HISTORY IS BEING REMADE ON A REGUlar basis lately at the New York Stock Exchange. Last year the exchange ended more than two centuries as the ultimate members-only club, merging with electronic exchange operator Archipelago Holdings and becoming a public company. Then it created the first transatlantic market by acquiring Paris-based Euronext.
This past summer a different kind of history was recorded at the Big Board: Sometime in June the percentage of daily trading volume in NYSE-listed stocks that was executed by the exchange dipped below 50 percent. For the first time in its storied history, the institution that had for so long been at the epicenter of global capitalism no longer controlled its own market. The situation has only deteriorated further. In August the exchange executed just 45.8 percent of the volume in NYSE-listed stocks. It’s an extraordinary turn of events, considering that the Big Board’s market share floated above 90 percent for much of the 1990s and registered as high as 82 percent just two years ago.
These days, traders of NYSE-listed shares can buy and sell stock through an array of hyperefficient, highly automated and low-cost rivals. The biggest of these, the Nasdaq Stock Market, now handles close to 20 percent of the volume in NYSE listings, up from next-to-nothing just a few years ago. A further 35 percent or so is divided among some 40 alternative trading systems, most launched in the past few years, and newly resurgent regional exchanges. These challengers are capitalizing on a host of developments -- from stunning technological advances to new rules opening the NYSE to competition from faster electronic markets -- that have combined to finally end the Big Board’s stranglehold on U.S. stock trading after decades of premature obituaries.
“I am surprised at how fast the market share erosion has occurred,” says Anthony Abenante, co-CEO of Instinet, the technologically advanced brokerage that Japan’s Nomura Holdings acquired earlier this year from private equity firm Silver Lake Partners. “Volumes are surging from the fast, automated players in the market, and that just couldn’t happen when those orders had to go to the floor.”
The NYSE’s swift decline may be bad news for the exchange and its shareholders, but it is proving to be a boon for investors. The migration of NYSE volume to more-efficient market centers is helping to dramatically reduce transaction costs, which -- especially for pension funds, mutual funds and other big institutions that must move hard-to-trade blocks -- can be a significant drag on investment performance. During the 12 months ended June 30, the average institutional trade of an NYSE-listed stock cost just 14.80 basis points to execute, according to the 11th annual survey of global transaction costs conducted for Institutional Investor by New York research firm Elkins/McSherry. That is down 15.5 percent from the previous year’s 17.51 basis points and establishes NYSE stocks as by far the cheapest in the world to trade, besting those of other low-cost markets like Japan, the Nasdaq and the U.K. (see table, page 78.)
NYSE shares have long had among the world’s lowest transaction costs, but they have gained ground rapidly. As recently as 2003 the NYSE was in seventh place, behind Japan, Switzerland, France, Belgium, the Netherlands and Sweden; two years ago our survey showed the cost of trading Big Boardlisted shares as the third-lowest in the world, behind Japan and Germany.
One sign that off-board trading is driving the cost reduction: The average commission for an NYSE-listed trade has fallen from 4.56 cents per share in 2005 to 3.65 cents per share today, according to Elkins/McSherry. Transactions handled by the all-electronic systems that are taking share from the NYSE generally carry commissions of 2 cents per share or less, about half what firms charge for orders that require human intermediation and often end up being executed by floor traders. The average commission for Nasdaq-listed stocks, which have traded in automated fashion far longer, was 4.19 cents per share two years ago and now stands at 3.39 cents per share.
“The New Yorklisted market is truly open to competition now, and more competition is always a good thing for investors,” says Alfred Eskandar, CEO of Miletus Trading, a division of Liquidnet Holdings, which operates one of the most popular alternative trading networks for institutional investors.
The NYSE is trying to fight back. Late last month it announced a joint venture with BIDS Holdings, a crossing network owned by the 12 biggest NYSE member firms, to launch an electronic block-trading system. The move is an attempt to reclaim volume that has been lost to Liquidnet and other alternative trading systems.
“It struck us that BIDS had a brokerage-sponsored model, consistent with ours,” said NYSE president Duncan Niederauer during a conference call announcing the joint venture. “We thought it was best positioned to reaggregate all the dark liquidity.”
