The New York Stock Exchange is renowned for its grand market-opening ceremonies, during which star CEOs, celebrities and heads of state grace a marble balcony overlooking the iconic trading floor and ring a bell that starts the daily buying and selling of billions of shares in the nearly 3,000 companies that list on the Big Board.
Things are a little different at the Chicago Stock Exchange. The 124-year-old bourse, long overshadowed by the NYSE and the Nasdaq Stock Market, lists just a handful of companies and is located in a nondescript, Windy City high-rise.
Its light, 50 million-shares-a-day volume is mostly handled by computers. This spring its big opening-bell ringer was Bonny Brown, the bugler at nearby Arlington Park racetrack, whose visit coincided with the start of the horse-racing season.
“We ring the bell, but all that happens is that trading screens light up,” shrugs David Herron, CEO of the CHX. “The numbers change. You start to hear the mouse clicks.”
Regional bourses have fallen a long way since the days when equity markets flourished in cities like Boston, Chicago and Philadelphia, where the nation’s first stock exchange was founded in 1790. As New York cemented its status as the country’s dominant financial center in the 19th and 20th centuries, these regional markets mostly receded into obscurity. Big local companies increasingly listed their shares in the Big Apple, and investors followed. Today about four out of every five U.S. stock trades is handled by either the NYSE or Nasdaq. Much of the remainder goes to sophisticated new electronic markets, like Liquidnet and Pipeline Trading Systems, that have developed alternative ways for institutions to trade blocks of stock. The collective market share of regional exchanges in equity trading is less than 10 percent. Some, like the Philadelphia exchange, known as the PHLX, have survived by turning to options trading. Others, such as the CHX, cross-list NYSE and Nasdaq stocks but haven’t had much luck attracting volume.
Lately, though, things have begun looking up for the regionals. During the past year or so, Wall Street has been betting that the future of these markets will be far brighter. In June 2005, Merrill Lynch & Co. and hedge fund Citadel Investment Group each bought 10 percent of the PHLX. In August, Citigroup, Credit Suisse First Boston, Morgan Stanley and UBS followed suit, purchasing a 25 percent stake between them. (The six firms also own warrants that, if exercised, could double their collective ownership to 90 percent.) Also in August, Citi, Credit Suisse, Fidelity Investments and Lehman Brothers announced a joint venture with the Boston Stock Exchange to create an electronic market called the Boston Equities Exchange. Last month four firms — Bank of America Corp., Bear, Stearns & Co., E*Trade Financial Corp. and Goldman Sachs Group — spent a total of $20 million for minority stakes in the CHX. And the National Stock Exchange, formerly known as the Cincinnati Stock Exchange (and currently based in Chicago), is talking with potential partners; CEO David Colker says the bourse could announce a deal as soon as this month.
Why the sudden optimism? Like much else pertaining to money and markets, the answer lies with a combination of fear and greed. Big Wall Street firms worry that a consolidation wave is reducing competition among exchanges: In December, Nasdaq acquired the popular INET trading platform from Instinet Group, and in March the NYSE bought electronic bourse operator Archipelago Holdings. Now, as the big two try to extend their tentacles overseas — Nasdaq is attempting to acquire the London Stock Exchange, while the NYSE seeks a tie-up with pan-European market Euronext — the brokerage houses fear a looming Nasdaq-NYSE duopoly that could raise trading fees and be slow to innovate. Accordingly, they’re investing in the regionals to keep their options open.
“It’s a way for these firms to show that they have alternatives, that they are serious and putting money to work,” says Sang Lee, managing partner at Boston-based research firm Aite Group. “The message is, ‘You had better play nice, or you will end up paying a price.’”
Notes Seth Merrin, CEO of online block-trading platform Liquidnet, “Without competition breathing down the necks of the big two, it might end up costing each of the brokers more than $10 million every year in higher fees.”
The Wall Street firms and the regional exchanges also see a huge, lucrative opportunity in a battery of new trading rules that the Securities and Exchange Commission will begin implementing early next year. The reforms, collectively known as Regulation National Market System, or Reg NMS, will fundamentally restructure U.S. stock trading by creating a virtual centralized market in which exchanges will be automated and interconnected.
The goal is simple: to ensure that investors always get the best prices when buying or selling shares, regardless of which exchange posts those prices. The practical implications, though, are more complex and far-reaching.
