Thursday, April 21, 2005

Big Board to Acquire Leading Electronic Trading System

The New York Times
April 21, 2005
Big Board to Acquire Leading Electronic Trading System

The New York Stock Exchange, whose shouting traders and frenzied activity have become a global symbol of capitalism, announced yesterday that it would acquire a leading electronic trading system in a deal that allows the exchange to become a public company but casts doubts on its 213-year-old system of auction trading.

The exchange will merge operations with Archipelago, one of the biggest electronic trading operators, to form the NYSE Group. The deal will give the holders of the exchange's 1,366 seats $400 million in cash and 70 percent of the shares of the combined publicly traded company.

More important, it will enable the New York Stock Exchange to expand its ability to handle trades electronically, staving off challenges from its traditional rival Nasdaq and global competitors like Euronext and Deutsche Börse.

"This transaction, transforming the New York Stock Exchange into a public, for-profit entity, is an essential step to maintain our global competitiveness and leadership," said John A. Thain, the chief executive of the exchange, who will run the new entity. "We believe that our new combined company will be a world-class competitor in every respect."

The merger is the most significant acknowledgement yet that the Big Board's traditional market, driven by human traders, may not be able to survive in an era increasingly dominated by instantaneous trades.

On the storied trading floor of the New York Stock Exchange, hundreds of men and women in blue and green jackets spend their days monitoring screens, handling multiple calls and yelling at each other in an effort to get the best prices for buyers and sellers of stock.

Defenders of the system say their human judgment is critical; critics say the system is overrun with conflicts and rife with a history of misdeeds. After a three-year investigation, seven firms on the floor paid more than $240 million in fines for trading violations. Last week, 15 traders were indicted on related charges.

Electronic exchanges, on the other hand, match trades in complete anonymity.

The deal answers the calls of members, investors and, indirectly, regulators, who have demanded that the New York exchange - the last major one in the world to have floor-based trading - become faster and more electronic, more diversified and public.

Mr. Thain hopes to create an exchange that can use its stock to do deals and offer trading in different financial instruments to attract big investors. While small individual investors are generally unaware of how or where their stocks are traded, the big institutions that manage trillions of dollars through mutual funds and pension funds, have long complained that New York was too slow and too conflicted.

"We will offer our customers choice," Mr. Thain said. The choice will be to trade N.Y.S.E.-listed stocks, which the exchange trades today, as well as Nasdaq stocks, bonds and derivatives.

Many members of the exchange have resisted moving to greater automation, fearing for their jobs and their wealth, which for many is tied up in the price of a seat. Seat prices have fluctuated as sentiment about the exchange's future has wavered. In August 1999, a seat sold for $2.7 million, falling in January 2005 to $975,000. The most recent sale was back up to $1.6 million.

With the move to make the exchange a public entity, Mr. Thain escapes the exchange's long infighting among customers, seat owners and members of the exchange. By converting to for-profit status, the NYSE Group will have to answer only to its shareholders.

The deal is "a home run," said Frank Christensen, a 40-year member who is a principal at Kelly Christensen, a trading firm that operates on the floor. "It brings the connectivity we need to maintain our position globally."

But looming over the deal is an unanswered question: Is it the beginning of the end of open-outcry trading or the salvation of a seemingly outdated system? While Mr. Thain contends that the deal complements his "hybrid" proposal of floor and electronic trading, others wonder whether the exchange in Lower Manhattan, where everyone from presidents to Sarah Jessica Parker have visited to ring the opening bell, will eventually be silent.

"It is the end of the floor, in spite of what John Thain says," said Junius W. Peake, a professor of finance at the University of Northern Colorado. "It's a life preserver."

The chief executive of Archipelago, Gerald D. Putnam Jr., who at times has been critical of a floor-based system as expensive and inefficient, defended yesterday's deal. "If the customers see value, they will continue to trade there," he said in an interview. "If they don't, they won't. Having us in the mix adds choice."

The exchange's acquisition of Archipelago comes as the Nasdaq Stock Market, the largest electronic marketplace, and a consortium of private investors are nearing a deal to buy Instinet, the institutional brokerage and electronic trading network controlled by the Reuters Group. Archipelago, too, had been looking at both Instinet and Nasdaq. The two deals would mean that in just days, the four major competitors will be down to two longtime rivals: the Big Board and Nasdaq.

The transaction requires approval from the Securities and Exchange Commission. If approved, the deal will close at the end of the year or early next year.

Markets like the exchange and Nasdaq fight to be the place where investors trade. They make money from listing stocks, from executing trades and from distributing market data. As the cost of trading stocks has fallen, exchanges have become more dependent on volume and have looked more aggressively to consolidate. The competition has led to a ferocious game of musical chairs in which every player fears being left out.

In recent years, the New York exchange has been roiled by controversy over the compensation package of Richard A. Grasso, its former chairman, as well as by investigations into improper trading by some specialists on the floor. Competitors have sought to profit from the exchange's scandals and setbacks. They have reiterated that the floor-based system of humans searching for buyers and sellers, rather than having a machine anonymously match the parties, was riddled with conflicts, errors and corruption.

And yet the business of trading stocks has become less profitable and more challenging for everyone. At the same time, competition from global players from Tokyo to Frankfurt is putting pressure on all American marketplaces to broaden their scope.

"As we look to the future and the challenge of competing globally in a high-speed electronically connected world, it is clear that we must do more," Mr. Thain said.

The deal should put to rest concern that Mr. Thain was slow to act. His deal with Mr. Putnam answers many criticisms of the exchange: that it is not public, that it has no currency to do deals, that it offers investors only stocks not derivatives, a wildly popular new instrument and that it does not offer investors choice.

The New York Stock Exchange will own 70 percent of the new entity. It will pay each member $300,000 for a seat and issue stock for the remaining 70 percent of th company. Mr. Thain will remain chief executive while Mr. Putnam becomes co-president with the exchange's other two co-presidents. Three independent Archipelago directors will join the exchange's board and a separate board, made up of independent members, will regulate the entity.

Based in Chicago, Archipelago became a publicly traded company in August. Since then, it has made a number of transactions, including a deal for the Pacific Exchange. In terms of volume, it ranks behind the Big Board and Nasdaq, trading about a half billion shares a day.

The Big Board is the dominant player among markets, with 80 percent market share trading stocks which are listed on the exchange. But it has no presence trading Nasdaq-listed stocks, nor does it compete in the lucrative arena of trading increasingly popular investments like exchange-traded funds, options and other derivatives.

The challenges, however, are significant. Merging two fundamentally different models will be painful and it is unclear what success, if any, the Big Board will have integrating its own plan for further automation.

And the dark cloud hanging over the already tremendous hurdle of integration is simply whether the humans will be needed as part of the combined system.

"The floor really does add value," Mr. Thain said on a conference call, pointing out that a few hundred stocks which trade huge volumes and are highly accessible trade better electronically while less popular stocks tend to benefit from a system where individuals create demand for stocks.

Traders filed out of the exchange wearily yesterday, most ducking questions. "The world is changing and so are we," said one specialist.