In Merger Math, Change for Investors Is the X Factor
By Ben White
Washington Post Staff Writer
Sunday, May 1, 2005
Peggy and William Schmeltz haven't stayed up nights pondering the larger meaning of the New York Stock Exchange's decision to merge with electronic trader Archipelago Holdings Inc., or the Nasdaq Stock Market's plan to buy online trader Instinet Group Inc.
But the retired Ohio couple, both active investors, suspect the deals represent a historic shift in the way stocks are bought and sold.
Their gut feeling is that the deals will probably lead to faster, cheaper trading. And that, they say, can't be a bad thing.
"The only thing I'm concerned about is fair trading," said William Schmeltz, a certified public accountant who occasionally trades stocks online through his Fidelity account. "If these deals result in that happening, that's good."
Schmeltz said he once believed that NYSE floor traders provided a valuable public service, keeping markets calm and matching buyers and sellers at the best price for both sides. Now, with 15 former and current traders criminally charged with cheating investors out of the best prices for their trades, he said he thinks they exist mainly to snatch profit for themselves. At his expense.
"I think they try to take a quarter-point here and quarter-point there, whenever they can. So if you can shorten the process and eliminate the people in the middle, that's better," he said.
The Schmeltzes, of course, do not represent the full spectrum of opinion on the two big stock market deals announced earlier this month. The NYSE would become a for-profit, publicly traded company if its deal goes through; Nasdaq wants to do the same.
On one level there is general agreement: If approved, the two mergers will almost certainly create a pair of dominant competitors who will go all out to execute the largest number of trades, at the fastest speed and with the lowest cost. That means they will be aggressively courting big, institutional investors who account for more than three-quarters of daily stock trading volume, according to estimates.
But there is less agreement on whether this will benefit individual investors. Many mutual fund executives say it will by reducing execution costs, with the savings going to fund shareholders. But some consumer advocates, academics and other financial observers wonder whether the brutal competition will lead the markets to scrimp on surveillance duties and rule enforcement while catering to big players at the expense of the little guy.
And some fear that intense pressure to produce results for shareholders will lead a newly public NYSE to finally abandon its system, built around human traders, in favor of an all-electronic market. They say that while that might work well for heavily traded shares, it might be more chaotic for stocks that trade infrequently. Those stocks tend to have bigger "spreads" between the best bid and offer price.
The NYSE is the last big stock exchange in the country to conduct business on a physical trading floor. The exchange already offers some electronic trading but the vast bulk of orders are sent to the floor where traders called specialists match buyers and sellers at the best possible prices for both (or at least that is what they are supposed to do).
Nasdaq is a computerized trading system born in the 1970s as an informal group of broker-dealers, known as market makers, who traded non-NYSE stocks over the phone and via online systems. Over the years, Nasdaq has improved its order-matching system to the point where it now operates more like an electronic communications network, or ECN.
Both Instinet and Archipelago are ECNs, fully automated computer networks that match stock buyers and sellers and do not use market makers to match orders.
"We are talking about an order of magnitude change" in the structure of the stock market, said Robert A. Schwartz, finance professor at Baruch College-City University of New York. "This is taking us to an unknown place and the ramifications are very hard to think through."
Investors' Good NewsHarold S. Bradley, a senior executive at mutual fund firm American Century Investment Management, is among those delighted by the mega-mergers and the quickening trend toward more electronic trading.
A longtime critic of the trading floor-based model, Bradley said that currently, if he wants to sell a million shares of stock on the NYSE, he has to carve his order into small pieces to prevent other market participants from recognizing that a big chunk of stock is trying to move and using that information (which can temporarily depress a stock's price) before he can finish selling.
In an electronic system, Bradley said, he could instantly and anonymously execute one big trade. Over the course of a year, he said, not having to execute scores of small orders or "expose" big orders to the marketplace -- meaning that investors get a chance to bid on pieces of a big block -- could save his firm $100 million or more.
"That's $100 million that, instead of going to some unwanted intermediary, goes back to my investors," said Bradley, whose firm owns a stake in Archipelago.
In addition, Bradley said he thinks the current floor-based system allows professional market players, such as hedge fund managers, to pick up tidbits from floor traders about big, pending institutional stock orders, something that would be impossible in a fully automated system.
He said he also thinks a publicly traded NYSE would create incentives for the exchange to worry about pleasing customers first (principally big institutions like his), rather than about maximizing profits for a small, private group of seat owners. The NYSE currently is owned by these seat-holders. Even though the exchange is a not-for-profit, seats are tradable, with profits on their sale going to their owners. "All of a sudden you will have broken this really unhealthy structure," he said.
