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I would like to acknowledge Committee Chairman, Kevin Cronin. Kevin, who would otherwise have been here, is based in Houston. I want to express our best wishes for him, his family, his business, and everyone who is in the path of Hurricane Rita, which is rapidly approaching Texas.
Today, I want to address two main topics. One is the strategy of the New York Stock Exchange and how the Archipelago transaction fits into that strategy. Then I want to talk about our Hybrid Market initiative. I'll leave time for a few questions.
On strategy, when I look at the competitive position of the New York Stock Exchange, when I think of where are we today and I start to look around the world, the first place I look to is Europe. In Europe, in the Deutsche Borse and Euronext you have two exchanges that are public; the market cap of Deutsche Borse is about $10 billion. You have exchanges that are for profit, and in particular you see exchanges that have a much more diversified business than ours.
Both the Deutsche Borse and Euronext trade cash equities. They trade options; they trade futures; they trade derivatives; they trade some fixed-income instruments. And this is particularly true of the Deutsche Borse. They're vertically integrated, so they have settlement, clearing and custody functions. Often, when people look at the margins at different exchanges they ask: “Well, why does Deutsche Borse have much higher margins than some of the U.S. markets? Or even the margin we talk about for ourselves in a public context?”
Well, it's not only because they have a quasi monopoly, but they also have a clearing, settlement and custody business which probably account for close to half of their earnings—a very-high margin, very attractive business. So when I think about competing with them, it is certainly a cause for concern given their financial power, their high margins, their growth, and earnings diversification.
I then come back to the U.S. market, which is very fragmented. The cash markets are separated from the options markets, which are separated from the futures markets. There are probably too many players in each of those marketplaces, particularly cash and options. A lot of the exchanges that exist are not financially attractive right now. So I believe there needs to be consolidation in the U.S. marketplace, both among the cash markets and certainly the options markets. Over time, although there are obviously regulatory issues, there should be opportunities among cash and futures.
I then look at the New York Stock Exchange and say: “Well, where do we stand in this mix of kind of global competitors, and then where in the U.S. market?” The New York Stock Exchange, as you all probably already know, has three main sources of revenue. We have transaction fees, listing fees, and market-data fees. We basically trade one product, our listed equities. And if you look at our market share in our three revenue sources, in terms of listings, we get 95 percent of all the companies that are qualified to list on our market. It's a very good business for us. It's actually been better this year than last year. So far this year we have over 100 new listings, which is up significantly from last year. But we're not going to gain much market share there. We're just going to grow as fast as the market grows.
In terms of market data, we get about 90 percent of the market data revenues off the Tape A, which is our listed-company tape. So again, we're not going to get market share increases there. We're really just going to be able to grow as fast as the market grows. And if you look at the transaction fees, right now we have just under 80 percent market share in our listed company stocks. I know some people think that they're going to grab lots of that market share. We'll see. Last Friday, for example, we traded just over three billion shares, and our market share was slightly over 80 percent. But no matter what, it's pretty unlikely our market share is going to grow. If you look at our three main sources of revenues, we can grow really only as fast as the market grows.
So the fundamental strategy behind our Archipelago transaction is to really do four things.
- One is we become a for-profit company;
- The second is we become a public company;
- The third is we diversify our products--that's a very important thing as we will have a much broader group of products;
- And the fourth is that we have better opportunities to grow.
Let me talk about diversification and growth opportunities.
When combined with Archipelago, we will pick up a position in the over-the-counter trading space. Today, we don't trade non-New York Stock Exchange-listed stocks. Archipelago has about a 25-percent market share in the over-the-counter market. Once together, we broaden our existing trading business. We also pick up an options business. Through the Pacific Exchange, they now have about a 10 percent share in the options business. I believe there are a lot of opportunities between cash and options. The options market is also growing about three times faster than cash markets. There's a lot of opportunity for us to expand in the options business and to trade cash and options on the same platform. Right now if you're doing one side or the other, you have to leg into it. Yet there's really no platform today where you can execute both sides of a cash and options trade. That’s a very good opportunity for us.
The third area includes Exchange Traded Funds. It's a rapidly growing category with a lot of money going into it. We've done very well in listing ETFs, but Archipelago has a better platform for the trading of ETFs. If you look at their market share, they have about a 35-percent market share in trading of Exchange Traded Funds, and that's going to be a business that's going to grow. Between the two of us, our listing venue and their trading venue, it's a place where we can also make a lot of progress.
Another area where there's great opportunity that is not yet an organized market is the fixed-income side. We're in the process of getting approval from the SEC to trade the debt of our listed companies. Personally, I think there are as many people who want to trade GM's debt these days as who want to trade GM stock. We'll probably use an Archipelago-type platform to do that. So we're in the process of developing a fixed- income business.
