by Verne O. Sedlacek, President and CEO, Commonfund
Last week, the Wall Street Journal reported the purchase of the American Stock Exchange building by investors with the intention of turning it into shops, a hotel and condos. How long will it be before the venerable New York Stock Exchange becomes the largest Starbucks in the world?
During the last decade we at Commonfund have discussed the implications of the fundamental changes that have been transpiring in the U.S. capital markets. Several of these analyses have focused on the changes going on at the New York Stock Exchange and the potential impact on the investment process for institutional investors. The latest news out of New York is the merger/ takeover of the NYSE by Germany’s Deutsche Boerse. While this may come as a shock to some, it is the final end to the path of events that was set in motion a number of years ago.
There are two tributaries which came together to form this mighty roaring river of change. The first was unleashed by “Dick Grasso/Specialist problem” and the second was the combination of improvements in technology and the push for “faster and cheaper” by very large traders of securities mostly among mutual fund complexes.
If we travel back in time to the days of the Buttonwood Tree, we would find that until recently the concept of the Exchange had not changed. It was a group of people or firms that created a membership organization to provide a platform for the exchange of securities and information. The form of the exchange was created for the mutual benefit of its members, not for the benefit of the exchange. The members would get together and trade stocks for themselves or on behalf of others and generate a profit for the activity. The role of the exchange was to create the venue and to ensure that the traders played by the rules.
The opportunity to make money by trading was accessed by buying a seat from the exchange or from another member. The exchange charged a small fee to pay the rent and the cops to ensure people were playing by the rules. In buying a seat, the specialist (member), as it was called, also had the obligation to provide orderly markets in those stocks for which they were responsible. That meant providing capital to reduce the volatility of the shares when order imbalances occurred. The specialists’ revenue came from two primary sources. The first was the spread between the purchase price and the sale price which was in 16ths (i.e. 1/16th, 3/16ths etc.) and the profit or loses they would experience from taking positions in the stocks. Since they had the inside track on order flow this could be very profitable.
All of this transformed in 2001 with the change in the measurement of spreads from 16ths to decimals. The minimum spread that could be earned by a specialist on a share of stock went from 6 ¼ cents (1/16th) to one cent: the result was that specialists could no longer earn a living. The value of a seat on the NYSE dropped from $2.65 million in 1999 to $1 million at the end of 2004. Contributing to this decline in addition to the compressed spreads was the specialist scandal which hit in 2003, wherein specialists instead of acting as facilitators, matching buyers with a sellers, tried to profit by getting between the investors, buying from one and selling to the other. The NYSE and later the SEC fined the largest specialist firms for improper trading for their own account and to the detriment of customers.
All this was taking place at the same time that Richard Grasso, the long time CEO and the Board of Directors, was coming under criticism for issues related to corporate governance including CEO compensation. (This was led by then New York Attorney General Elliot Spitzer.) The world is a strange place. Grasso left the NYSE and the claims regarding his compensation were eventually dismissed.
Finally, in December of 2005, NYSE announced that it would merge with Archipelago (an electronic execution platform) to create a public company. This ended the over 200 year history of the NYSE as an organization that provided the infrastructure for others to execute transactions as a service. Now the NYSE itself had to make a profit for the benefit of outside shareholders.
The second major tributary affecting the fundamental market was the improvement in technology and the shift in control from the specialist system to large pools of capital. Large pools of capital wanted two things: (i) lower cost of execution and (ii) quicker execution. They wanted execution not in a minute but in seconds. This need for speed led to a move away from the floors in buildings staffed by people and telephones to virtual exchanges run on silicon in remote areas. The system went from one where two decades ago almost all trades were touched by humans to a system where almost all trades are automatically matched in a computer. The NYSE, wanting to compete in this electronic market, originally created something called the Hybrid Markets where some NYSE trades would be executed on the floor while others would be executed in their electronic system. While most of the electronic trading over the prior decade was originally done at NASDAQ, there has been a significant growth of competitive systems including what has become known as Dark Pools where the buyers and sellers are anonymous.
This of course has led to a completely new term called High Frequency Traders (HFT). This is a broad category of investors that utilize information available in the electronic systems (the order books and other limit information previously kept by the specialist) to interface with their own computer systems to place bids and asks across the various electronic systems to take advantage of the information in real time. The power and the sophistication of these HFTs didn’t hit me until I was told by the CEO of the NYSE that these traders were attempting to get their computers as close as possible to the electronic platform so they could gain an edge by having the information flow slightly quicker. (Think about it, information is traveling at the speed of light.)
It is now estimated that 70 percent of the all executions are the result of HFTs.
We can see what happens when humans are left out of the flow. The May Flash Crash happened in part because all orders were funneled away from the NYSE floor and went into the electronic platforms. When the market started to break the HFTs pulled all buy orders from the system and some stocks automatically went to the best bid which may have been mere pennies.
While the regulators have put in circuit breakers on individual stocks and proposed charging HTFs a fee for bids and offers, the implications of these changes are still being sorted out.
What does this mean for the future?
In 2004 we wrote that the changes brought on by the events of the NYSE were hard to predict so while we know that the butterfly flapping its wings in New York will cause major amplifying currents somewhere, it is hard to fully understand the eventual outcomes.
Let me try and outline some possible futures.
- The short term volatility of individual stocks and markets will continue to remain high. I believe that we are in a new normal (to steal a catch phase) for market volatility. Less and less capital will be utilized to ensure orderly markets.
- Barring monopolistic issues we may end up with one worldwide exchange.
- The opportunity for regulatory arbitrage will increase as exchanges become cross border entities. Today the regulations are still a source of great nationalist pride so that until we get a major breakdown, investors will seek those jurisdictions that offer the greatest regulatory benefits. (All we have to do is to look at the listings of companies on NYSE relative to non U.S. exchanges after the passage of Sarbanes Oxley in the US.)
- Derivatives will continue to increase in their usage. As the trading in underlying cash instruments offer less benefit of the value of diversification, derivatives will fill in the space. This includes a greater number of ETFs on everything under the sun.
- The cost of execution in the cash market will continue to drop. This is good for investors, but with this, the amount of stock specific research will also go down. This means that the individual equity positions will become more mispriced relative to underlying fundamentals and the market as a whole. This should be good for stock pickers as long as investors can deal with longer periods of relative underperformance and higher levels of volatility.
- You can get your venti skim latte at 11 Wall Street.
As I have said in the past, it is difficult to predict all of the outcomes of these events which appear to be only small changes. But one thing is for sure: the outcomes will be significant. I am hopeful these changes will provide opportunities for long-term patient pools of capital by reducing the cost of execution and increasing the amount of mispricing that might exist in the individual names and markets that can tolerate higher levels of short-term volatility, but we can never be sure.