George U. "Gus" Sauter, chief investment officer at mutual fund giant Vanguard Group, said the deals would create a highly competitive dynamic between two big marketplaces, reducing transaction costs as well as the "spread" between the prices at which people offer to sell stocks and others are willing to pay for them.
"I think the impact on investors could be major," he said. "Transaction costs are largely hidden in mutual fund performance, but they can easily represent a half a percent to 1 percent of total costs."
NYSE Chairman Marshall N. Carter said in an interview that the new NYSE Group Inc.'s ability to offer more investing products in one place could be another way individual investors feel the difference in the post-merger world.
Among other things, the NYSE Group plans to offer exchange-traded funds (ETFs), options and derivatives, many of which are currently traded on other markets such as the International Securities Exchange and the American Stock Exchange.
"Someone's broker could say, 'Okay, these new ETFs are good investments. Why don't you sell X, Y, and Z assets and get into those, and you can do it all in one transaction.' That could produce significant savings," Carter said.
Steven J. Randich, chief information officer at Nasdaq, said active traders would quickly notice significantly lower costs and faster speeds for trades in both Nasdaq-listed stocks and shares listed on the NYSE.
He said it would take about a year for Nasdaq to fully integrate Instinet's technology, which is generally considered superior to Nasdaq's automated market. But once that is accomplished, he said, the firm will have a solid edge on the NYSE because Nasdaq is already all-electronic, and the NYSE is trying to build a hybrid model that mixes man and machine, something Randich views as pointless and impossible.
"We are basically taking the leadership position we already have and dramatically extending it with the Instinet platform," he said.
Regulatory WorriesBetter, cheaper, faster trades. Who could argue with that?
Well, a number of people, as it turns out. The concerns center mainly on the NYSE-Archipelago deal. For 213 years, the exchange has operated in a curious market niche, existing as both a brass-knuckled, privately owned operation and a quasi-public trust.
The exchange is recognized by the federal government as a "self-regulatory organization" charged with conducting fair trading while policing its members, mainly big brokerage houses and individual traders, and protecting investors.
In return for the right to operate on the exchange floor, NYSE specialists are required to act as liquidity providers, stepping in to take the other side of a trade when no other buyer or seller can be found. They are also expected to reduce volatility by helping buyers and sellers meet at a mutually agreeable price and buying themselves if necessary to stabilize the market.
Some worry that as a public company beholden to shareholders and focused on the bottom line, the NYSE might move to eliminate costly specialists in favor of cheaper computers, even if that would not be the best thing for the marketplace and overall investor confidence.
"They are going to have to get their cost structure in order," said Michael Obuchowski, money manager at Altanes Investments LLC in New York.
This might not matter in big, heavily traded stocks but it could cause problems for companies whose shares do not trade very often and where a specialist can add value by buying when no one else wants to buy and selling when there's no one else with shares to sell.
Then there is the question of how the NYSE's regulatory function will operate. After the scandals surrounding former chairman Dick Grasso's compensation package and allegedly illegal trading by specialists, the exchange created a beefed-up and more independent regulatory body. As a public company, the exchange has said it will spin off the regulatory arm as a not-for-profit entity housed under the larger corporate umbrella of NYSE Group Inc.
The oversight body, dubbed NYSE Regulation, will get a long-term contract (perhaps seven to 10 years at a time) to provide regulatory services to the exchange and will be funded by the fees collected under the contract and for examinations, as well as by fines levied on rule violators.
But some question whether the parent company, under pressure to streamline costs and meet Wall Street earnings estimates, will be inclined to pay what it takes for the regulator to do a good job.
"The regulatory function has to have an unassailable funding source," said Barbara Roper, head of investor protection at the Consumer Federation of America. "And if you look at the directors of a for-profit exchange, they will have a fiduciary duty to shareholders to maximize value. So they would not only have the incentive but perhaps the obligation to give short shrift to any part of the operation that doesn't contribute to the bottom line."
Roper and others also said that both the NYSE and Nasdaq might be tempted to ease the standards they demand of companies whose shares are listed to trade on the exchange as their head-to-head battle to sign up new companies intensifies.
NYSE Chairman Carter acknowledged that his exchange would have to prove to the SEC and Congress that it will not relax standards to beef up the bottom line. "We will have to explain to the SEC and people on Capitol Hill that this structure is the right way to ensure independence and investor confidence, as well as our responsibilities as a regulator," he said. "We have to make sure that we will not go light on regulation as a for-profit organization."
