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September 25, 2006 9:54 pm

John Dizard: Will NYSE floor ever die?

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Market people and journalists have been pronouncing the last rites over the New York Stock Exchange since I got into this business over 30 years ago. Their reasoning was always sound, but the floor of the exchange, or “the New York” as they call it in the trading business, never loses its dominance of trading in US stocks.

Now, though, as one member says, “This is the first time you have seen a real risk to New York dominance. It used to be when we used [electronic, off-exchange] crossing networks, one piece would be traded on the network, and the other would be on the floor. Now we get more done on the crossing networks, and they aren’t even stopping to look [at the pricing] on the exchange. NYSE has got to get with the programme, or it risks losing control of its own listed stocks.”

His clients tend to be the ultra-transaction-cost-sensitive programme traders, but even so, the NYSE share of the market has gone from more than 80 per cent five years ago to 63 per cent today. Lately, its market share has been dwindling at an accelerating rate. After its last set of pricing changes was put into effect on August 1, Nasdaq promptly took away 1.75 per cent of market share in the next 30 days. Not auspicious.

From the point of view of active equity traders, though, the NYSE’s stock has provided what they need: volatility, and since August it hasn’t disappointed. From a high of over 90 back in March, the stock touched 50 by mid-June, then rebounded only to sink again to the low mid-50s with the decline in market share. Then, early in September, it began to rebound. On September 14 the NYSE Group announced a revision to its fee structure intended to make it more attractive for “black box” computer-driven large traders to run their streams of orders through Arca, the automated order execution division of the NYSE group. While the stock rebounded to the mid-60s by last week, the floor traders felt the exchange had bought a few points of share for a few months at their expense.

You can debate the merits of the NYSE Group as an equity investment, but never its entertainment value. The floor’s always-imminent death by computer reminds me of the 1955 film Les Diaboliques, which gave two generations of hack scriptwriters the “Diabolique ending”. That’s where the murder victim, whose lifeless body we thought we saw, is suddenly missing. He (or she, in Fatal Attraction) has to be killed all over again.

The endless tweaks to the pricing model are intended to give the large broker-dealers just enough incentive to push their huge order flows through the exchange, while somehow avoiding the dealers’ gaming the model to cut the exchanges’ revenues. It isn’t easy for the specialists and others on the floor. “The pie has grown,” says Joe Gawronski of Rosenblatt Securities, “but even so it’s hard to survive on the floor. Compliance costs have gone through the roof. If we only had the floor business, I might be singing the same mantra [of misery] as the people down there, but now the upstairs [trading desk] is the bulk of our business.”

Before the real estate developers start measuring the floor for squash courts and a shopping mall, though, there are still some scenes to get through. One will be the introduction of the hybrid model of trading, which will debut later this year, with full implementation coming by the spring. No one is sure what that will be, though it will include both electronic trade matching and floor trading.

In any event, as one leading floor trader points out: “Even if they wanted to end floor trading now, they wouldn’t have the electronic platform to replace it for at least two years. The general problem is that there is a back-up in the technology pipeline to get stuff done.”

While automated execution works well on high volume stocks, there’s still work to be done on providing the same liquidity for lower-volume stocks.

In the meantime, the exchange has been chasing diversification. The best-known example is the proposed Euronext acquisition, which is supposed to provide derivatives expertise as well as international reach. The recent sharp rise in the NYSE’s share price suggests the market now believes this deal will happen, in spite of much controversy.

However, John Thain, the NYSE Group’s chief executive, has expressed a strong interest in taking on the trading of credit default swaps, presently the preserve of the big dealers and banks. This makes sense, theoretically. Both CDSs and stocks represent the securitisation of risk, and CDS dealers hedge their positions in corporate credits in part by using the equity options of the issuers.

Also, the transaction costs for the CDS market are measured in hundreds of dollars per trade, rather than the cents, or fractions of a cent, collected by the NYSE. Furthermore, he might add, should some congressional committee ask him, price discovery is far more efficient, quick, and accurate on the exchange.

You can see why there’s a gleam in Mr Thain’s eye. Which, the dealers say privately, would be poked out if he got any ideas. As one CDS strategist says: “The purpose of an exchange is to open the market to a wider group. Mom and pop don’t belong in this market. We don’t want the public touching CDSs. Non-professionals can’t evaluate the risks.”

“I think it’s a stretch,” says Mr Gawronski. “While price discovery and transparency are what the exchange does, it’ll be people who have credit market experience who set up a CDS exchange. It would be more like a broker-dealer consortium, or investors in an electronic platform. It needn’t be a floor-based product.”

So the exchange’s management would probably be better off trying to perfect the pricing and technology implementation of its core business. It’s much more fun for top management to chit-chat about the view from 10,000 metres. But too much more of that, and they’ll find out that eventually, the Diabolique victim really does wind up dead.

johndizard@hotmail.com

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