Lastly, let’s look at our listings business. As I said, we get 95 percent of all the companies that are qualified to list on the New York. If a company doesn't qualify to list on the New York Stock Exchange, it has no choice other than to go to Nasdaq. So we're going to create a second listing business with Archipelago. We'll compete directly with Nasdaq for companies that don't qualify to list on the New York Stock Exchange.
That is going to be a very interesting and attractive business for us. It will make it easier for companies to move when they get bigger and do, in fact, qualify. Although we have moved quite a number of companies from Nasdaq to New York over time, there's a little bit of: “The club that didn't want me when I was little. Now that I became successful, they want me to join the club.” It's a little bit harder to move these companies when they're on a competing market. It will be an easier transition to move a company from an Archipelago listing to a New York listing as they grow and get bigger.
From my perspective, the combination of New York Stock Exchange and Archipelago will give us a much broader product mix and give us better opportunities for growth.
If you look at the market's reaction to the deal, it has been very positive. The best way to gauge the market is looking at Archipelago's share price, because Archipelago share price has an implied value for the combined entities. With Archipelago trading around $40 a share right now, the combined value of the NYSE group is north of $6 billion, so it certainly puts us in a league to compete with Deutsche Borse and Euronext.
The other measure of how the deal is being perceived is the market in seat prices. Seats sold under $1 million in January of this year. Most recently seats have been selling at around $2.9 million. So we've almost tripled the value of seats in seven or eight months. Using Archipelago’s share price to impute the value of the new combined entity, the imputed value of a seat is about $3.5 million. So, from the perspective of both Archipelago’s share price and seat prices, the market likes the concept of this combination.
With regard to the status of the deal, I’ll quickly give you a sense of where we stand. We continue to look to close the transaction in the first quarter of 2006. There are four big pieces of documentation that we need to get through. There's an S-4, which is the equivalent of the proxy statement. We actually have filed Amendment #1 in response to the first round of SEC comments on the S-4. The second big document is a 19-b4, basically the market regulation-side rules, which we're in the process of negotiating and discussing with the SEC. Bob Colby of the SEC told me that he received it a couple of days ago. So we're working on that with the SEC. The third piece is the Department of Justice. We have to clear the Department of Justice and we're in the process of providing documents. We did get a second request, which we expected, given the size and importance of this transaction. And the last piece is the IRS ruling, which is also in process. With all of that, we continue to look to and be hopeful of a first quarter '06 closing. Of course, we have to go to a member vote and Archipelago has to get a shareholder vote. That's where we’re at with the deal.
When I talk about strategy, one other part of the world I think about is Asia. Asia has been a big source of new listings for us, and for the world. Indian companies and Chinese companies, particularly, are two major sources of new companies coming into the marketplace looking for capital. Currently, the markets in Asia are pretty fragmented. You really don't have consolidated competitors as in Europe. There’s also less overlap today in terms of the marketplaces. But over the next 5 to 10 years I do believe Asia is a place where we will want to be. There will be a lot of opportunity on the listing side and opportunity in the Exchange space.
Let me move to the Hybrid Market. And as you probably know, we filed Amendment #6 on the Hybrid Market. The good news is that there's only going to be one more amendment—there are some technical issues we're working on with the SEC, so we will probably file one more. The number of comment letters on our proposal seems to be dwindling. I think we got five last time, although ICI was one of them. By the way, we respectfully have addressed at least some of the issues raised by ICI. So we appreciate those comments.
Philosophically, I want to remind people of where we started with the Hybrid Market. We wanted to do three things.
The first is responding to you, our institutional customers. When I first started, a group—not everyone—said: “You know what? We want to trade a different way. We want to trade electronically, we want to trade instantaneously, and we want to trade anonymously.” That push from customers was really how this all started. Making ourselves fit into Regulation NMS is also very important to us. But we moved in this direction because of the reaction from our customer base, which we hadn't previously been listening to well enough.
We know that you don't have to trade at the New York Stock Exchange—you can trade somewhere else. We really needed to be more responsive. If you have a group of big and important customers who want to trade in a certain way and you don't give them that capability and somebody else does, that's where they're going to go. So the first objective of the Hybrid Market is to allow those institutions that want to trade electronically, instantaneously and anonymously to do so.
Obviously, Hybrid also fits into Regulation NMS. We will be characterized as a fast market. The implementation of Hybrid is set to line up with the implementation of Regulation NMS.
