WSJ: Make Way for the Virtual Exchange

http://on.wsj.com/j6JDf4

Should we care who owns the renowned New York Stock Exchange? Not really.

Right now, the Germans want it. In February, Deutsche Börse bid $9.5 billion for NYSE Euronext, only to be topped on April 1 by a combined $11.3 billion bid by U.S. exchanges Nasdaq and ICE. And yet, twice now, the NYSE has politely declined the higher offer, even calling it a "strategic mistake." That's a curious position to take, especially since a deal with Nasdaq would get rid of the only real competition for share listing.

Investors, not surprisingly, voiced their anger with management at the NYSE's annual shareholder meeting yesterday, questioning its preference for a bid that many believe undervalues the exchange.

But there's a more basic question worth asking: Do we even need exchanges anymore? It's been said that a stock exchange can only be as large as a voice can carry. On May 17, 1792, after years of shouting out on the street, a group of 24 prominent brokers met under a buttonwood tree at what is now 68 Wall Street and decided to move indoors, so to speak. They created the New York Stock and Exchange Board and vowed to "pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at least than one quarter of one percent Commission on the Specie value and that we will give preference to each other in our Negotiations."

This is classic collusion that, wrapped and hidden in regulatory language, pretty much exists to this day. But now technology has rendered the stock exchange as we know it obsolete.

Don't get me wrong. Stock trading is critical for capitalism. Stock markets provide price discovery, liquidity and the only real mechanism for capital allocation. When millions and billions of shares trade every day, based on news and innuendo about the future earnings power of corporations, a company's true value is discovered. Not always accurately, as markets are often missing information or have too much noise, but enterprise values rise and fall and do the dirty work of deciding who gets capital and who gets starved. Founders or early investors may sell shares of their company, thus unlocking and liquefying their risk capital to find more productive uses.

The 2008-09 financial crisis was caused by almost nonexistent price discovery on mortgage-backed securities and derivatives that barely traded, on exchanges or otherwise, causing way too much capital to be allocated to home financing for too long. The scarcity of initial public offerings these days means that the trading of a limited number of private companies' shares (Facebook, Twitter, etc.) is taking place without the price discovery from the robust buying and selling of shares that generally follows an IPO. Who knows what they're worth?

So we need markets. But we barely need humans and traditional exchanges anymore to implement these markets. And certainly not inside a building, as voices now carry to the far reaches of the globe in 300 milliseconds, and even that's considered too slow. Trading on Wall Street is just plumbing these days. Value is added much further up the food chain. Trades take place on servers in the great data cloud in the sky. A third of trading even takes place in so-called Dark Pools, privately owned servers that match institutional orders without ever revealing the size or price of the order.

Nasdaq is further along in moving to automated trading than the NYSE.

Sen. Charles Schumer (D., N.Y.) is "concerned about how this [Nasdaq-ICE] deal affects jobs in New York." But of course it will eliminate jobs in favor of automated trading. Now you know why the NYSE says it's a "strategic mistake." Maybe for the NYSE, but not for the rest of us.

But even a Nasdaq-NYSE super exchange is not the future. Stock exchanges today are remnants of a regulatory regime that fought hard to keep human markets fair while the owners of the exchanges got rich.

Stock exchanges make a killing—easy, risk-free profits. They charge listing fees for the privilege of having shares trade on the NYSE—though the assumption of quality for NYSE-listed stocks that have included GM, Fannie Mae and Freddie Mac, Lehman, AIG and Enron is tragically dated.

Then there's market data fees, a charge for your own and other's trade data sold back to you. Add to that technology fees for the right to hook up to the exchange. It's an amazing racket and makes up for trading itself not making much money anymore (which is why Wall Street firms took up creating and eventually owning derivatives).

Check out these numbers. In 2010, the NYSE received $422 million in listing fees and another $373 million in market data fees, which just about equaled their operating income for the year. But here's the rub: The NYSE doesn't even trade half of NYSE-listed shares anymore. Five years ago, they traded 70% of listed shares; today it's 36% and dropping, the difference made up by BATS Exchange, Direct Edge and other alternative trading platforms, including Nasdaq.

Nasdaq's numbers are similar. Market share of their listed stocks was 90%-plus in 1998 and is all of 27% today. No one's quite sure what they're getting for those listing fees anymore, when so much of the trading takes place elsewhere. But without them, there is no exchange, no matter who owns it.

Today, speed is everything. High-frequency trading firms probe the market with a flood of orders from fast computers sitting right next to stock exchanges. Eventually, they will bypass exchanges and create a virtual exchange with all the other trading platforms and match orders themselves.

Is this good or bad for Wall Street? The "Flash Crash" last May 6 seemed like automated trading run amok. Yes, but electronic markets require a whole new set of rules, maybe even shining light on Dark Pools. Commodity trading pits won't be immune either. No matter who ends up with the NYSE, the regulatory regime is in need of a serious overhaul away from human-operated exchanges to cover a system of computer-to-computer trade-matching.

In all my years working on Wall Street, I only went to the NYSE once—to the visitors' gallery where I gawked at traders through a glass wall, much like an aquarium's shark tank. Those sharks are becoming extinct.

 

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