Date: May 2, 2005
Publication: Pensions & Investments
By: Gregory Crawford

Patience is the reward in the NYSE merger

In less than a week, institutional investors got what they had been seeking for at least 30 years.

The combination of the New York Stock Exchange and all-electronic Archipelago Holdings Inc., Chicago, and the acquisition by Nasdaq Stock Market Inc., New York, of New York-based Instinet Group Inc.'s INET electronic trading platform together give buy-side investors such as pension funds and money managers greater flexibility in how and where to trade, and, most observers believe, gives that to them at a lower cost.

"This leads back to institutional investors just getting tired of what they viewed to be excessive costs," said Wayne Wagner, chairman of Plexus Group Inc., Los Angeles. "This goes back to before 1975 and negotiated commissions ... all the way to the rise of institutional money management in the 1960s."

William Cline, managing partner in the global capital markets practice at management consulting firm Accenture, New York, characterized the changes as launching a "battle of titans" for liquidity between the NYSE and Nasdaq, with institutional investors the big winners.

Still, industry pundits point out that institutional investors were unable to break the power of the NYSE trading floor without help from regulators, which they got on April 6 when the Securities and Exchange Commission approved Regulation NMS. When it takes effect next year, the new regulation will put a premium on automatic trade execution.

Applying pressure

"The whole reason for Reg NMS was to pressure New York" - which handles about 80% of listed stock trading every day - into moving more rapidly to increase automation and lower costs to investors, said one longtime market observer, who asked not to be named.

On April 20, as NYSE Chief Executive Officer John Thain and Archipelago CEO Gerald Putnam were announcing their deal, SEC Chairman William Donaldson acknowledged as much.

The deal "is illustrative of the intense competition between various markets," Mr. Donaldson said at a news conference following a speech to the Bond Market Association. "It illustrates vividly the importance of the level playing field we've tried to put in place."

Two days later, Nasdaq announced its deal to acquire INET.

"Reg NMS was there to even the playing field, and it's doing that," said Ted Oberhaus, director of equity trading at Lord, Abbett & Co. LLC, Jersey City, N.J. "Electronic networks are the markets of the future." He said the latest consolidation "should be good for us, the institutional community."

After the two deals are completed, the Big Board and Nasdaq will emerge as the two main cash equity trading centers in the United States, each competing for the other's order flow. It will leave one remaining electronic communications network; a handful of small, regional stock exchanges; and the American Stock Exchange, which trades mainly options and exchange-traded funds.

Accenture's Mr. Cline sees good things coming from the deals.

"I've read dire predictions that fees will increase, but I don't personally agree," he said. "Given the increasing importance of scale, both for liquidity and to spread needed IT (information technology) investments over a broader base, I think it's better for U.S. capital markets to have two very strong competitors than it is to have five, six or 10 competitors. In capital markets, it's not quantity as much as it is quality.

"Having these two very strong and well-financed competitors is likely the healthier scenario. I don't believe either party is going to have the luxury of increasing the total cost of trading."

That total includes explicit charges such as the cost to do business on the exchange and implicit costs such as market impact. Market centers cannot directly influence the cost of market impact, which in some cases can be a bigger component of the overall cost of trading, but they can influence market impact indirectly by the liquidity they bring to the marketplace.

$100 million a year

According to the NYSE, its combination with Archipelago is expected to save $100 million annually in explicit costs. Similarly, Robert Greifeld, president and chief executive officer of Nasdaq, said the deal would result in cost "synergies" of $100 million a year for at least the first three years of the new entity. Those savings and synergies could flow to investors through lower costs of doing business on the exchanges.

Eugene A. Noser Jr., president of Abel/Noser Corp., New York, an agency-only broker and transaction cost analysis specialist, said he expects both components of trading costs to decline in the new markets.

"It definitely should quicken the speed of trading and lower the cost," he said, referring to the market consolidation. "It should lower costs very considerably."

