By Don Miller
The days of shouted orders and crumpled trade tickets on vast floors jammed with frantic stock traders are numbered.
Turns out the human faces of Wall Street are rapidly being replaced by nondescript computer technicians quietly monitoring speedy rack-mounted servers. They execute billions of trades daily in placid data centers located in remote locations far from the high rises (and high rents) of Manhattan.
Based on technology known as electronic communications networks (ECN), these new trading platforms allow traders to bypass the big exchanges and match buy and sell orders online.
The trend has triggered a wave of consolidation among major stock exchanges around the world that is expected to gain momentum as they struggle to compete against a barrage of emboldened upstarts.
But the markets may see newcomers grab even more market share before the big boys can contain the damage.
It's a new paradigm that has shaken the markets and toppled the established worldwide bourses from their lofty perches, changing the very nature of the securities business.
Reform Laws Create New Trading Platforms
After a deluge of complaints, federal regulators in 2007 approved new rules ordering brokers to route their trades to the cheapest exchanges, as opposed to the most convenient. Similar regulations were enacted in Europe, as well.
Almost immediately, a number of small but sophisticated market exchanges sprang up, and the interlopers quickly began to poach business from the major players.
In the United States, the newly minted Bats Exchange, just three years old, now commands approximately 12% of all U.S. volume. In Europe, Chi-X, burst onto the scene 18 months ago, after new European regulations took effect. Turquoise, another upstart, was launched at the start of last September.
Even Nasdaq OMX (), which has been "floorless" – all electronic – since its inception in 1971, is busy grabbing customers from its traditonal Wall Street brethren. Nasdaq now trades more New York Stock Exchange listed stocks daily than the Big Board itself.
And even though they are just starting to gain traction in Europe, the latest data suggests the smallfries have been taking big pieces of market share, particularly from the London Stock Exchange.
"People used to talk about each stock having a principal exchange," Daniel Mathisson, managing director in charge of a Credit Suisse Group AG (CS) division that uses computers to direct trades to the lowest-cost exchange, told Forbes.com. "Now the trading's going all over the place, and there is nothing to stop that trend."
These new competitors grab market share by harnessing the fastest computers in the business. They're stealing large chunks of business from established exchanges by offering quicker, cheaper trades and innovative pricing.
The inability of humans to react quickly enough to compete is borne out by the fact that computers now account for 50% of all trading volume, Forbes Magazinereports.
"," said Merck Finck analyst Konrad Becker. "Stock exchanges are more or less like IT companies and their main role is to develop IT systems that are secure, reliable and operate a huge number of deals from different regulatory platforms, which is very expensive," he told Forbes.com.
Diving into Dark Pools
Another way the ECNs are luring traders in is with the exotic nature of the trading tools they offer. Turquoise, for instance, offers a trading platform incorporating "dark pool" trading.
By allowing traders to operate anonymously, dark pools keep other market participants in the dark about what they're buying and selling. The new exchanges are doing about 7% of their volume in dark pools, according to Tabb Group, a Westborough, Mass. market researcher
Some ECNs also up the ante by paying traders to provide greater numbers of limit orders – buying or selling a stock at a committed price – which attracts increased numbers of sellers.
This entices "black box" traders who use computer programs to buy and sell stocks in milliseconds – often for a tiny loss. They turn a profit from so-called "liquidity rebates" – usually 20 cents or so on 100 shares. These kinds of rebates are now ingrained on big U.S. exchanges.
Big Bourses Pin Hopes on Mergers
In order to compete, the big exchanges have been moving to combine operations to lower costs and grab some of the new technology:
- In March 2007, the first transatlantic stock market was created when the New York Stock Exchange won control of pan-European market operator Euronext, linking trading platforms in New York, Paris, Brussels, Amsterdam and Lisbon, as well as the Liffe financial futures market in London.
- On July 9th 2007, the Chicago Mercantile Exchange and the Chicago Board of Trade merged the two companies to form CME Group Inc. (CME), consolidating most of the futures and commodities markets into one exchange.
- Nasdaq recently paid $935 million for Instinet, one of the largest electronic exchange operators, mostly to get the Island trading engine, an especially fast and inexpensive trading technology. Nasdaq also bought Stockholm OMX, to increase trading of securites and derivatives in northern Europe.
"The more volume they can get on one platform, the better for exchanges, so all the mergers make sense," said Octavio Marenzi, chief executive of Celent, a consulting firm.
But recent merger talks between Deutsche Börse (PINK: DBOEY) and NYSE Euronext broke down on December 12th over regulatory and valuation concerns.
A merger between the two would have represented a serious challenge to CME Group, the leading derivatives market. The New York Stock Exchange, Euronext and Deutsche Börse combined handled 2.5 trillion trades in 2007, overtaking CME's 2.25 trillion trades, the International Herald Tribune reported.
The merger was an attempt by Deutsche Börse to reduce its cost structure. The German exchange's cost per trade was about 31 cents in 2007 – 35 times more than the CME and 12 times higher than the NYSE, according to a study by Celent. Thanks to the Euronext deal, NYSE saw its cost-to-income ratio drop to 49% in 2007 from 75.7% in 2006.
If Deutsche Börse acquired NYSE Euronext, the combined entity would account for 95% of all European exchange-traded derivatives, creating antitrust issues. A foreign company buying a landmark like the Big Board would almost certainly raise hackles in Washington.
But even though the talks ended with no result, it seems inevitable the two exchanges will have to make cross-border mergers to contain costs. The new exchanges are simply taking too much market share to ignore.
"I'd definitely say the ECNs are winning, says William Lupien, who founded the Instinet trading system. "Things happen awfully fast once you reach the tipping point. We're now at the tipping point."
The Big Board To Watch
One place to look for a possible profit angle on the shift in trading platforms might be an old standby. Nasdaq OMX has shown itself to be a particularly nimble participant in the new trading world.
Besides the Instinet and Stockholm acquisitions, the company recently bought the Boston and Philadelphia exchanges to increase trading of options, interest rate swaps and other derivatives. Nasdaq is trying to push more transactions onto its superfast, supercheap servers before its competitors can catch up, Forbes reported.
"As you add scale, your incremental cost goes to zero," says Robert Greifeld, Nasdaq's CEO since 2003. "Our goal is to add more incremental trades at zero cost."
The company handles about one-third of total U.S. equity trading, and takes in $800,000 in fees, on a typical two billion share day.
Thanks to its savvy dealmaking, revenue has quadrupled since 2004 to $3.3 billion, while earnings skyrocketed from $11 million to $362 million. The shares are down 50% since January 2008, trading at $26 or 13 times earnings.
News and Related Story Links:
- Money Morning:
Why Dark Pools May Render Traditional Analytics Ineffective
- Forbes Magazine:
Company of the Year: Nasdaq
- International Herald Tribune:
Questions amid a bourse merger stampede
The future of stock exchanges