Under the new rules, if an order to buy 100 shares of General Electric Co. is sent to the NYSE but the PHLX has the best price, the Big Board must send the order to the PHLX. Technically, that’s supposed to happen today, but the 30-year-old infrastructure linking exchanges, the Intermarket Trading System, is so slow and outdated that trades are often executed despite the availability of better prices on other markets. To solve that problem, Reg NMS decrees that only automated markets will receive protection from their quotes being “traded through,” as the Street vernacular goes. Investors will be allowed to ignore superior prices quoted on manual markets like the NYSE floor.
The result: The also-ran exchanges have their best chance in decades to flourish, provided they offer automated execution. That’s one reason brokerage houses are investing in the regionals — and it’s why the exchanges are using the money to build electronic trading platforms or to improve existing ones. Another inducement is the possibility that the regional markets will follow in the footsteps of the NYSE, Nasdaq and other big exchanges globally by selling shares to the public and participating in the ongoing consolidation of markets. Sales or IPOs could mean big paydays down the road for firms that are buying into the regional bourses at bargain-basement prices. Merrill and Citadel, for instance, paid $7.5 million apiece for their 10 percent stakes in the PHLX, valuing the exchange at $75 million — just 2 percent of Nasdaq’s $3.25 billion market capitalization.
Not surprisingly, regional exchange officials are ebullient. Some have even taken to calling themselves “nonprimary” exchanges, or by some moniker other than “regional,” which has come to connote irrelevance over the years. PHLX CEO Meyer (Sandy) Frucher, for instance, prefers the designation “smaller competitive exchanges.”
That classification also better describes the full range of markets that see new hope in Reg NMS. The New York–based American Stock Exchange — once firmly the No. 2 stock market to the NYSE before Nasdaq emerged in the 1980s as the go-to destination for growth companies, but now a distant third — is busy building an automated platform to supplant its stock-trading floor and is considering an IPO. The International Securities Exchange, a publicly traded, all-electronic market also based in New York that revolutionized options trading following its launch in 2000, announced in May that it was forming a joint venture with several brokerage houses — including Bear Stearns, Citadel (which runs a sizable market-making unit in addition to its hedge funds) and J.P. Morgan Chase & Co. — to create the ISE Stock Exchange. The Reg NMS best-price rules apply only to SEC-registered exchanges; when it launched, the ISE became the first market to win that designation in more than 25 years, but until now it has stuck to options trading.
“As of early next year, we will no longer exist as regional exchanges but as market centers within a national market system,” says Michael Curran, CEO of the Boston Stock Exchange. “The old model will be gone for good.”
Analysts, traders and exchange officials believe that one or more of these second-tier markets could emerge as a formidable challenger to the NYSE and Nasdaq and that, collectively, they will claim anywhere from 5 to 25 percent of equity market share.
“There is room for a third major equity trading platform,” says Josh Galper, managing principal of Vodia Group, a consulting firm based in Concord, Massachusetts. “There is no reason why a well-capitalized regional exchange couldn’t step into that role with the right management, business structure and technology.”
Many experts see in the rise of the regionals a repeat of the way upstart trading systems called electronic communications networks, or ECNs, shook up Wall Street in the late 1990s. Enabled by new SEC rules that mostly affected the trading of Nasdaq stocks — and backed by many of the same big brokerage houses now investing in the regional exchanges — ECNs like Archipelago, Brut, Island and Instinet captured a majority of Nasdaq volume in barely more than two years.
“There will be a lot of market share up for grabs in the coming years,” says CHX CEO Herron, who sees Reg NMS as a great equalizer for his tiny exchange. “If we can get 10 percent of that, we’ll be very well positioned to become an important player.”
THE SUCCESS OF THE SMALLER EXCHANGES will depend in large part on three factors: the quality of their technology, the fees they’ll charge and the degree to which their Wall Street partners will actually post quotes on and route orders to these markets. As automated trading extends its dominance, the market centers that provide the fastest, cheapest, most efficient executions will attract repeat business; those that fail to offer the best technology will suffer. The ECN wars of the late 1990s again offer an instructive parallel. As many as a dozen ECNs existed by early 2000, when a wave of consolidation began that, within only two years, had whittled that number down to a handful. The winners were those that had developed the fastest, most reliable systems, offered the most attractive pricing and had a broad base of Wall Street owners that were committed to providing them with orders and quotes.