The second main objective of the Hybrid Market is to automate some of what we do. Right now, if you were on the floor of the Exchange, particularly at the point of sale and watching what the specialist clerks were doing, you would see that they are doing too many keystrokes—as many as 40,000 key strokes a day. They can barely keep up, particularly on really busy days. On days where we trade 3 billion shares like last Friday, it is very hard for the specialist clerks to keep up. There's no way we could trade 6 billion shares in the current set up. So we will automate many of the non-value-added keystrokes that are taking place right at the point of sale. That will allow us to trade much higher volumes. No matter what we're going to accomplish, one of the things we're going to do is automate and make our trading platform more efficient.
We've spent a lot of time with the specialists on this. We have tested this particular piece of it. We took the trading volume, actual trades, in Citigroup, which is a pretty active stock. We took 30 minutes of data and ran it triple speed--basically compressed it into 10 minutes, running 30 minutes of real data in 10 minutes. The clerks were able to keep up quite well.
In the end, specialists will be able to spend more time doing what they really should be doing—which is keeping the bid-ask quote tight, being competitive with the other marketplaces, and dealing with imbalances and blocks rather than just trying to do enough key strokes to keep up with the marketplace. So that's the second thing, automating our process so we can trade higher volumes.
The third main objective in Hybrid—which by the way is the hardest of the three—is to make sure we retain the things that are special about our marketplace. We are not interested in turning the New York Stock Exchange into an ECN. There are a few of you who think we should. But, I'm sorry, we're not doing that.
There are some things that are special about our market that differentiate us that we want to keep. One is price improvement. One of the differences between the New York Stock Exchange and other marketplaces is that investors can get price improvement, and we intend to keep that. The people who provide price improvement, whether specialists or brokers, need to have the tools to do that. This is one of the things in Amendment #6—adjusting under what circumstances and how the specialists can provide price improvement. That is an important characteristic of our marketplace.
Another important characteristic of our marketplace is lower volatility. The stocks that trade on the New York Stock Exchange do, in fact, trade with a significantly lower volatility than stocks in a purely electronic marketplace. I've used this statistic before, probably here, but I'll repeat it just to remind people how significant it is. We moved 51 companies from Nasdaq to the New York Stock Exchange. The intra-day volatility of the trading of those exact stocks—comparing the same stock to the same stock—fell by 50 percent on average. So it makes a big difference. It wouldn't make a big difference in a super liquid stock like Microsoft, but it does make a big difference in most stocks because they're not liquid enough.
We want to continue to produce the low volatility that's characteristic of our market—which means we don't want trading to simply ping back and forth between the bid-ask spread. We want the specialist and the broker to be able to fill in volume when there is an imbalance, and interact with the marketplace as they do today.
Next, we need to maintain our floor brokers' ability to represent their customers—verbally on the floor like they do today and also electronically. So many of the more complicated things that we're putting in to our Hybrid Market are tools that allow brokers to continue to represent their customers.
It's always interesting to talk with our customers about exactly what they want their brokers to be doing. The general reaction is that all institutions want the market to be completely transparent at every single price point except for their orders. What we're trying to do here is to try to balance the need for transparency and the need for liquidity. But still address the need for brokers to be able to represent their customers in a way that adds value—while knowing that many institutions really don't want their orders to be completely transparent and displayed in the marketplace.
In Amendment #6, we've gotten the basics of Hybrid Market down, like addressing how price improvement works and about how parity works away from the best bid and offer. There will also be more on how brokers can represent their customers in their order files. There will be more on the discretionary order type, which is intended to give them the capabilities to represent their customers in the electronic marketplace as well as on the physical floor.
I do think we're at the point now with the Hybrid where we have to seek SEC approval. The implementation dates for Regulation NMS are coming very quickly. Software programming changes will be needed and done in stages. We need to say: “Okay, it may not be perfect, certainly not from any one person's point of view, and it may not initially work exactly like everyone thinks it should work.” As we move forward with it, I'm sure there will be change, which we will certainly address. However, we're really at the point now where we have to get it approved and implemented to meet the Regulation NMS implementation dates, which begin June of next year.
Thank you. I’ll stop here and take questions.
Q & A
Audience Question: You talked about the fixed-income markets, and I think our group has been feeling for a while that the regulators have spent a lot of time thinking about the equity markets and causing us to change and adapt. As you contemplate moving to fixed- income markets, which might be the last bastion of great profitability for the sell-side firms, do you expect that you are going to get some push back? In some respects that's a perfect opportunity for transparency and increasing volumes and all kinds of things that happen in equity markets. So do you think you're going to get some roadblocks there?
John Thain: You know, inherent to your question is the answer. Our business is to make markets more transparent and to make markets more organized. In the end that will be good for all investors, whether they're institutions or individuals. The fixed- income markets right now are very difficult for individuals and difficult for institutions as well. Although it's true that wide bid-ask spreads are opportunities for sell-side firms to make money, sell-side firms have seen that as all markets commoditize. As they become more transparent, they're perfectly capability of inventing new and more complicated products that have wider bid-ask spreads and are less transparent. I still think it's a great opportunity, and that our role is to provide that transparency and that organization. I'm very confident the investment banks will find more ways to make money.
