America’s Stock Markets in Turmoil

The most prominent casualties of the historic merger between the New York Stock Exchange and Internet-based Archipelago will probably be the 1,500 traders and clerks who work for the Big Board’s seven major specialist firms, as trading commissions drop and order flows are routed to more efficient, computer-driven trading systems.Specialists are floor traders responsible for matching buyers and sellers in individual stocks, and who use their own capital to maintain orderly markets. Under the merger proposal, specialists would be allowed to purchase licenses to make markets in stocks, but they would be subject to much more scrutiny and forced to offer more liquidity than they now do. A spokesman for the stock exchange, Ray Pellechia, said that while nothing has been decided, “They will continue to play a crucial role in our market.”Wednesday’s announcement of the planned merger of the 213-year old stock exchange and Chicago-based Archipelago, founded in 1996, will create the NYSE Group, with the Big Board’s regulatory functions for member firms and listed companies spun off into a separate, not-for-profit subsidiary.The Big Board’s 70% stake in the new company was valued at $2.4 billion, with the 30% stake of Archipelago worth $1.3 billion. Yesterday, shares of Archipelago jumped 60% to $29.96 from $18.76.That is a sharp turnaround for a company that did its initial public offering last August at $11.50, almost 20% below where its investment bankers had initially tried to sell stock.To the chief executive officer of NYSE rival Liquidnet, Seth Merrin, the central component of the merger is the eventual end of the stock exchange’s trading floor.“This was absolutely the greatest head fake in the new century,” he said. “There was no question in stock traders’ minds that once investors were offered the option of doing volume through the specialists or via a screen, they were going to go for a screen.”Mr. Merrin’s privately held, New York-based company tries to match, anonymously, institutional buyers and sellers of NYSE-listed stocks.By way of explanation, Mr. Merrin said that if the stock exchange’s chief executive officer – and future NYSE Group CEO – John Thain had announced that the exchange’s trading would be entirely electronic, he could not have persuaded members to agree to the deal.“So he offered them the next best thing: a compelling financial deal, and the hope that maybe the market would choose a role for them,” Mr. Merrin said.A 22-year Chicago Stock Exchange floor-trading veteran, Chancellor Dougal’s Jim Hennessy, said a specialist system does not begin to meet the needs of the hedge funds, which increasingly dominate global equity trading.“The hedgers are demanding lower transaction costs, faster execution, and more transparency,” Mr. Hennessy said. “They don’t care about extensive ‘price discovery.’ They want the trade done cheaply.”He said the specialists do not add significantly to the movement of capital, because under the NYSE’s rules they needn’t show every bid or offer.Any role specialists have a decade from now, Mr. Hennessy said, will be confined to managing the markets in illiquid stocks.The greatest threat to the specialists’ role, however, may be posed not by a merger but by their inability to make a buck.The seven NYSE specialist firms posted losses totaling $38 million after taxes last year, and would have lost even more if Citigroup had not purchased a trading system from publicly traded LaBranche & Company, the largest specialist firm, allowing it to book a onetime gain of $24 million. LaBranche issued a warning April 8 that it would not meet earnings expectations because of weak trading volumes and program trading. The stocks of both LaBranche and Van der Moolen Holdings, the other publicly traded specialist, are down sharply on the year and near their 52-week lows, at $7.34 a share for the former and $6.17 for the latter.Then there is the parade of legal troubles surrounding specialists for the past two years. Fifteen specialists were indicted April 12 on federal charges of placing trades in front of customer orders, allegedly resulting in $20 million in profits. The NYSE itself agreed to pay a $20 million Securities and Exchange Commission fine for failure to supervise the specialists. That came on the heels of a settlement in March 2004 in which the five largest specialist firms agreed to pay $241 million to resolve allegations of illegal trading. Two weeks ago, the Big Board ordered video cameras installed at specialists’ trading posts to monitor their trading.The future isn’t so gloomy, in the view of the head of the NYSE’s specialist trade group, the Specialist Association, David Humphreville. A former specialist, he said that while there are many legitimate questions to be asked about the role of floor-controlled auction markets, “most questions don’t have anything to do with the merger, which was done almost entirely to allow the Big Board to get market share in options and Nasdaq trading.”He said that though the going has been rough recently, specialists offer “truly impressive abilities to let the market take a stock somewhere in an orderly fashion.” He described the attitude of specialists toward the merger as “cautiously optimistic.”The real challenge to trader control of the NYSE’s floor will be when Mr. Thain’s so-called hybrid marketplace is introduced over the next six months, in the view of a 25-year NYSE floor-trading veteran, Richard Rosenblatt. The proposal, made in August, would have investors’ buy and sell orders processed electronically, with no role played by a specialist or a floor trader in completing trades. Currently, just 10% of the trades on the Big Board are executed electronically, using the exchange’s three-year-old NYSE Direct system. “The economic and cultural challenge to specialists and traders will come as we wrestle with that,” Mr. Rosenblatt said.

America’s Stock Markets in Turmoil

America’s Stock Markets in Turmoil

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