This paper was entitled “The Perfect Storm” before we realized how many different papers and speeches on diverse topics had used the same title. We suppose that this is natural since the concept of different factors conspiring to create an event that is too big to be created by a single factor has many applications. The popularity of the metaphor notwithstanding, we have chosen to stick with the concept of a perfect storm to describe the events in this paper. We differentiate our usage of this metaphor from most of the other references we found in that we are not trying to sell gold, investment advice or any other products. We are only “hawking” ideas.
We would like to thank Michael Atkin of the Financial Information Services Division of the Software and Information Industry Association; Junius “Jay” Peake , Monfort Distinguished Professor of Finance at the University of Northern Colorado; and Barbara Richards, an independent consultant and industry expert for their editorial help and comments.
Executive summary
Dramatic change — wars, social revelations, disasters and industry transformations — usually occur as the result of a combination of actions and forces that, in combination, are too great to be reversed. We are on the brink of such a change. As we consider the current economic environment we believe that a combination of forces and events are conspiring to change the securities markets dramatically. Like the climatic forces in Sebastian Junger’s book The Perfect Storm: A True Story of Men Against the Sea, the massing forces are likely to change the prospects for many firms and individuals and may swamp the unprepared.
The forces and events that will transform the markets can be grouped as follows:
- Structural factors
- Technological factors
- Demographic factors
- Political factors
- Economic factors
In combination these forces are creating an environment where the historic structure of the buy and sell sides of securities industry (the Industry) is unlikely to survive in the present form.
The last Industry-altering event of comparable magnitude was the passage of the Securities Acts Amendments of 1975 (the ’75 Amendments.) Enactment of the ’75 Amendments was precipitated by a number of forces, including the near-collapse of the Industry as a result of operational problems that have come to be known as the “back-office crisis.”[1] In the aftermath of the back-office crisis we created most of the basic infrastructure that has supported the securities markets for the last quarter century. Moreover, the end of fixed commissions seemed to foster dramatic growth in trading volumes that generated income that dwarfed the impact of reduced commission rates on individual transactions. More careful examination of the demographic forces at work after May Day[2] suggests that massive volume increases that bailed out the Industry at that time are unlikely to be repeated.
In last thirty years there have been many significant events in the securities markets. These events have included the end of fixed rates, the requirement that Nasdaq report last sales, permission for shelf registrations, the order-handling rules and the end of the NYSE’s Rule 390. Each event has resulted in a chorus predicting: “The end of American capitalism.” In each instance capitalism did not end. In fact, the Industry often did better after these “dire” events than before. As a result, the Commission, the Congress and the public are not very sympathetic to predictions of catastrophe. The forces at work now will not cause the end of capitalism. They may, however, cause the end of capitalism, as we know it. It is likely that many firms and institutions may not survive or will survive only after dramatic restructuring.
Ironically, if these changes are as dramatic as they seem to us, the Commission and the Congress, which together precipitated many of the changes, may find themselves confounded in their attempt to regulate the Industry in the future.
While we are describing the changes here in an American-equities context, we do not believe these changes can occur in one country or one market without expanding or spreading to other regions and markets as well. In fact, some of the changes such as demutualization and exchange-independent listings are more advanced in Europe than they are in the U.S.
We believe these factors, combined with technological changes that are occurring independently, but in parallel, suggest a new industry structure that is far less tightly linked and less dependent on relationships — both formal and informal – than has existed until now. This paper will not dwell on the future of the Industry, but rather on the reasons the past is unlikely to continue.
A look back
This paper is the second of three papers considering the changing nature of the securities industry and its possible future. In the spring of 2003 we wrote a white paper on the market-data industry entitled “The Death of 1000 Cuts.” The paper made some predictions about the future of market data, but did not establish the foundations on which the predictions were based. Looking back, we believe that paper would have benefited from a more encompassing context. As a result, we have been thinking more broadly about what is going on in the larger securities markets. A broader analysis of the state of the markets and interviews with industry experts prompted this paper. We have also engaged in a more comprehensive speculation about the nature of the future of the entire securities market; not just market data. This paper focuses on the reasons that change seems to be both inevitable and, when it comes, dramatic. The last of the three papers will address the structure of the future market.
It seems appropriate to compare the period leading up to the enactment of the ’75 Amendments to the present. Both periods can be identified by financial “storms’ that precipitated dramatic change. Actually, the current period is more similar to the period in the late 1960s when the collective back-office of Wall Street nearly collapsed under the staggering trading volumes of about 20 million shares per day on the NYSE. (Our introduction to the securities industry came after the back-office crisis was past and the Industry was trying to recover. Nevertheless, we learned about the Industry at the knee of Junius “Jay” Peake who managed the back office of Shields and Co. through the crisis. As a result of Jay’s teaching, we feel as if we were present during the crisis.)