The need for a built-in base of liquidity is the reason regional markets have welcomed investment from big brokerage houses. To exploit fully the opportunities presented by Reg NMS, an exchange can’t just hang out a shingle. To attract trades that might otherwise go to competing markets, it needs to offer the best prices in the country — and frequently. And an exchange can’t hope to have the best prices unless at least a few firms regularly post their quotes and send customer orders there. It’s the trading world equivalent of not being able to get a job without experience: Liquidity leads to more liquidity.
The big trading firms investing in the regionals and the ISE have a clear incentive to provide that liquidity: to put pressure on the NYSE and Nasdaq. That’s an especially pressing need as these markets complete their metamorphoses from cooperatives that sought to provide low-cost service to members into public companies that must maximize profits for shareholders. Late last month the NYSE increased by 25 percent the maximum monthly fees paid by its biggest customers.
“The brokerage houses still prefer to see the exchanges as utilities, and their interest is in influencing costs and driving them down,” says Philip DeFeo, former CEO of the California-based Pacific Exchange who recently co-founded Lithos Capital Partners, a private equity fund that aims to invest in exchanges and alternative markets. “They have an overwhelming need for competition to keep costs low, and they want to have an investment interest in that competition, so they have a voice in how those models work.”
Mark Haggerty, executive vice president of Fidelity Brokerage Co., says he will try new market venues — including, but not only, the Boston Equities Exchange that Fidelity co-owns — to see how orders are handled. All it may take for one or more of these markets to thrive is for a few early adopters to get excited enough about their initial experiences and become true believers, he argues. “If it goes well, we can increase that order flow, and then you will see liquidity beget liquidity. That is how the ECNs took off.”
But Wall Street firms can only go so far in trying to prime the order-flow pump for the upstart electronic bourses they partially own. A brokerage may choose to post proprietary quotes on a given exchange, or to send a chunk of its customers’ limit orders (which specify an execution price, unlike market orders, which are filled at the best bid or offer) to a particular market. But because Reg NMS requires orders to be executed at the best price, these broker-owners can’t guarantee that their trades will get done on the exchange of their choosing.
“Our strategic alliance gives us capital and gives us a look,” notes PHLX CEO Frucher. “After that we have to earn order flow like everybody else.”
Says Thomas Richardson, a managing director in Citi’s equity trading division: “There is no commitment to direct order flow to any particular exchange. We will send our orders to the place with the best execution. Period.”
Well, yes and no. Under Reg NMS firms will be able to continue to “internalize” certain trades. That means executing one customer’s order against another customer’s — or the firm’s — matching order instead of finding a counterparty in the market. Trades can be internalized as long as the execution price is equal to or better than the best available price in the national market system.
Several firms, including Citi and Credit Suisse, are building in-house ECNs that will help them more efficiently internalize trades when possible. These transactions must be reported to other market participants through an SEC-registered exchange. That’s where ownership in the regionals comes into play. Exchanges derive a significant portion of their revenue from selling the information about their quotes and completed trades to vendors like Reuters and Dow Jones & Co., which compile data feeds for brokerage houses and online services. Markets also can rebate some of that revenue back to the customers that post quotes and execute and report trades. Some use more-generous rebates as a way to attract business. The regionals’ broker-owners, then, will have a strong incentive to report internalized trades to markets in which they own stakes. They will be providing revenue to support their investments, plus benefiting from the data rebates.
Indeed, some experts believe that certain regional markets may become mostly places where internalized trades are reported, or “printed.” Vodia Group’s Galper estimates that big brokerage houses can each earn as much as $7 million per year in profit by operating an in-house ECN and printing internalized transactions on a part-owned regional exchange. Such markets, however, wouldn’t be very attractive places for other traders to seek the best prices for their market orders because they would lack a sufficient level of price quotes. For that reason exchanges that wind up being mostly print facilities won’t pose much of a threat to established bourses like the NYSE.
For its part, the Big Board says it isn’t worried. Robert McSweeney, senior vice president of competitive position, contends that investors who place orders with other markets “risk both delays and nonexecution of their orders.” The NYSE’s proposed hybrid market, he adds, is designed to make it easier for customers to execute trades electronically. “We intend to enhance our competitive position and our share of trading,” he declares. As for worries about a duopoly, McSweeney replies: “If we are not careful in how we price our business and how we serve our customers, new competitors will emerge.”
Nasdaq transaction services chief Brian Hyndman — who, as president of Brut, spent plenty of time in the trenches of the ECN wars — says that the regionals present a more credible threat now than ever. “They have been lining up partners and working on their technology,” says Hyndman. “When Reg NMS is rolled out they will be ready to compete, and we take that seriously.” Still, he sees the new rules more as an opportunity for Nasdaq to seize market share from the NYSE than to lose it to the regionals.
