When the stock market has a big day, TV news is sure to show hundreds of agitated men and women in colored jackets, on their feet and yelling to one another on the floor of the New York Stock Exchange. For more than 200 years, trading at the NYSE has used this “open outcry” auction system. “Specialists” representing sellers shout out offers — so many shares of a given stock at a certain price. Others, representing buyers, shout counter-offers. And the parties haggle until a deal is done.
But on April 20, the exchange announced an agreement to merge with Chicago-based Archipelago Holdings Inc., a nine-year-old trading company that joins buyers with sellers the modern way, inside quietly humming computers that work at light speed.
In the reverse merger, the publicly-traded Archipelago will buy the privately held, non-profit exchange, and the NYSE’s member-owners will be issued 70% of Archipelago stock. The deal will create a public, for-profit company called NYSE Group Inc. It still needs regulatory approval, and a vote by NYSE members and Archipelago shareholders, but the merger is expected to be completed in the fourth quarter of 2005 or the first quarter of 2006. The new NYSE will trade options and other derivatives in addition to stocks, getting into a booming market.
Does this signal the end of the NYSE’s human-based system? If it does, should small investors and other outsiders even care? “I think investors get a better deal in the electronic markets,” said Wharton finance professor Jeremy Siegel, suggesting it is past time for the NYSE’s auction system to fade away.
The NYSE and Archipelago insist the two systems will work side-by-side, but many observers think the electronic side will gradually become dominant. A move into electronic trading was probably inevitable at the exchange, given the success of electronic markets, Siegel said, but may have been hastened by recent scandals at the NYSE.
He and two co-authors argued in a 1993 book, Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange, that the tradition-bound NYSE was dragging its feet on technological advances that could make exchanges more efficient and reduce the various costs associated with trading. Although the NYSE and Archipelago say the auction system will continue to operate alongside the electronic one, many observers expect the floor specialists to survive for only a few years.
“We were commenting [in the book] that there were a large number of different interests in the membership of the exchange. It was very difficult to get anything done,” said one of Siegel’s co-authors, Wharton finance professor Marshall E. Blume. The third author was writer Dan Rottenberg.
Exchanges of all types provide places for buyers and sellers to come together to trade, just as people once did on market days. A good exchange must have fast systems to complete trades and to disseminate price and other information, so that prices accurately reflect supply and demand. The exchange itself is not concerned with whether prices rise or fall.
Decline of the “Big Board”
The NYSE was formed in 1792 when 24 traders signed the Buttonwood Agreement, named for the tree under which the original trading was done. Throughout its history, the exchange has been owned by the people and firms that conduct trading there. Today there are 1,366 members — individuals, partnerships or companies that own the seats required to execute trades for brokers and other customers. The exchange was incorporated in 1971 as a not-for-profit corporation, and it operates on various fees charged to people and companies that use it, including the 2,774 companies whose stocks are listed.
It has long been considered a matter of prestige for a company to meet the NYSE listing requirements and to be accepted to the “Big Board.” But the prestige has diminished somewhat in recent years, as some big, successful companies like Microsoft and Intel have chosen to stay on the Nasdaq market even after they grew big enough to qualify for the NYSE. Indeed, in the past two decades the NYSE and Nasdaq have sparred over which provides the best service to listed companies and traders. The Nasdaq is a completely electronic system, as are virtually all the exchanges formed around the world in the past few decades.
Service is typically gauged by a number of criteria: liquidity — whether there are enough buyers and sellers to provide for one another’s needs; volatility — the tendency of prices to surge up and down (less volatility is preferred); trading speed — how fast trades are executed; and certainty — the likelihood a trade can be completed at the agreed-upon price before conditions change.
The NYSE has long argued that its human specialists make the system work better than an all-computer system. A specialist firm typically trades only a handful of the stocks listed on the exchange, and it trades those stocks in its own accounts in addition to bringing together outside buyers and sellers. If a buyer places an order and there is no seller to fill it, the specialist is, under certain conditions, required to sell the shares out of his firm’s account, or to buy them if there is no other buyer. The specialist can also try to nudge parties together at a price between what the buyer offers and the seller asks. Or a specialist may find a buyer willing to pay more than a seller has asked — a process the exchange calls “price improvement.”