The back-office crisis of the late 1960’s caught the securities industry unprepared to handle modern financial realities. The Industry was dependent on old business practices that had evolved over nearly two hundred years. While some of these practices — such as honor and personal integrity — should be mourned for their passing, others were less attractive. Protectionism, archaic governance, antiquated legal structures and needless insularity among lines of business were bound to change whatever their original purpose or merits.
The back-office crisis triggered the Congressional reviews that resulted in the changes to the operational infrastructure of the securities market. Of equal importance were changes to the economic structure of the market including the end of fixed commissions. As critical changes occurred, many market participants believed the end of the securities industry was at hand. Banks had more capital than broker/dealers and some experts predicted that banks would swallow the brokers to create a European-style financial market, dominated by banks.
Those predicting the end of the securities industry after May Day failed to take into account five collateral trends or forces that were separate from the effects of the Securities Acts Amendments of 1975.
First, broker/dealers were tougher than banks. In the aftermath of the crash of 1929 and the depression, two fundamental philosophies developed for banks and broker/dealers. Banking regulators, traumatized by bank failures, developed the belief that the worst thing for public confidence was a bank failure. Therefore banks were propped up at all costs. Broker/dealers were deemed to be one step better than thieves, and as long as investor money was protected, the collapse of a broker/dealer was considered inconsequential. As a result, weak broker/dealers were aggressively weeded out, while nothing short of creative incompetence was sufficient to close a bank. (In fact, weak banks were not closed but merged into stronger organizations.)
The second factor was demographic change. From the late 1960’s to the mid 1980s, the post-World War II “baby boom” reached majority and began to contribute to the economy. This population shift created huge demand for financial products. Such products and services as individual trading, mutual funds, pensions, mortgages, and other products and services saw dramatically increased demand.
Third, the Congress passed the Employee Retirement Income Safety Act (ERISA) in 1974. ERISA fostered a huge increase in the pool of institutional pension money under management. Corporate officers sought the services of professional managers because of their strengthened fiduciary obligations. Many financial institutions set up separate pension divisions. Much of this money was actively managed, resulting in increasing trading volumes.
Fourth, the creation of financial derivatives, in particular standardized exchange-traded options, resulted in collateral increases in the trading activity for the underlying instruments.
Finally, the 1970s saw a dramatic increase in the “securitization” of financial instruments: mortgages became mortgage-backed securities; short-term bank loans became commercial paper; and syndicated sovereign loans became government bonds. Brokers generally benefited from securitization at the expense of banks.
All of these factors created both underwriting and trading revenues. These factors, more than changes in commissions and improved infrastructure, created the boom for the securities industry that began in the early 1980s.
The boom for the financial markets following the enactment of the ’75 Amendments fostered three potentially dangerous premises about the securities markets on behalf of the Commission, the Congress and the public. These groups hold the belief that:
- Whatever change or improvement is proposed, the Industry will weep and wail that the “end is near;”
- Any change that decreases transaction costs will have a beneficial impact on the Industry as a whole and the public in particular; and
- Any reduction in the costs of an individual transaction will be made up by increases in the total volume of trading.
While the first premise is demonstrably true, it is unfair. Any business owner or senior manager opposes change with its attendant uncertainty. The financial industry is not unique. The second premise has two questionable foundations: the first foundation is the assumption that the only group in the security markets that needs protection is the individual investor trading for his or her own account;[3] the second foundation is that each transaction can be evaluated independently.[4] The third premise is based on the assumption that the demand for execution services is essentially elastic[5] (e.g., that a decrease in the price of the service will create an increase in demand).
The best evidence that improving structure and reducing transaction fees do not of themselves ensure market success is the “Big Bang” in London. In 1980, the Wilson Committee recommended a number of improvements in the U.K. markets that were analogous to some of the changes created by the ’75 Amendments. When the changes were agreed and implemented in the fall of 1986, most people expected the same level of benefit to the U.K. market that had seen in the U.S. The anticipated jump in market activity and profits was not realized. In fact some of the beneficial structural changes initiated in Big Bang were ultimately watered down.[6] Our conclusion is that simply making structural changes and reducing transaction costs is not a guarantee of increased trading volumes and revenues.
The gathering storm
The overall mood in the markets from the enactment of the’75 Amendments to early 2000 ranged from halcyon to ebullient. Volumes increased dramatically — two orders of magnitude on average. These growing volumes and a guaranteed spread of at least $0.0625 per share created huge benefits for the brokerage community. The guaranteed minimum spread provided a cushion to absorb pricing errors and still permit a dealer to remain profitable. Huge demand for capital ensured robust investment-banking profits. Demographic patterns made certain that all forms of institutional investment management could count on dramatically larger pools of money to manage. Larger investment pools in turn generated increased trading volume. Relatively lower transaction costs resuscitated both active individual investors and day traders. (Both groups had been discouraged by the high cost of fixed-commission trades.) Finally, the costs of individual transactions and error costs for problems were reduced dramatically by the changes to the post-trade processing structure.
