Dr. P.V. Viswanath
Why trade is good for you
Europe May Offer a Glimpse
By CARRICK MOLLENKAMP in London, EDWARD TAYLOR in Frankfurt, and AARON
LUCCHETTI in New York
For clues to what the New York Stock Exchange of the future might look like as it moves more toward electronic trading, try Europe.
During the past decade, Europe's stock exchanges have replaced human traders with computers. The result: Cheaper, quicker stock trading plus an expansion into trading more esoteric and sophisticated products. Two of Europe's largest stock-exchange companies, for instance, own big derivatives-trading operations.
How much further advanced trading is in Europe compared with the U.S.
is more than a matter of national pride. It appears to have been a key
motivation for NYSE Chief Executive John Thain to pursue a combination
of the NYSE with Archipelago Holdings Inc., an electronic exchange based
in Chicago. In announcing the deal Wednesday, Mr. Thain said the NYSE
needed to be stronger in electronic trading and to have a more-diverse
product line including stock options and exchange-traded funds in the
U.S., which Archipelago offers, so as to compete more effectively with
In the U.S., the NYSE competes with other trading venues such as the Nasdaq Stock Market and Instinet Group, majority owned by Reuters Group PLC. In Europe, Asia and Latin America, the NYSE competes for the listings of global companies. Such companies pay the exchange fees to have their shares listed. It has become more competitive as global companies scrutinize the need for their stocks to trade on multiple exchanges around the world.
The emergence of electronic exchanges in Europe owned by publicly traded companies -- as the NYSE intends to be once the deal is done -- also has another big effect on European stock trading: consolidation.
Just before the euro was launched in 1999, there were 32 stock exchanges on the Continent and various derivatives exchanges. Armed with traded stock that can be used as a purchase currency, Deutsche Boerse AG and Euronext NV have expanded aggressively.
Deutsche Boerse runs the stock exchange in Frankfurt, owns the Eurex derivatives exchange, and has pushed into the U.S. by opening a derivatives exchange in Chicago. Euronext, based in Amsterdam, bought the London International Financial Futures & Options Exchange, known as Liffe, in 2001, as well as four stock exchanges across Europe in the past several years. The Finnish and Swedish exchanges merged to create OMX AB and this year acquired the Danish exchange.
Despite the consolidation, electronic trading has led to fierce competition among the exchanges to offer the lowest cost of trading to brokers. The cost of operating the exchange is much lower, too. Compared with an electronic exchange, the total costs of trading, including personnel and real estate, are between five to seven times higher at a nonelectronic exchange, said Walter Allwicher, a Deutsche Boerse spokesman.
Europeans say that electronic trading reduces the potential for problems, increasing efficiency and safeguards. "You don't have the human factor," said Gregor Pozniak, the deputy secretary-general of the Federation of European Securities Exchanges in Brussels.
If the European electronic model is any guide, there likely will be an explosion in the number of hedge funds that turn to the NYSE because of greater liquidity and ease of trading. Currently many hedge funds -- especially those that specialize in frequent trading based on formulas -- trade on electronic exchanges in the U.S. and Europe. "Trading strategies are going to become more profitable," said Benn Steil, senior fellow, international economics, at the Council on Foreign Relations in New York.
There are challenges to operating an exchange as a publicly traded company, including producing profit while not driving away trading clients. It is a "balancing act," said David Russell, head of Morgan Stanley's European cash trading.
Even with publicly traded currencies, Europe's big exchanges have run into limits in their ability to expand. Cost savings can be restricted by having to operate in multiple regulatory environments and, in some cases, in different currencies.
Late last year, Deutsche Boerse unveiled a preliminary offer for London Stock Exchange PLC, Europe's largest exchange by trading volume. Deutsche Boerse withdrew the bid in early March following massive opposition from Deutsche Boerse's shareholders to the 530 pence ($10.17) a share offered for the LSE. Euronext also has approached LSE with a view to opening preliminary takeover talks.
The fate of the LSE will remain on ice until at least September, when a United Kingdom government agency will decide whether a bid for the exchange would result in an "adverse competitive impact."
The merger of the NYSE and Archipelago likely will ignite speculation that the NYSE or Nasdaq would try to extend into Europe with a deal.
Floor-based trading hasn't disappeared altogether from Europe though. Frankfurt still has a tiny floor that dominates the electronic side in trading small, less-liquid stocks because there isn't enough business for electronic market.
Sweeping the Floor on Big Board
Exchange's Archipelago Purchase
Mutual-fund firms have long called for the New York Stock Exchange to expand beyond its traditional open-outcry trading system. It looks like they're finally getting what they asked for with the NYSE's plan to acquire electronic trading firm Archipelago Holdings Inc.
The result, money managers say, should be savings for fund investors.