Fully electronic markets cannot provide this kind of matchmaking. But they offer something else that traders prize: extraordinary speed and certainty of execution. These are critical for the mutual fund manager or other institutional trader who wants to make a large trade before the price changes.
Clearly, each system has its merits; otherwise companies would list on only one type of exchange. But Siegel argues that electronic markets have the edge because the spread, or difference between bid and asked prices, is smaller on those markets. That indicates that liquidity, price transparency and speed are working more efficiently to produce prices that accurately reflect supply and demand. A wide spread means buyers and sellers aren’t sure of the correct price, increasing the chances that buyers will pay more than they have to, or that sellers will settle for less than they can get. In many cases, the difference is likely to end up in the pockets of the middlemen — the specialists. “The Nasdaq market is more efficient than the NYSE is now under the specialist system,” Siegel said.
In the past, many of the exchange’s seat holders had a vested interest in the status quo and resisted pressure to modernize, Blume added. “Being a member of the exchange used to be a family business. You passed it on to your children and you made a good income.”
This has changed over the past 10 to 15 years as members found ways to wring more value out of their seats. “They formed partnerships, and then sold those partnerships to firms like Merrill Lynch and Goldman Sachs,” he said. Many seats are rented out, as well. “So now it’s corporate interests. It’s not family interests.”
Under pressure from regulators and the companies listed on the exchange, the NYSE has loosened rules that in the past made it extremely difficult for a listed company to jump to another exchange. Hence, the NYSE is not just competing for listings from companies that are newly eligible; it must also compete harder to keep the listings it already has.
Amidst all these pressures, the value of seats has fallen. The record price for a seat was $2.65 million in August 1999, near the peak of the bull market. This past January, a seat sold for only $975,000. The status quo is not as valuable as it once was.
A Series of Scandals
The exchange has also been tarnished. First was the pay scandal involving chairman Richard Grasso in 2003. Then came a string of scandals involving the specialists themselves. Last year seven specialist firms paid $243 million in fines and restitution to settle regulators’ accusations that the specialists had defrauded traders. Specialists were said to have traded in and out of their firms’ accounts when they should have matched sellers with buyers, for example. Profits that should have gone to the buyers and sellers thus went to the specialists’ firms. In April, 19 former specialists were arrested on criminal charges over similar allegations. The human element, which the NYSE has so long claimed to be a benefit, has come to look more and more like a shortcoming.
The Nasdaq and other electronic markets have had scandals of their own. The biggest, in the 1990s, involved efforts by firms that execute trades on the Nasdaq to keep the difference between bid and asked prices artificially large, enhancing those firms’ profits at other traders’ expense. But these scandals are now long in the past, and the system flaws that made them possible appear to have been fixed.
The Securities and Exchange Commission has pressured the NYSE and the numerous other stock exchanges around the country to change. Under SEC head William Donaldson, chairman of the NYSE from 1990 to 1995, the commission has forced exchanges to link together more closely, so that someone buying or selling on one exchange will get the best deal available anywhere in the country.
Because its ownership is more corporate than it once was, the NYSE has less reason to cling to tradition, Blume said. After the Archipelago merger was announced in April, the price of NYSE seats soared to a near-record $2.6 million. That suggests that those in the know believe there’s more money to be made under the new system than the old. Archipelago shares soared nearly 50% when the deal was announced.
None of this matters much to small investors. While one system may offer slightly better prices, greater speed and cheaper transaction costs, the differences are so small they matter only to big institutions that make many enormous trades. Small investors do, however, have an interest in the NYSE’s regulatory functions, which are supposed to prevent fraud. But that operation will remain a non-profit entity overseen by independent directors.
As for the long-running debate over the merits of the auction and electronic systems, that will now be put to the best test ever, says Blume. “The NYSE can provide both services, and the market will determine how valuable each is. My suspicion is that for many trades the electronic market will be preferable, because you get it done with minimal costs and quick turnaround.”