Over the nearly thirty years since the ’75 Amendments, there have been difficult interludes. But for the most part, this period may be viewed by historians as one of the most favorable periods of all times in the financial markets. With such a rosy past, what is there to stop the good times from continuing unchanged? Certainly the period from the first quarter of 2000 through the second quarter of 2003 has been a “bad patch,” but the current cycle will end. Is there any reason to assume that we will not return to the status quo ante?
We believe the markets are on the verge of a dramatic structural change that is being precipitated by forces that have been building for a number of years. The pace of this change is being accelerated by governmental actions taken in what is perceived to be the public interest. The final result is likely to be a market structure that will not be consistent with the vision of many of those who have played an active role in causing the changes to take place.
Before addressing the changes, we need to review the sources of revenue in the securities markets.
Four types of entities participate in the securities markets:
- Broker/dealers — Firms registered as broker/dealers get revenues from: trading either as dealers or agents; investment banking and corporate financial advice and services; using their own capital both to provide financing to customers and in proprietary trading; and finally, acting as asset managers for customers.
- Exchanges — Trading venues registered as exchanges get revenues from: transaction fees; listing revenues; and selling data about the transactions and related information.
- Institutional investors — Institutional investors, whatever the statutory basis for their creation, get revenue from fees based on the money they manage; and in some cases as equity partners that participate in the performance of the funds they control.
- Vendors — Vendors get revenue from: product sales; per-transaction fees; and consulting fees based on per-days rates.
Understanding the risks inherent in generalizations, we generalize about these revenue sources as follows:
At traditional spreads (i.e., 1/8ths and 1/16ths), dealing was more profitable than commission business.
Traditional investment banking (pricing an issue, buying the entire issue for syndication, and then selling the issue to customers, perhaps taking a position to participate in the after-market “bump”) is more profitable than charging fees for corporate financial advice when the investment-banking customer sells the issue directly to the end investor.
- The end of payment-for-order-flow is likely to change the economics of discount brokerage.
- The end of soft dollars or “soft commissions” will change the economics of investment management and may change the apparent performance of funds.
- For execution venues, it is generally possible to make more money charging cents-per-share than charging dollars-per-execution.
- For execution venues, information fees are only attractive if you control enough share of the trading in a region or instrument to force those who trade the instrument to buy your data.
- Vendors can make more money by selling products than by charging day rates.
Most of the forces we describe are moving entities in the Industry from economic models that are economically favorable to less favorable models. Any forces that change the economics of these revenue sources will ultimately affect the relative economic power of Industry participants and therefore the structure of the Industry.
The tempest
Good, speak to the mariners: fall to't, yarely,
or we run ourselves aground: bestir, bestir.
Master
The Tempest
Act I Scene 1
Most dramatic change is not the result of one single force or event. During the period since the ’75 Amendments the securities industry has sustained many jolts, most notably the crash of 1987. Following each incident the Industry continued to prosper. For momentous change, a number of factors have to coalesce.
Also, significant shifts in power are not binary. For the balance of power to change in an industry it is sufficient for modest changes in relative influence of various groups within the Industry to occur. Therefore, in considering the changes we are predicting, do not assume that we are suggesting unquestioned victory or total defeat. We simply believe that a number of forces and events are coalescing at this moment to precipitate shifts among the centers of power in the securities markets and dramatic structural change.
For convenience we have grouped the factors we will discuss under several headings. Most of the factors could be categorized under more than one heading. Moreover, the headings themselves are interdependent.
Structural Factors
The structure of the securities markets has changed in a number of important ways in the last several years. The markets have fragmented. There has been an erosion in the historic collegial relationship between the buy and sell sides. The changes required for straight-through processing (STP) are creating a new order and trade-processing environment. Problems created by a variety of scandals are likely to force de facto or de jure changes in market structure.
Market fragmentation is most notable in the Nasdaq marketplace and in options. However, the NYSE-listed equities market and the markets in Europe are also beginning to show signs of fragmentation. The extent of possible fragmentation in the NYSE market and in Europe have been masked by depressed market conditions since 2000. Also, rules requiring trades to be printed on the NYSE and the London Stock Exchange have historically disguised trades that were effectively negotiated upstairs.
A number of industry experts seem to think that fragmentation is a transient condition. These experts may believe that as the markets are redefined, a new order will emerge. If this assumption is true, then as some new market structure evolves one market will again dominate and end fragmentation.
We believe that market fragmentation will continue to be a permanent fact of the markets in the future. Each of the significant venues (in terms of trading volume) that trade Nasdaq securities is particularly well suited to a specific trading constituency. Each constituency would be less well served by the alternate venues. The appeal of any market or trading venue depends on a mix of execution algorithms, transaction charges and rules for disclosing information. The existing market centers are actively manipulating their mix to enhance their appeal. We believe there is no “optimum” mix that will appeal to all trader categories, or even a majority. Therefore, fragmentation will not end.