"It's an interesting marriage of the new wave of electronic trading with the old generation of an auction market," says Gus Sauter, chief investment officer at mutual-fund giant Vanguard Group. "It will presumably allow our traders to execute larger trades with lower costs, which ultimately means lower transactions costs for fund investors."
"This will wring the inefficiencies out of the market structure
of old," adds Ted Oberhaus, director of equity trading at Lord Abbett
"I think this will be a significant positive for both funds and fund shareholders," says Ian Domowitz, managing director of global research at Investment Technology Group Inc., a New York provider of electronic-trading services. Trading costs, including brokerage commissions, are deducted directly from fund assets, reducing returns to investors.
With Archipelago, Chicago, under the NYSE umbrella, stocks "will be far easier to trade, spreads will narrow, volume goes way up, and the ability to move larger blocks of stock will go up," says Harold Bradley, chief investment officer for stock funds focusing on small and midsize companies at American Century Investments.
Mr. Bradley for years has been among the most vocal proponents of electronic trading and critics of the NYSE. In June 1999 a venture-capital unit he led at American Century invested in Archipelago, which at the time was privately held. American Century now owns shares in Archipelago, which is publicly traded.
But giant Fidelity Investments, another vocal critic of the NYSE, sounded a more cautious note yesterday. While saying the planned deal could be positive if it leads to more automated trading, a spokesman said that the firm questioned whether the deal "limits competition among market centers through the elimination of a competing market." Fidelity expects regulators to look into that question, the spokesman added.
Trades handled electronically, in which buyers and sellers are matched automatically, are far cheaper than floor-based trades. Mutual funds pay less than two cents a share to trade NYSE-listed shares electronically, half what it costs them to trade on the NYSE floor, according to consultant Greenwich Associates.
Electronic trading also gives mutual funds anonymity in their trading, making it easier for fund managers to buy large amounts of stock without driving the price up or sell large amounts without driving it down.
"Right now, big orders allow market makers to track Big Foot around the forest," Mr. Bradley says. "Technology allows us to hide our footprints."
John Montgomery, founder of Bridgeway Funds, applauded the NYSE deal, saying that more electronic trading will result in a better deal for his shareholders. "We get better prices" through electronic trading, he says.
By haggling for lower brokerage commissions and expanding their use of electronic trading, mutual funds' average commissions on NYSE-listed shares fell to 4.5 cents a share last year from 5.2 cents a share in 2002, Greenwich Associates says. Lord Abbett's Mr. Oberhaus says more than 40% of his firm's trades are handled electronically today, up from zero 10 years ago. He expects that percentage to rise.
Fund investors often aren't aware of trading costs, since they aren't broken out separately in a fund's expense ratio. Trading costs include brokerage commissions and such less-concrete items as market impact -- broadly defined as a trade's impact on the price of a stock -- and opportunity cost, the cost to an investor when there is a delay or failure to execute a given trade.
"There's a lot of squishy stuff in there beyond commissions when it comes to measuring trading costs," says Charles Bevis, research editor at Boston fund consultant Financial Research.
That said, it's not disputed that commissions, in addition to subtler trading costs, can be a significant drag on fund returns. The average U.S. stock has a 103% portfolio turnover ratio, roughly defined as the percentage of its assets traded in a year, according to researcher Morningstar Inc.
Still, some said it's far too early to say how helpful the NYSE's deal with Archipelago will be. Investment Technology's Mr. Domowitz notes that merging different electronic systems with floor trading is far from simple. Others caution against focusing on electronic trading and lower commissions as a silver bullet for mutual funds.
"It's really early," says Andy Brooks, head of trading at Baltimore-based T. Rowe Price Group. "Lower commissions don't necessarily make for a better marketplace or more confidence in a fair and level playing field for investors."
Anyone doubting how deeply partisan acrimony has permeated the governmental machinery of Washington need only have witnessed yesterday's Securities and Exchange Commission vote approving new rules for stock trading.
William Donaldson, Republican chairman of the usually staid SEC, sided with the commission's two Democrats to pass a rule that requires brokers to seek the best possible price when buying or selling a stock. Passage of the order-protection rule came over strong objections from Republican SEC members Paul Atkins, who accused Mr. Donaldson of laboring under a "fundamental misunderstanding of how markets work," and Cynthia Glassman, who claimed her compromise proposal was "rebuffed" by Mr. Donaldson. That prompted the SEC chairman to later tell reporters Ms. Glassman's recollections "were totally incorrect," the Financial Times reports. Mr. Donaldson defended the new rule as one that "protects investors … particularly small investors." The changes would extend to the Nasdaq Stock Market a rule that has long covered stocks traded on the New York Stock Exchange , barring brokers from executing a customer order at a price worse than the best price then available on any market, the New York Times explains. The SEC's head of market regulation said the rule would save investors as much as $321 million a year, an assertion Republicans disputed.