“Why would I send an order to Philly if it is much less likely to be traded than it would be on the NYSE?” asks Thomas Peterffy, chairman of Interactive Brokers Group, a Greenwich, Connecticut firm that makes markets on exchanges around the world. Unless an exchange has enough captive liquidity, it’s unlikely that its prices will be the best at any given point in time, he contends.
One answer to that argument is that limit orders represented manually at the NYSE — its proposed hybrid market will offer automated execution but will revert to floor trading under certain conditions — won’t enjoy trade-through protection under Reg NMS. There will be times, then, when seeking the deepest pool of liquidity may mean not getting an execution because potential counterparties are trading instead at inferior prices on automated markets.
“People will have to weigh whether they want to send their limit orders to the high-density liquidity pools where they may not be protected, and thus there is no guarantee that the liquidity will actually be a benefit to them,” says Citi’s Richardson. “Only time will tell what conclusions they come to, but you can be sure everyone will be tracking how those trade-offs work in practice.”
Another possibility: One or more regional exchange may become the dominant market for the thousands of small, relatively illiquid stocks that trade in the U.S. Liquidnet’s Merrin points out that 60 percent of all NYSE- and Nasdaq-listed stocks trade fewer than 100,000 shares daily. A regional exchange with the right partners providing liquidity could make a nice living supporting those securities. “You need someone to provide a market-making structure and liquidity for these companies,” Merrin says. “That could be the new area of expertise for the regional exchanges.”
With the implementation OF Reg NMS still several months away, it’s too early to identify winners and losers among the regional exchanges, although a few do appear to have a leg up. The PHLX, for instance, was the first of the regionals to get a capital injection from Wall Street and thus got an earlier start on building, testing and refining its automated execution platform. It also executes 12.8 percent of U.S. equity options trades. That’s an advantage as exchanges seek to offer a broad array of products to satisfy hedge funds and other customers that increasingly trade stocks side by side with options and other derivatives as part of complex strategies.
For this reason many also view the ISE as among the favorites. In just six years it has seized a market-leading 29.98 percent of U.S. options volume from established competitors like the PHLX and the Amex, thanks to its electronic trading platform and unique market-making system. It plans to take a similar approach to stock trading, relying on tech-savvy partners, such as Citadel and Interactive Brokers, that use sophisticated computer models to make tight markets and attract more orders seeking the best prices.
Less certain, but still strong in the eyes of market participants, are the prospects for the Boston Equities Exchange, which shares some of the same Wall Street backers as the ISE and derives some credibility from the successful launch in February 2004 of the Boston Options Exchange, a sister electronic market that has grabbed 5 percent of options volume in two years.
Another exchange that offers options trading, the Amex, got a later start on automating, has less credibility in the electronic-trading world and lacks brokerage firm backers. The National Exchange was one of the country’s first automated exchanges, but it has served as little more than a print facility for brokerages and ECNs, which took advantage of its generous market-data rebate policy, in recent years. And it is only now lining up Wall Street liquidity providers. The CHX, which was slower to automate than the National Exchange, is also late in allying with partners.
Meanwhile, Wall Street is spreading its bets. “My personal view is that the number of players will shrink as competition increases,” says Citi’s Richardson, whose firm so far owns chunks of the PHLX and the Boston Equities Exchange. “Obviously, we would hope that one of those we have invested in will ultimately become that third player.”
The only certainty in this Darwinian struggle is that the endgame should be relatively quick in coming. It took just a few years for the mushrooming ranks of ECNs to be pared down to two survivors: Archipelago and Instinet, which have since been acquired by the big two exchanges. The markets with the most early success will attract order flow from those that stumble. As the winners and losers become apparent, the weakest of the bunch will either become acquisition targets for the strongest or resume their pre–Reg NMS descent into irrelevance. In a bit more time, the most successful minor markets may wind up being acquired by the NYSE and Nasdaq as the bigger bourses attempt to recapture lost market share.
“For the first four or five years, we’ll see consolidation among the regionals just like we saw consolidation happen with the ECNs,” says Larry Tabb, the head of Westborough, Massachusetts consulting firm TABB Group, who has studied trading markets extensively. “NYSE and Nasdaq market share will go down, but eventually they will wind up acquiring the regional exchanges th