Linking the Nasdaq market venues has become critically important because of fragmentation. A Nasdaq linkage is difficult to achieve by a regulated entity. Each linkage mechanism inherently advantages some trading venues while disadvantaging others. The continuing problems with ITS for the AMEX and NYSE markets argue against a similarly-structured linkage. Failure to create a mandated linkage for Nasdaq has created a vacuum into which firms such as Lava Trading and SLK’s Redi products have moved. These private linkage mechanisms provide users with the capacity to get to multiple markets efficiently, but they are not subject to direct oversight. Destination selection and preference algorithms in these systems are the product of customer demand, not regulatory control. Moreover, these systems are not “free,” as ITS is, to market makers on participating exchanges. This may be good, but it is different.
Separately, the NYSE has been successful over the years by permitting different modes of trading to take place in a single, physical venue. Each mode of trading is loosely linked to all of the others. The result has been that different classes of traders can interact in an imperfect but effective manner. Curiously, it is very difficult to accommodate multiple trading modes electronically. As aggressive electronic competitors attack the NYSE there is created a difficult, perhaps impossible, conflict among the trading mechanisms. We do not believe that a “National Market System” structure can be created to link these disparate trading styles (i.e., the physical NYSE floor with electronic venues such as ECNs) without favoring some mechanisms over others.
Now the NYSE is under pressure, not only because of the governance concerns created by former-chairman Richard Grasso’s salary, but also because of issues related to specialists’ practices. The irony of the specialist investigation is that it is being pushed by the Wall Street Journal. The Journal’s initial reporting on abuses by specialists was refuted by the New York Times the day after the Journal article. The Times suggested that the Journal had overstated the nature of the problem. Whatever the reality of the events it is clear that the Journal has an interest in ensuring that the story about specialists’ impropriety does not “go away.” The Journal seems intent on proving that their original exposé of the specialists was not wrong and that true abuse has and is occurring. This has spurred both the Commission and the NYSE regulatory unit to continue to pursue an issue that might have faded in a different political climate.
We do not mean to diminish the magnitude of problems with the NYSE specialist system. The point is that a problem that might have washed over the NYSE with little impact at some other time is at this moment likely to force significant changes in the specialist system. We find it ironic, and central to our argument, that at the moment when Nasdaq is in trouble the NYSE is also in trouble.
One might assume that problems for Nasdaq and the NYSE would be a bonanza for the ECNs. If “success” means increasing their relative market share of trading volume then problems for Nasdaq and the NYSE may make the ECNs more successful. However, increased trading volume does not necessarily translate into a profit bonanza. We argued in a paper entitled “Do We Need Exchanges” for the World Stock Exchange Handbook last year that “for profit” execution is, by its nature, “for very little profit.” Execution services are unlikely to be a good profit opportunity. (We will summarize our views on why this is true below.)
Technological Factors
In many ways technology has been the facilitator of substantially all of the economic and structural changes that have occurred since the late 1960s. The growth of computing power provided the ability to cure the flaws in the Industry’s infrastructure uncovered by the back-office crisis. The personal computer democratized processing and facilitated the development of derivative markets. PCs also had other effects, such as reducing the need for large offices and providing for many more types of trading strategies.
The Internet is proving to be one of the most corrosive creations for traditional relationships in the securities markets. The ability to connect customers to brokers, investment managers, firms seeking to raise capital and other providers of financial services reduces the close bond between customer and supplier.
- Retail customers can effect transactions, access account information and gather all manner of research information without the necessity of direct contact with a registered representative.
- Corporations that have to raise money regularly can go directly to institutions that are regular investors without the need for a traditional investment banker.
- Institutional investors access multiple trading venues directly, reducing the dependence on broker/dealers for execution.
Most of these services could have been created without the Internet, but they would have required networks with huge capital investments that would only be available to the biggest sponsors. The Internet makes theses services available to vendors and users of all sizes.
Of equal importance to the Internet are the changes being crafted to permit straight-through processing. Faster settlement and the push to remove human intervention in the order-execution and the post-trade processes has the collateral impact of weakening bilateral relationships among the entities that participate in these processes. Weakened relationships imply that trading and processing functions are likely to be priced based on cost. Efficiency and low cost will become more common considerations in choosing services than premiums historically charged because of the close relationships among counterparties.
Demographic Factors
The major demographic event at the present is the absence of any trends that will compensate for the loss in revenues from the economic events described below. There is no deus ex machina. No population-growth bubble can be expected to generate huge growth in trading volumes. Indeed, the aging of the overall population may cause a long-term relative decrease in volumes.