Audience Question: Do you anticipate shrinking the number of seats after the merger?
John Thain: My SEC colleagues will be very happy to hear this question: Do we anticipate shrinking the number of seats post closing the deal? Seats today represent two things. They represent an equity ownership and they represent the right to represent your customers or and trade on the floor. So seats actually go away when the transaction closes, but we still have to have a mechanism to give people the right to trade on the floor. People will keep their equity ownership through the shares, but we need to come up with a licensing program for those who have the right to be on the floor.
Our licenses will be very similar to what happens today for leases. In essence, leases give you the right to trade on the floor. Most leases are for one year. We're going to come up with a structure that is similar to the current structure for leasing of seats, so we will sell licenses or the right to trade on the floor. We're going to start off as close as possible to what they're used to, which is a one-year license. We want to set the price of that through a market mechanism as the price changes a lot based upon the economics of the floor. If you go back to 1999 or 2000, lease rates were as high as $300,000 a seat. Today lease rates are more like $60,000. So there are a lot of variables to establish the right price. Having the Exchange set the price is going to be a lot more difficult than having the market do it. We want to have a market mechanism to do that.
What we're proposing is a form of modified Dutch auction, where before the beginning of the year all those people who want seats will in essence bid for them. They'll be able to bid similar to a Treasury auction on a non-competitive basis, so that you could bid the equivalent of a market price so that you are guaranteed to get a seat. And then we'll look at all of those bids and set a clearing price that will represent kind of what's a fair market price for the seat for that year.
There are 1,366 seats today, so we're probably going to propose to capping the number of seats at 1,366. We probably will have some floor number as well to guarantee access. There are a lot of reasons why you have to have a floor: One, to make sure that there is in fact access to the floor; second, to make sure that somebody can't corner all the seats and control them all.
Today of the 1,366 seats, there are probably 200 that aren't being used. If you just looked at kind of what the demand is today given the current economics, it's probably around 1,100 seats. We have to work out the mechanics and this will be a topic of discussion with the SEC.
Audience Question: You talked about diversifying. And I'm wondering why you are looking at cash and options as opposed to cash and futures, and what are the characteristics of the market that make that seemingly more synergistic?
John Thain: That’s a very good question. The reason is that there is much more interplay between cash and options. Most people when writing options hedge them either in another option or in the cash market. Then a lot of people who are buying stocks—or who could be selling—who are also hedging their position in options. So if you're long, 10,000 shares of IBM, you can obviously protect the down side by buying puts. A lot of people also who are long stocks write calls as an income-producing mechanism, so there is a lot of trading that goes on between cash and options. There are a lot of hedge funds that are always arbitraging between cash and options, so there are just much closer linkages, and there really is no other direct way to hedge. If you write an option on IBM, you can really only hedge it in another IBM option or IBM stock. You can construct a basket of other stocks that try to trade like it, but there's always tracking error if you do that. So the hedging and the trading between the cash and the options is much more direct.
The futures market, partly because single-stock futures haven’t really taken off as much, is not as closely linked. A lot of people still hedge in the futures market—they buy a big portfolio of stocks and they want to hedge it in the S&Ps or something, but it isn't quite as closely linked between cash and futures as are cash and options. And then there's the regulatory split, and the regulatory split I personally think has been, and will continue to be, an issue for keeping those markets separate. The markets would on their own tend to want to be together because there are still lots of people who trade between cash and futures and use one to hedge the other. Today they have to do that in two different places with two different sets of rules, with two different sets of margins. So if the regulatory split didn't exist, it would be much more likely you'd see combinations of cash and futures.
Forgetting about the New York Stock Exchange for the moment, I think as a country that's not really a good thing for our markets to have this arbitrary split for regulatory reasons. It's not the case in most other countries to have futures separated from cash —over time that needs to be addressed. Finding ways for the cash markets and futures markets to interact with each other probably will happen eventually.
Audience Question: If the New York Stock Exchange moves to more of an electronic platform, is there any talk about an automated early open of any kind?
John Thain: There's really no talk about making the opening or closing more electronic. Our opens and closes are basically paperless now, so they are all automated. We might need an earlier open particularly when there is some news out on a certain stock. Then there is a tendency for a stock to trade before we open. Archipelago actually does pick up a quite a bit of that trading. Personally, I still think the 9:30 a.m. open is not exactly 21st century hours, and I'd rather see us open earlier. But there isn't a lot of support for that at the moment. To the extent that stocks are going to trade earlier, having them trade on Archipelago at least keeps it inside of our family. But we're not intending to change the opening of the market.