The NYSE's new structure will be similar to Nasdaq's. Nasdaq currently contracts with the self-regulatory organization NASD for regulatory services. The NASD has been criticized in the past as a weak regulator, but its reputation has grown much stronger in recent years under vice chairman and regulatory chief Mary L. Schapiro.
Former SEC chairman Arthur Levitt said he thought the NYSE's new structure would improve the independence of its regulatory arm, not weaken it, by fully removing it from any influence by brokerage and trading firms.
"By breaking up the clublike atmosphere of the member organization and becoming a more democratic, publicly owned company, you take a great step toward more disclosure and greater investor protection," he said.
Several observers also said they did not expect a race to the bottom in standards for listings as competition to sign up new companies heats up between NYSE Group and Nasdaq. Instead, they said, a reputation as a home to well-run companies would be a competitive advantage.
"I don't think any market has ever benefited from a public perception of weak oversight or weak listing standards," said Brandon Becker, a securities lawyer at Wilmer Cutler Pickering Hale and Dorr in the District.
Levitt said the SEC would probably consider joining NYSE Regulation and the NASD to create one umbrella self-regulatory organization. Wall Street, which often complains about overlapping regulation, has lobbied for this change.
Folding all regulation into the SEC is not considered a viable option. The agency is viewed as too removed from day-to-day market operations and inadequately funded to hire the kind of skilled experts needed to keep an eye on sophisticated Wall Street traders.
Richard G. Ketchum, a former Nasdaq president and now head of the NYSE's regulatory body, said he thought creating one uber-regulator would be a bad idea because the NASD and the NYSE have different areas of expertise. The NASD, for instance, is responsible for the entire universe of securities dealers, including tiny boiler room operations, while the NYSE focuses more on the biggest brokerage houses.
And he said it is always best to have regulators dedicated to the marketplace they know best. "I think it's always more valuable to have a knowledgeable self-regulator close to the market if you can address the conflicts," he said.
Words of CautionSo if the NYSE-Archipelago merger does pass regulatory scrutiny and no one on Wall Street succeeds in blocking it with an alternative deal (former NYSE director Kenneth G. Langone has been trying to put together a competing bid) , should individual investors consider buying shares of the new venture? What about the merged Nasdaq-Instinet?
Several money managers urged caution. It will take time to see whether the new firms can cut costs, successfully introduce new products and produce robust profits.
Matching buyers and sellers of stocks and other securities is a harshly competitive, low-margin business, and historically neither the NYSE nor Nasdaq has made big money (though of course it has not been the NYSE's purpose to make money for itself).
In the first quarter of 2005, for instance, the NYSE reported revenue of $287.6 million. Of that money, $85.1 million came from listing fees and $44.2 million came from the sale of market data, which becomes more lucrative as trading volume rises. The NYSE's net income was $24.9 million. Archipelago reported net income of $21.9 million for the quarter.
"I would really like to see how they make money," said Obuchowski of Altanes Investments. "The NYSE's cost structure is pretty high, and they have never focused on making money for themselves. This is a big shift, and they are going to have to adjust to start working for shareholders and not just an insular little world of members."
Nasdaq, for its part, reported net income of $12.7 million for the first quarter of 2005, while Instinet recently reported preliminary results for the quarter showing net income of $14 million. (By way of comparison, General Electric Co. reported first-quarter earnings of $4 billion.)
The Home FloorBeyond all the concerns about regulation, valuation, marketplace competition and the like lies one other big question.
What will it mean if the NYSE floor, the symbolic home of American capitalism, source of millions of photos depicting traders in the throes of euphoria and the depths of despair, goes away? Won't something be lost forever?
"The NYSE has always been baseball, motherhood and apple pie all rolled into one," said Bradley of American Century Investment, an opponent of human traders working on a floor to handle stock transactions. "But it's not really the NYSE that is the envy of the world," he said. "It's the capital-raising process in this country that is the envy of the world."
And there are plenty of people who believe there will continue to be a role for human traders on the floor for years to come, especially in volatile and thinly traded stocks. "We will see a lot more electronic trading and automation in stocks where there is no need for an intermediary," said Sauter of Vanguard. "But where I do see the need for the traditional floor model is for less liquid stocks with wider [fluctuations in price] where you want someone who will take risks and make a market in those stocks. The combination of the two models is really exactly what you want."