Economic Factors
Ultimately, fundamental change in the structure of the Industry is being driven by economics. In particular, the movement that has been labeled “decimalization” has already had profound effects. The true impact will be even more profound, and is likely to take several years to be fully realized.
The move from fractional to decimal pricing is not a significant event. The move from 16ths ($0.0625) to pennies ($0.01) as the minimum pricing increment for trading has been profound.
- Penny increments mean that there is less profit in a normal trade. This in turn implies that dealers are less willing to commit capital. ECNs have siphoned-off many simple trades that might have provided low-risk revenue to justify good pricing on more complex trades. As we have noted above, it is no longer possible to count on a total relationship as a basis for profitability. This will ultimately cause dealers to be less willing to commit capital and force the buy side to seek other means for executing complex trades.
- “Stepping in front” or “penny jumping” has served to make the markets more opaque to those without direct access to the markets. Even for those with direct access, fragmentation clouds the true picture of the total market. Ironically, the NYSE is being forced to provide more transparency about the NYSE market to counter the effects of decimalization. As more information is provided about what is happening on the Floor of the NYSE, much of the “mystique” is lost and traders have less incentive to route orders to the NYSE.[7]
- Penny increments have exacerbated the trend of quantitative traders to flood the markets with orders, cancels and cancel/replace orders. The cost of trading strategies that employ rapid order placement and removal has dropped significantly. Some of those employing these strategies are highly sophisticated and their strategies provide both liquidity and market coordination. However, at the current costs, it is possible for the inept to participate as well. The market should eventually weed out inept traders but they can cause significant damage in the meantime. Moreover, markets are reluctant to take actions that will discourage aggressive traders since they can be an important source of order flow in down markets.
- The total activity is creating huge capacity problems. Many observers originally thought that because the conversion to decimals in late 2000 and early 2001 did not cause the Industry to collapse that there are no capacity problems. This is not the case. There have been volume problems in networks and capacity is being strained. The fact that options trading stayed at nickel/dime trading and quoting increments has provided some mitigation, but the problems are real. Moreover, there are problems with systems handling order volumes as well. Worse, we expect that the nickel/dime increments will collapse as too many options exchanges scramble for limited business. At a recent conference one options-exchange expert reported sadly that the probable result of this unconstrained volume growth will be a “train wreck.” We suppose that permitting train wrecks is one method for regulating the number of trains.
- Nasdaq, an early and vocal opponent of trading in less-than-penny increments, has effectively given up the fight by requesting permission to trade in sub-pennies themselves. Therefore, the problems of decimals will intensify before the final impact is known.
The impact of decimal (and sub-penny) pricing increments has yet to fully play out. Two obvious impacts can be predicted. First, the dealing function will not be completely dead, but there is very little prospect that it will be the guaranteed basis of profitability that has been the case in the past. This says that trades that are complex, and trades where immediacy is more important than cost, will be more difficult to execute for institutional investors.
Second, the method for paying for services by institutional investors and Internet trading firms will change. If there is not enough profitability in trading for soft-dollar services or to pay for order flow, then these practices will of necessity be curtailed. Many Industry observers will applaud the end of these practices. The fact remains, however, that some new method of payment must be found if the markers are to remain efficient. We expect that some market information — research, analysis and market data — will be lost at the margin. Alternatively, new business models may evolve to fund the creation of information that keeps the markets efficient.
Political Factors
Ironically, a set of unrelated events have conspired to make it unlikely that a coordinated response will be made to the forces and trends we are describing. There are many examples of momentous disasters that, when reviewed in hindsight, seem potentially avoidable; yet there seems to have been a fatal inevitability at the time. The Titanic sinking, World War I, the shuttle disasters and the loss of the fishing boat in The Perfect Storm all seem in retrospect to be preventable. Conditions at the time, however, conspired to subvert actions that might have prevented these disasters. Today events seem likely to prevent the Industry, the Commission or the Congress from taking actions to avoid the financial storm that we predict will cause the existing market structure to founder.
First, the political problems of Harvey Pitt caused him to step down as the SEC chairman. Pitt stepping down has also pushed the SEC away from interventionism and toward a role as caretaker. The tendency toward passivity is further reinforced by the overall conditions in Washington and the geopolitical situation. This does not mean to diminish the Commission’s importance or the quality of the people who are there. We simply suggest that these events militate against the Commission taking an aggressive or revolutionary action to shape market structure.
The Congress and the public have not had a lower esteem for the Industry since the Depression. The drumbeat of bad news has been relentless: the settlement of Attorney General Elliot Spitzer’s suit against the largest investment banks; the problems of corporate governance; disclosures of the salaries of corporate officers at a time of high unemployment; revelation that honesty in research reports was compromised to enhance investment banking transactions; the view that Wall Street is responsible for the pillage of individual investment portfolios and retirement accounts; and the mutual fund scandal, all suggest that a stone ear will meet cries from the Industry for relief. Whatever the pros and cons of decimal units of pricing we are embarked on an orgy of: “How low can you go?” There will be no intervention to prevent it.