Meantime, transaction costs are declining globally, according to the Elkins/McSherry survey. The firm’s analysis of trading in 47 countries during the 12 months ended June 30 shows that the average institutional trade cost 40.45 basis points to execute, down 9 percent from 44.44 basis points during the same period one year earlier. Cost declines on such major markets as that for Nasdaq-listed stocks, though not as dramatic as the reduction for NYSE listings, helped drive the overall improvement in efficiency. Underlying the trend, pension funds and other institutions around the world are stepping up their scrutiny of how much trading costs are eating into their returns, using firms like Elkins/McSherry and Plexus Group to measure these costs and altering their behavior accordingly by directing trades to the most efficient electronic platforms. The main beneficiaries of this shift are so-called algorithmic trading platforms, which break up block orders and route the small pieces to be executed over time at the best available prices, as well as crossing networks that can anonymously match tens of thousands of shares at a time.
Investors are getting an assist from regulators, who are instituting major reforms aimed at increasing competition among market centers globally. In the U.S. a battery of Securities and Exchange Commission rules, dubbed Regulation National Market System, has been phased in over the past year and is having a profound effect on market structure. Starting March 5, all exchanges and competing trading systems were required to comply with the portion of the regulation that requires trades to be executed at the best price available across all market centers. This means that if an exchange does not have the best price for a given stock, it must route orders for that stock to the competitor that does. The rule protects only those quotes against which investors can execute trades automatically. Prices displayed by manual markets like the NYSE floor can be “traded through,” in the industry parlance, under the new regime. Previously, NYSE floor traders had 30 seconds to update their quotes to match or beat better prices elsewhere.
In response the Big Board has introduced what it calls a hybrid market, which features an automatic execution system but sometimes reverts to the floor-based auction. The hybrid, although embraced by many customers, is generally seen as too slow to compete with all-electronic rivals for certain trades, a problem that is contributing to the exchange’s market-share losses.
“When the new regs went into effect, we saw a quick shift,” says Joseph Ritchie, founder of Fox River Execution Technology, a 20-person firm in the Chicago suburb of Geneva, Illinois, that offers trading algorithms to institutions. “Trading the NYSE-listed names got easier to do and more economical, almost in a stair step.”
A similar regulatory initiative put forward in Europe, called the Markets in Financial Instruments Directive, goes into effect this month. One important component of MiFID encourages competition among European exchanges, in hopes of creating a pan-European stock market from the collection of national bourses that exists today. Nasdaq’s planned acquisition of Swedish exchange group OMX is clearly aimed at exploiting the new rules to take share from more-established European markets. And start-ups have already emerged to try to snare business from the likes of the London Stock Exchange, some more successfully than others. A seven-month-old electronic platform called Chi-X, operated by Instinet, handled nearly 368 million shares in September; on some days it executes more than 15 percent of the volume in shares of blue chips like Bayer and BASF.
In the U.S. the effects of Reg NMS have only accelerated already-heated competition and further fragmented what were once two centralized markets for Nasdaq and NYSE stocks. Nasdaq long ago saw its volume migrate to rival electronic networks, which sprang up in the mid-1990s and targeted the less-protected over-the-counter market. Now the same phenomenon is gripping the Big Board. Institutions are directing their block trades to algorithmic systems run by brokerages like Credit Suisse and Goldman, Sachs & Co. that tend to prefer the lightning-fast, automatic executions offered by Nasdaq and other electronic markets. Such platforms handle as much as one third of all equity trading, some analysts estimate.
The new rules make it easier for investors and their brokers to trade NYSE-listed stocks through these algorithmic systems. Nasdaq and two other rivals, BATS Trading and Knight Capital Group’s Direct Edge system, have been siphoning volume from the NYSE by offering superfast technology and cut-rate fees. BATS, a two-year-old firm whose moniker is short for Better Alternative Trading System, began trading NYSElisted shares in June and by mid-October was handling almost 6 percent of daily NYSE volume.