For some time Mr. Donaldson has been taking flack from fellow Republicans, as well as U.S. and foreign business interests, for the SEC's persistence in sticking by the Sarbanes-Oxley rules enacted by Congress and other regulations aimed at protecting investors that were put in place following the turn-of-the-millennium scandals epitomized by Enron and WorldCom. Yesterday's vote only intensified that heat, The Wall Street Journal reports. The vote "reinforces what appears to be a disturbing trend of actions that have resulted in split decisions" that undermine the SEC's authority, said Sen. Richard Shelby, the Alabama Republican who chairs the Senate Banking Committee. Two Republican senators said they will consider introducing legislation to stop the rule from going into effect. While the White House has in the past expressed its support for Mr. Donaldson, officials there privately have acknowledged to the Journal that they are monitoring the rising complaints against him.
May We Trade Through?
By CHARLES SCHWAB
It's not often that an arcane market structure rule intended to protect public investors generates the level of controversy that surrounds the Security and Exchange Commission's proposed trade-through rule. Why should you care? Because it has the potential to significantly change our stock markets, neatly placing sand in the gears of a fast, efficient, highly competitive trading system relied on by millions of Americans every day.
As you might guess, when government agencies take action claiming to protect public investors, I take particular notice. My business is focused exclusively on individual investors and the investment advisers who serve them. With over seven million individual customer accounts at Schwab, we are a guardian of the financial futures of multiple generations of Americans. We assume that role gravely. That is why I write to disagree with the SEC's proposal. In my view, the trade-through rule will not benefit public investors and may cause significant harm to our equity markets. And it is a mistake to adopt such sweeping change in the absence of a clear mandate from investors.
Nevertheless, the SEC intends to bring the debate to a head on April 6 even though there is no consensus within or without the Commission. House Financial Services Chairman Michael Oxley and Capital Markets Subcommittee Chairman Richard Baker have asked the SEC to proceed with caution and act incrementally. The securities industry is deeply divided over the proposal, which is backed by the NYSE and other floor-based exchanges , and opposed by Nasdaq , other electronic markets, and a number of major institutions like Calpers and TIAA-CREF, who represent individual investors. The SEC itself appears divided three-to-two on the issue.
So what are "trade-throughs"? And why is disruptive change required to eliminate them? "Trade-through" is old exchange-floor jargon for when a specialist on one exchange ignores a better quote on another market and executes (i.e., "trades through" that quote ) for a worse price. The exchanges and the SEC are now using the term to mean any execution that did not receive the best price, but that's a misnomer. All customers want to get the best price; but in today's fast-moving markets, it's often the case that a customer will voluntarily bypass (trade-through) the best quote , which may be good for only a small number of shares, in favor of getting their whole order executed all at once for a better overall price. In other words, it's not that customers are preferring speed over price -- it's that they often choose the faster execution because they've found from experience that it will lead to an overall better price. This is as true for the individual customer buying 500 shares as it is for the institution buying 50,000.
In an ideal world, trade-throughs should never happen because investors would theoretically have enough time to execute against the best quote first, even if good for only a small number of shares, before moving on to the next best quote , and so on. In reality, however, a stock often trades many times a second and the next best quote is often gone by the time the first part of an order is executed -- which explains why a customer may prefer to trade through the first best quote . In any case, trade-throughs are rare, even by the SEC's own estimates (less than 2% of the time). Independent analyses find they happen even less than that. Do these numbers really justify changing how the other 98% or more of orders are handled?
Most troubling is the SEC's plan to extend the trade-through rule to Nasdaq , a market that is already highly competitive and efficient. So much so that in popular stocks like Microsoft or Intel, executions occur at spreads of a penny, and often less (no spread at all) for customers using limit orders. What happens to the occasional order that gets traded through? The instant trading occurs at prices below a bid or above an offer, arbitrageurs leap into action, automatically generating orders to take out the traded-through order. When asked about the inevitable drag on market efficiency from a trade-through rule, Chairman William Donaldson said that several seconds is not too long to wait for an execution. How ironic, given that in today's Nasdaq market, orders traded-through likely wait only milliseconds before multiple orders seek to execute against them. So, it shocks me that the SEC seeks to take us all back to the slower processes of a floor-based system.
The proposed trade-through rule will dictate where and at what price orders are executed, with regard only to the best quote , and without regard to other crucial factors, such as depth of trading interest, market efficiency, market impact and firmness of quotes . What is the cost of disallowing choice and the competition it engenders? No one will invest in new bells and whistles to improve markets if there can be no competitive advantage. Even price is not really protected by the Commission's approach, since a better overall price in one market must be ignored in order to execute in a market with a better quote but fewer shares available.
What benefit could possibly come from denying customers the choice of where to send their orders? What benefit comes from protecting exchanges from competition? Investors have chosen, particularly in the last decade, the extraordinary innovation that has come from intense competition. Their trades have never been faster, more accurate, better priced, or cheaper. Let's not roll back the clock.
Mr. Schwab is founder and CEO of The Charles Schwab Corporation.