The dealer community was unwilling to permit the creation of a Nasdaq limit-order book in the late 1990s. This decision created an unprecedented incubator for the ECNs. By the time SuperMontage was permitted, constructed, regulated, dissected and finally approved Nasdaq was so far behind that its struggle for market share that SuperMontage’s success is uncertain. We find it sad and ironic that Nasdaq may not be able to compete effectively in its own market. This creates a situation without precedent that may create precedent: first, the center of a market might collapse like a city imploding from urban decay; more shocking, that the broader market might continue after such an event undeterred.
The events at the NYSE are potentially of equal, or perhaps greater, impact. The NYSE has been the Industry’s sea anchor in storms past. It was the safe vessel members clung and rallied to, and the white whale that others cursed, hated and ineffectively stalked. Through the period from just after May Day to early September 2003 the Exchange had a series of masterful chairmen. Mil Batten turned down the Exchange’s volume on public debate concerning the National Market System. Batten moved the Exchange’s fight from the “steps at Foley Square[8” to the back halls of Congress. John Phalen came from the trading floor community, and used his credibility as a member of that community to move the floor traders and specialists to embrace technology and reforms that would have been unthinkable for any other chairman. Dick Grasso realized the importance of the “NYSE brand” and moved the Exchange to capitalize on its global recognition. The NYSE has been transformed, in a few short weeks, from a dreadnought with near-hegemony into a leaking vessel. There is a new leader now, but the power of the chairman has been curtailed. Moreover, any current or future leader of the NYSE will be reluctant to pursue a “defend the floor” strategy. At a time when the Exchange needs to be able to take decisive action, no leader for the next several years will want to be bold. And the sharks are circling.
The sell side and/or the buy side might be expected to step into the vacuum that seems to be forming and take decisive action. This seems unlikely. Industry groups have told us that the leaders of the sell side are unwilling to take a decisive stand. Perhaps this is the result of the criticism, court actions and the subsequent settlement against the largest firms. By contrast, there is no single group that represents the buy-side. There are many different firms with different statutory reporting requirements, each with unique needs and problems. Finally, the largest firms are now complex mixes of buy-side and sell-side functions. These heterogeneous firms may find it difficult to determine what market structure is in the best interest of the overall firm.
And so as the storm breaks over the Industry there is no firm hand on the tiller and no clear course to navigate.
“O brave new world”
O, wonder!
How many goodly creatures are there here!
How beauteous mankind is! O brave new world,
That has such people in't!
Miranda
The Tempest
Act V Scene 1
As Shakespeare showed us in The Tempest, even a fearsome storm is not the end of the world, although it may be the end of the world, as we know it. We expect that the events that are washing over the Industry will not destroy the Industry — only change it. The exact nature of the future world is the subject for our next paper, but the impact of this perfect storm on the existing structure deserves to be explored.
The buy side
Buy-side traders are among the most vocal for changes in the current market structure, particularly the NYSE specialist system. They also decry the lack of transparency created by decimals and the fragmentation in the Nasdaq marketplace. Even though the buy side has played a major role in undermining the foundations of the traditional market structure, the buy side is unlikely to find the future comforting. The magnitude of the money the buy side must manage is continuing to grow at the same time the size of individual executions in the major markets is going down dramatically. This inescapably implies that the cost of executing large trades will increase and the work involved in executing large orders will become harder and more complex. Nevertheless, in the future the buy side will exert increasing leverage in the markets as a whole. As the buy side becomes ascendant, we believe the markets of the future will remain fragmented. Fragmentation will continue because there is so little commonality in the execution needs of the many types of firms that comprise the total buy side. Indeed, fragmentation will increase because the dominance of the NYSE over its market will decline, much as Nasdaq’s dominance has declined.
The sell side
The last twenty-five years have been a golden period for the sell side. Rapid growth in trading volumes and strong demand for investment banking services created huge revenues and immense profits. This is not likely to continue. Decimal trading has “holed” trading profits at or below the waterline. Execution services are unlikely to be more than marginally profitable over the long term and there are no obvious demographic lifelines to rescue trading. This does not mean that trading will stop, but trading will be less profitable than it has been in the past.
As a result of the Internet, many issuers that regularly used investment banks for routine underwritings are more likely to raise funds directly in the future. As with trading, this is not the end of investment banking. As more funds are raised without intermediaries, the services of an investment bank will be used primarily when underwriting is necessary because the outcome is uncertain and/or when the pricing is difficult. In short, the profits will be less and the risks will be higher.
What this implies is that the role of a broker/dealer will less profitable. Broker/dealers will be more dependent on financing customer positions and managing customer money. Both of these roles are important, but they do not create the same level of wealth and power for the sell side that has been available for the last four centuries, culminating in the bonanza of the last twenty-five years. The profitability is likely to be more nearly that of other parts of the economy.