Explained Ian Domowitz, a managing director at ITG Inc., New York, an equity trading and transaction analysis firm: "Historically, the costs of providing both operational and building services decrease sharply with electronic trading technology. You can then think about whether or not that's going to impact commissions, and the cost to trade could indeed go down on a commission level as exchanges become more competitive. The reason is simply that as they become more competitive, the sell-side that trades with them faces lower costs and, in principal, that will be passed onto the consumer."

On the implicit cost side, the cutting-edge trading methods and strategies that are increasingly being used by buy-side investors - to limit market impact and maintain their anonymity - work best in an electronic market environment, which also suggests the new market structure will lower costs for investors.

"Trading is a game of information leakage - the more information leaks, the more expensive the trading becomes," Mr. Domowitz said. "To the extent you can achieve anonymity, whether through block trading systems ... or an electronic or automated exchange, you're going to save money."

From a purely economic standpoint, less competition typically means greater pricing leverage by the remaining participants, but Theodore R. Aronson, a partner at institutional money manager Aronson + Johnson + Ortiz LP, Philadelphia, said that's not the case here.

"An economist could make a pretty reasonable case that competition is a good thing and a monopoly is a bad thing," he said. "But if you fragment the markets enough they can - and in my opinion they did - approach better things for smaller investors and bad things for big investors. And over the last 30 years, small investors have subcontracted their money management to big investors."

He called the market acquisitions "unbridled good news" for investors and added: "I have no vested interest other than lower transaction costs."

At the $64.5 billion Ohio Public Employees Retirement System, Columbus, Joan Stack manages equity trading. During the past two years, she has moved "99.9%" of trading for the fund's passive index investments to electronic direct market access, which has lowered the system's broker commissions on passive index trades by 62% and overall implementation shortfall - a common transaction cost measure - by 58% year over year. While she said she would welcome greater electronic access to the NYSE for trading active funds, the wave of consolidation might only offer short-term cost savings.

"Less competition sometimes means higher prices in the long run," she said. "For all the benefits we're going to get near term with better technology, connectivity and speedier executions, maybe longer term costs will rise."

Costs could go up

Others agreed.

Joseph C. Gawronski, chief operating officer of agency-only broker and NYSE member Rosenblatt Securities Inc., New York, said two factors might put a cap on the cost savings investors ultimately realize from the NYSE-Archipelago combination: less competition between market centers and the fact that a for-profit NYSE could push up costs to sell-side firms working on the exchange. Those costs would eventually flow to buy-side investors.

"It's undeniable there will be cost savings," he said. "Who will they benefit? Will they simply benefit public shareholders (of the new NYSE Group), or will they flow through to users of the system?

"If they end up charging the sell-side more, that means the sell-side can't keep cutting rates," he added.

But Mr. Noser said he thought any increases would be small.

"Firms might have to pass increased costs back, but since you can do business at a penny, it might go to a penny and a half," he said. "You're talking about angels dancing on the head of a pin."

Market experts said that beyond the question of cost savings resulting from the consolidation of market centers, institutional investors are likely to benefit from the ability to trade more products at one venue.

Indeed, many expect the battle between the NYSE and Nasdaq to be about product rather than order flow.

"If you are a serious investor, you've got to go to the largest pool first," said Larry Tabb, chief executive officer of Tabb Group, Westborough, Mass., a financial consulting firm. He said the NYSE will likely maintain its 80% market share in listed stock trading, while the new Nasdaq will control up to 70% of Nasdaq order flow.

"The idea of trying to put together cash and options into one single product or have a closer affiliation may have some cost advantages or product advantages that down the road might be really compelling," he said.

That suggests this latest round of consolidation in the U.S. capital markets will not be the final round.

"Once these deals are through, the people running those exchanges are going to look at what features and functions people want, and offer them up," said Murray L. Finebaum, president and chief executive officer of electronic trading platformFutureTrade, Lake Forest, Calif.

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