,” said Whitcomb of Automated Trading Desk. “You can go into Amazon.com or EBay and trade any time you want to, in the middle of the night if you feel like it. In the stock market you can’t, and that is going to change in the next couple of years.”
For West Coast investors, 24-hour trading would mean a big dose of convenience. People with day jobs now must either trade from work or put in orders at night to be executed the next morning.
“A lot of people have busy days,” said Michael Dessoye, a former AT&T; consultant in New Jersey. “If there’s some breaking news coming out about stocks they know about and want to own, [extended trading] is an opportunity to place an order and get the stock. It gives a little bit more flexibility.”
After-hours action also lays the foundation for individuals to trade in stock markets around the world.
Several U.S. online brokers are aggressively setting up shop in Europe and Asia. In fairly short order, that is expected to lead to foreign investors being able to trade U.S. stocks directly and American investors doing the same in foreign issues.
There are, of course, many risks in all of this--for the investor and for Wall Street. Although small investors stand to be greatly empowered by the new market order, taking full advantage of it requires that they learn the pros and cons of new trading systems.
Still, the opening of the stock markets to more competition is viewed by many experts as ultimately beneficial to most investors. And long overdue.
“It’s hard to capture the breadth and depth of the changes taking place,” said Softbank’s Burnham. “For years, people have been hemming and hawing about how the markets are changing, and all of a sudden they really are changing.”
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Wall Street Timeline
Key events in the history of U.S. stock markets:
* 1685: Wall Street becomes a byway in lower Manhattan.
* 1792: Twenty-four brokers and merchants sign the Buttonwood Agreement on Wall Street, forming the basis for the New York Stock Exchange.
* 1867: First stock-quote ticker installed.
* 1871: Stock “specialist” role created on NYSE floor; enables continuous trading of each stock.
* 1878: First telephone installed on NYSE floor.
* 1903: NYSE moves to current site.
* 1934: U.S. Securities and Exchange Commission created.
* 1971: Electronic Nasdaq market created as rival to NYSE.
* 1975: Trading commissions deregulated; dawn of discount brokerage industry.
* 1978: NYSE is linked electronically with regional stock exchanges.
* 1982: First 100-million-share day on NYSE.
* 1992: Average daily NYSE volume reaches 200 million shares.
* 1994: First Internet stock-trading service offered by K. Aufhauser & Co.
* 1997: Nasdaq dealers required to show all investor orders to entire market. With that change, ECNs--rival electronic trading networks--begin to blossom as Nasdaq competitors.
* 1997: Stock trading allowed in increments of sixteenths instead of eighths, narrowing the “spread” specialists and dealers take from investors on trades.
* 1997: NYSE daily volume tops 1 billion shares for first time.
* 1999: NYSE and Nasdaq announce steps toward becoming publicly traded companies themselves, to raise capital to expand electronic trading capabilities.
* 1999: Numerous brokerages offer extended trading hours for individuals.
Sources: Times research, New York Stock Exchange