The change is likely to parallel the change that has occurred in banking. For banks, competition reduced the spread between the cost of money and the rates they could charge. The result is that most income is now derived from fees. This is not the end of banking, but banking is a much less attractive business than it was.
One interesting sidelight of all of the factors we have considered is that the changes affecting the future of the securities industry have the effect of reducing the importance of bilateral relationships. The reason that broker/dealers have been able to sustain profits that are dramatically higher than most other firms in the economy has depended on the relationships the broker/dealers had that were not available to others. This included the relationship that the broker/dealer has with an exchange that limits membership and restricts those who are permitted to trade; and the broker/dealer’s relationship with a community of its other customers that permits the broker/dealer to execute a complex trade for an institutional customer. Similarly the unique relationship between an investment bank and corporate clients that are raising money on the one hand, and customers willing to buy new issues on the other, have made it possible for the sell side to realize profits that are greater than the profits in most other industries. As technology and other factors erode the value of the broker/dealers’ relationships, then the profitability will erode as well. Interestingly, weakened relationships suggest the nature of the Industry in the future.
Nasdaq and the NYSE
Given the nature of the events that have occurred since 1997 for Nasdaq and the far more rapid sequence of events at the NYSE, it is at least conceivable that both organizations could collapse or become trivialized. A more likely scenario is that both organizations will continue but be dramatically less important to their respective markets. Nasdaq already has a limited role. For the NYSE events already in motion can only weaken the Exchange’s position. The Exchange may recover, but we doubt that a market share in excess three quarters of the total trading in NYSE-listed securities can be sustained. Moreover, if there were any trend for the listing of U.S. securities to be a regulatory or governmental function (as occurs in Europe) then the long-term profitability of both Nasdaq and the NYSE would be more seriously threatened.
The ECNs
If “the enemy of my enemy is my friend” then surely any set of events that is likely to affect Nasdaq and the NYSE negatively must benefit the ECNs and other new-age trading systems. If increased market share is the measure of success, then ECNs are likely to be winners. If profitability is the key, the picture is less clear. We assume that ECNs will have difficulty achieving and/or sustaining profitability because we believe that execution is not a differentiable product.[9] We believe electronic execution is differentiated only by the rules that govern trading. By creating rules that attract one user group, there is a strong chance another user group is alienated. Aggressive competition is likely to devolve into a price war. If our assumption is incorrect, then the outlook for ECNs may be brighter than we foresee.
This does not suggest that all new execution venues will not do well. In particular firms such as Lava Trading and Liquidnet are likely to benefit from the chaos that we have described. Liquidnet provides a different type of execution mechanism that is poised to step into a void created by a wounded NYSE. Lava Trading is growing rapidly by providing an ITS-like role for Nasdaq securities. Lava could also becomea replacement for ITS if the ITS system fails as some experts are predicting.[10] A private-sector linkage will, however, dramatically change the economics of specialists on regional exchanges.
A new problem is likely to face the electronic markets as they get larger market shares. “Algorithmic trading” that involves using computer models to automatically generate orders as well as cancel/replace orders in large volume threaten electronic limit-order books that are the core of ECNs. A consultant who provides technical support to ECNs has told us that electronic order submission may overwhelm the current limit-order-book technology. (It is often assumed that ECNs only have to add more and/or bigger processors as volume grows. This seems reasonable if volume is the result of normal expansion. However, if the growth is the result of aggressive strategies where the order submitter has computers as large and as fast as those used by the ECN, and if there are multiple submitters, then growth becomes difficult and expensive.)
A second problem that must be faced if ECNs become the dominant execution vehicle is overall system capacity. As a mutualized entity, the NYSE and SIAC, as the “exclusive Securities Information Processor” (exclusive SIP), have been willing to provide capacity to handle almost all contingencies. ECNs, and all other for-profit trading venues, of necessity must balance the need for sufficient capacity to keep traders comfortable with the need to keep owners happy. Whatever the balance, the total capacity will be less in a for-profit environment.
Finally, with private-sector linkages, coordinated market action becomes difficult when problems occur— perhaps impossible. The recent problem of a trading halt at Nasdaq and the subsequent decision of ArcaEx to resume trading highlight these problems. Incidentally, the problems grew out of trades resulting from algorithmic trading.
All of the problems we have raised can be solved. Our point is that the solution will be a dramatically different market structure. This may be good, but it will be different
The Commission, the Congress and the public (the Captain, Gilligan and the passengers)
Using the metaphor of a storm to liken the SEC, Congress and the public to characters in the sitcom “Gilligan’s Island” is low comedy and may be unfair. However, we believe these groups will find the future less comfortable than the past. Ironically, all three have been quick to undercut traditional systems. The market structure of the future is likely to be dominated by entities over which the Commission has no mandated regulatory oversight. We believe any overt attempt to expand its authority over the new structure will be effectively thwarted by the type of political pressure that the ECNs have been able to exert in debates over the role of Nasdaq in the Nasdaq marketplace. Therefore, the future is likely to have less regulation unless (or perhaps until) some scandal among unregulated players prompts the Congress to act. This may be a good thing, but again, it will be different.
