Buttonwood
The cyberbuttonwood era arrivesApr 26th 2005
From The Economist Global Agenda
SourceAmerica’s fragmented stockmarkets are consolidating with a vengeance as electronic trading increases. This must be good news for investors—but for some more than othersIT IS not widely appreciated—even by the willing but baffled Family Buttonwood—where the name of this column comes from. So cast your minds back a couple of centuries to Lower Manhattan, where two dozen brokers and merchants gathered in the shade of a spreading—you guessed it—buttonwood tree and agreed to trade securities at an agreed commission, thus forming the first American investment community. The origins of the New York Stock Exchange are intertwined with the roots of that tree, at least in legend. The buttonwood itself is no more; the NYSE, on the other hand, which not long ago looked as if it might be heading the same way, has just made a deal that should transform it into one of the strongest players of the electronic age.
Most of America’s exchanges were slower than Europe’s to embrace electronic trading, convert from mutually-owned associations to profit-making corporations, and run derivative- and share-trading under the same roof. The world’s biggest capital market can get away with a lot, but as the financial system becomes increasingly globalised, parochialism looks like paying less and less.
The huge NYSE, with listed companies (including foreign ones) worth $20 trillion at the end of last year, basked in its franchise while its floor-based specialists guaranteed liquidity (and occasionally short-changed their customers). NASDAQ, an electronic exchange set up in 1971, made a run at it and failed, partly because the bursting of the dotcom bubble ruined many of the smaller and high-tech firms in which it specialises. Meanwhile, a host of electronic communication networks (ECNs), used mainly by big institutional investors who valued their speed and anonymity, went from nipping at both exchanges’ heels to threatening the core of their business.
One pressure for change at the NYSE came from institutional investors. Partly to placate them, the exchange’s new chief executive, John Thain, promised to extend the use of its existing computerised trading system, which now handles 10% of daily trading volume, into a hefty hybrid. The other main pressure came from the exchange’s 1,366 seatholders—a mixture of family-owned brokers and offshoots of Wall Street’s most powerful firms. They watched with growing frustration as the shares of recently-demutualised exchanges, such as the Chicago Mercantile Exchange, soared (see chart), while the value of their own seats dwindled.
The catalyst may well have been the Securities and Exchange Commission’s decision to tighten the controversial “trade-through” rule linking America’s markets. In an attempt to create a single pool of liquidity out of the nation’s fragmented markets and to make sure that investors all have access to the same best prices, the SEC ruled on April 6th that in a year’s time all trades must be executed in the market where the best price is immediately available. This put the NYSE, where prices tend to be good but execution is usually slow, on notice that it had to upgrade its electronic capability at once in order to speed up trades.
The scene is now set to change dramatically. The NYSE announced on April 20th that it plans to merge with Archipelago Holdings, owner of ArcaEx, a fast-growing ECN that now handles a quarter of the trading in NASDAQ-listed shares and has just acquired the Pacific Stock Exchange, which specialises in derivatives. No sooner had the fibre optics hummed with that news than NASDAQ revealed plans to buy Instinet, another ECN, owned mainly by Reuters.
Where does that leave both exchanges? The NYSE becomes a public company, with the ability to amass capital for investment in its own systems and acquisitions—and a need to make money for its shareholders. With ArcaEx’s electronic trading business it gains a vantage point from which to compete for trading in NASDAQ-listed shares and to seek listings by smaller companies that do not meet the qualifications of its own “main board”. Finally, it will now have a platform on which to develop trading in fast-growing derivatives and exchange-traded funds. And, of course, it has effectively eliminated a strong rival. “Before, other markets were looking at the NYSE as a prey during its hybrid evolution; with this deal, it will now be seen as a predator, and rightly so,” says Bill Cline, managing partner in charge of global capital markets at Accenture, a consulting firm that has worked for many of the world’s exchanges.
But though Mr Thain’s move has rightly been termed bold, it may not be immediately brilliant. First, Archipelago’s technology and its vaunted entrepreneurial culture are both quite different from New York’s. It is not yet clear exactly what use New York has for ArcaEx’s trading technology. In the short run, it seems that the NYSE will use it alongside its own hybrid system, but something encompassing the two may need to be developed for the longer term.
Second, not all of the NYSE’s members are thrilled by the terms of the deal, and many are particularly unthrilled by the various roles assumed by Goldman Sachs as shareholder in Archipelago, NYSE seatholder and adviser on the deal to its ex-employee, Mr Thain. Disaffected Wall Streeters are being courted by Kenneth Langone, a former NYSE bigwig and sidekick of Dick Grasso, Mr Thain’s now-disgraced predecessor. Mr Langone was trying this week to put together a rival bid for the New York exchange. But though some of the NYSE’s members may want more, even on the current terms they seem certain to get more than seats have been selling for recently: as if in confirmation, a seat sold on April 25th for $2.4m, up $600,000 from the previous sale and not far off the 1999 peak.
NASDAQ’s deal looks less revolutionary but more digestible. By merging with the INET electronic trading side of Instinet, it will consolidate its position as the market where NASDAQ-listed shares are traded, and could end up with 75% of the total. With more liquidity it may also be able to offer better prices and thus raise its share of trading in New York-listed shares. It is also acquiring what many consider the top electronic trading system in America.
The real question, though, is how these changes will affect the companies that rely on the markets to raise capital, and the investors who pour their money into them. The big picture is that two concentrated pools of liquidity are emerging, one centred on the NYSE, the other on NASDAQ. Buttonwood’s bet is that this will intensify competition, not reduce it. That, in turn, should drive down costs, speed up transactions, spur innovation—and perhaps permit American exchanges to take on Europe’s head-to-head. Companies should benefit from increased liquidity; institutional investors are likely to see costs fall; there is no reason why retail investors should see theirs rise.
And yet…and yet…all this profit-maximising can lead people to do strange things. It feels like an awfully long time ago that stock exchanges were seen as a utility to be operated in the public interest and bewhiskered businessmen loosened their cravats, or whatever they wore, under a now-defunct buttonwood tree.
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