The business of crossing networks, which are often called dark liquidity pools because they don’t require users to identify themselves or display price quotes, is also surging, taking volume away from both the NYSE and Nasdaq. The number of these systems has exploded in the past two years, with networks run by big brokerages -- including Credit Suisse’s CrossFinder, Goldman Sachs’ Sigma X and two systems owned by consortia of Wall Street firms, BIDS and LeveL ATS -- joining stalwarts like Liquidnet and Investment Technology Group’s Posit. Even Nasdaq is executing 40 million shares daily in crossing sessions held at the open and close of trading. Nasdaq is planning several more crossing products, including one that will operate continuously throughout the trading day.
“We’re taking a lot of share from the New York right now, but we’re also focused on maintaining our Nasdaq-listed market share,” says Christopher Concannon, executive vice president of transaction services at Nasdaq. “Our No. 1 focus right now is putting out unique new products to help our customers trade more efficiently.”
Yet another group that is beginning to make life difficult for the established markets: electronic market-making firms such as Automated Trading Desk, Citadel Derivatives Group, Getco and Tradebot Systems (from which BATS was spun off). These outfits employ highly sophisticated computers to emit rapid-fire quotes and profit from minute price differences. The movement of NYSE-listed volume to an automatic-execution environment is a big opportunity for these firms to apply their model to a marketplace that previously had been, for practical purposes, off limits. “They are becoming competitors for the exchanges,” says Robert Gasser, CEO of ITG.
In addition to revealing which markets globally offer the lowest transaction costs, Elkins/McSherry’s data -- based on an analysis of more than 420 billion shares traded by more than 1,100 money managers and 1,900 brokerage houses worldwide -- show which firms do the best job of minimizing costs. Among brokerages, those firms that employ the most advanced technological systems for executing trades rank the highest. Credit Suisse, Fox River, Goldman, Instinet, ITG and Liquidnet each rank in the top ten in more than one category (see tables, page 76). Elkins/McSherry ranks brokerages by comparing the prices they obtained for clients with the volume-weighted average price for the same stocks on that trading day, for global equities as well as NYSE and Nasdaq shares. It also ranks them according to the difference between the price at which they executed orders and the price of the same stocks upon receipt of those orders, a benchmark known as arrival price.
Among these firms, Fox River is a relative unknown that turns in a stunning performance, placing first among NYSE brokerages and second among Nasdaq firms, measured against VWAP. It started writing algorithms seven years ago for its parent, Fox River Financial Resources, which Ritchie founded in 1993 after selling derivatives firm Chicago Research & Trading to NationsBank. Its group of about a dozen programmers has built Fox River’s algorithms to take into consideration what Ritchie, a veteran of Chicago’s futures and options pits, calls the “dirty logic” that elite traders rely upon. The systems are programmed to recognize multiple patterns that become part of human traders’ intuition, along with how they work with or against one another in a multitude of situations.
“It’s a whole host of things that become part of what a broker in the pit can just smell or feel,” says Ritchie. “They’re very messy, very hard to define and program into an algorithm without them stepping on each other. But we’ve been able to do it, and right now it’s clearly helping us break away from the pack.”
The firm guarantees that prospective clients who try its products will improve upon their current transaction costs by one half to three quarters of a cent per share, or it will make up the difference with its own money. So far, says Ritchie, it has not had to dip into its pocket once. Since it began marketing its algorithms to outsiders last year, it has picked up about 25 clients, who collectively trade anywhere from 7 million to 25 million shares per day using its products.
“We’re not salesmen,” says Ritchie, explaining that distribution isn’t one of the firm’s strong suits. “We’re more like riverboat gamblers. We’re very confident in what we’ve built, and we back it with our own cash. When people see that, they listen.”
Now that strategies such as Fox River’s, which generally tend to work better with hyperefficient execution venues, can be more fully applied to NYSE shares, it is likely just a matter of time before the Big Board loses even more market share. Something else to consider: The full impact of Reg NMS is only now beginning to be felt. The Elkins/McSherry survey measures trading through June 30. In July and August the final phases of the rule went live, requiring brokerage firms to comply with the prohibition on “trading through” advertised quotes that are available for automatic execution.