“A voice! a voice! my kingdom for a voice!” [11]
We are in the middle of a period of radical restructuring and there is no word from the Industry. In part this may be because it is too early in the process. Many of the things that we are describing are just occurring. Many firms have not yet had the opportunity to figure out the impact. Alternatively, many large firms may believe that diversification will protect them whatever the future brings.
For whatever reason, there is no Don Marron, James Lorie, Junius “Jay” Peake, Don Stone or Don Weeden at the moment passionately arguing to change the current market structure or to preserve the existing structure. There are partisans from the Exchange, Nasdaq and the ECNs, but all seem to be arguing for a larger slice of the existing pie — not for the creation of a totally new pie.
What kind of storm occurs without thunder, lightening and, most of all wind? We are uncomfortable with the idea that massive change may occur without passionate debate. Perhaps there is a need for a new National Market Advisory Board (NMAB) similar to that formed in 1976. It is easy to suggest that the NMAB ultimately accomplished nothing.[12] The NMAB (and earlier Congressional testimony leading up the Securities Acts Amendments of 1975) did, however, permit all parties to express their views. It also encouraged extensive discussion of the implications of a wide variety of possible future environments. What the impending storm really needs is early warning, improved forecasting and broad debate.
Beyond discussion, we believe those charged with developing strategy for exchanges, firms and institutions must consider how you will survive in a radically altered market. Even if you do not agree with some or all of the premises of this paper or its conclusions, can you afford to dismiss them without thinking about the changes they imply?
[1] We use standard Wall Street (“the Street”) jargon of back office to mean the operations portion of broker/dealers. “Front office” is used to mean traders, investment bankers and sales personnel who deal with customers. We also use the term “buy side” to mean individual and institutional investors and “sell side” to mean the broker/dealers.
[2] The ’75 Act Amendments went into effect on May 1, 1975. This date quickly became known as “May Day” as a play on the presumed distress that unfixed commissions would cause for brokerage firms.
[3] The financial assets of the vast majority of individuals are not managed directly, but rather by institutional money managers in pensions, mutual funds and many other structured investment vehicles. Nevertheless, most of the debate about investor protection presupposes the individual investors managing their own assets directly. This may be the result of the fact that, in large measure, those framing the debate are themselves active investors. Therefore, the focus of protection is on a demonstrably small segment of society with both the wherewithal and inclination to manage their own portfolios.
[4] For institutional investors and others who are required to trade actively, the lowest overall effective transaction cost may well involve establishing a relationship with an intermediary in which fees for some simple transactions may be effected at costs that are higher than the lowest possible rate if the quid pro quo is more attractive costs for larger or more complicated transactions. By forcing each transaction to be evaluated independently, it is likely that the overall transactions costs for all funds managed by institutions are higher.
[5] At the margin, hyper aggressive traders — day traders, hedge funds and proprietary traders — have highly elastic demand for transaction services. It is less clear that those trading based on the fundamental value of securities, those investing based on an index or most other broad-based investment strategies would trade substantially more often just because the costs to trade are lower.
[6] Initially, all transactions in the U.K. market were required to be reported immediately as they are in the U.S. When dealers became unprofitable after Big Bang, the dealers pushed the regulators to permit large trades to be delayed before they are reported. This practice continues.
[7] In the past, traders felt obliged to route many orders to the NYSE for fear of missing some undisclosed opportunity that might exist on the Floor. As more information is provided and as computers increasingly make routing decisions, orders will seek known opportunities rather that possible improvement. In time the possibility for improvement will fade.
[8] Batten’s predecessor , James Needham had threatened that the NYSE would meet the SEC at the U.S. District Court (i.e., on the steps the steps at Foley Square) if the SEC pushed for the end of fixed commissions and other market reforms.
[9] We might as well make a counterargument to our own proposition. We note that water can be bottled, branded and sold at a premium. Also dirt is branded sold at garden centers. Therefore, ECNs may be able to brand executions as well.
[10] There are people that suggested that ITS was never successful and so failure cannot occur now. This is not fair. ITS has flaws that cannot be corrected because of its governance structure. However, for twenty-five years ITS has permitted specialists on regional exchanges to be comfortable in trading because of the safety net of no-cost linkage to the NYSE.
[11] With apologies to the reader for switching metaphors and to William Shakespeare for misquoting Richard III
[12] We often joke that the Commission in the late 1970s took the advice recommended some time in the middle of Vietnam by declaring victory and going home. Modest changes were made to the status quo and the National Market System was declared.