John Dizard: Spanner in the works of big mergers

People in the financial markets have been assuming that the proposed mergers of the big stock exchanges with the electronic trading networks are more or less a sure thing.

The Securities and Exchange Commission has, in effect, blessed the merger of the NYSE with Archipelago, and Nasdaq's merger with Instinet. New York politicians weighed in to make sure that the position of the NYSE was protected, and the price of NYSE "seats", or memberships, has been bid up in response.

The assumption, then, was that, once all the papers were signed, the result would be a cosy duopoly, with the chaos (and price-cutting) much reduced from that prevailing during the competitive storm of recent years. There would still be competition . . . kind of . . . but just among the boys and girls already in the club.

The conviction that this would be so was reinforced by the power of the people behind the agreement, which is to say the big brokerage firms, the New York establishment and their $800-an-hour lawyers. Who could go up against that concentration of authority?

Answer: the Antitrust Division of the Department of Justice. There are some US government operations that do not deserve one's respect, some that do, such as the Antitrust Division. If they decide to focus their attention on you, you have a problem. Therefore, the NYSE and the Nasdaq, along with Archipelago and Instinet, have a problem.

I have spoken to a number of people who have had dealings with the Antitrust Division staff who are investigating the mergers, and to a person who assures me that the DoJ is undertaking a deep review of the mergers, and, more broadly, the structure of financial markets in the US. As one of them says: "If the deal happens, then the NYSE-Nasdaq duopoly will have close to 80 per cent of all the trading activity in the stocks listed on those exchanges. Therefore, they believe they have an obligation to consider the anti-competitive effect of the mergers." Says another: "There is no way with those market share numbers that the deals could pass any test from an antitrust perspective."

What about the SEC's oversight? Doesn't that mitigate the problem? As my first source says: "DoJ believes they are the only institution that has examined this that is above political pressure and the influence of the parties to the mergers. They will give no special passes to this industry or to any participants in this industry." In other words, they are on a mission.

Supposedly, the DoJ already has a theory on what the anti-competitive impact could be. "It's called 'parallel pricing'," says the first source. "With an effective duopoly, they wouldn't have to collude or even communicate. But when one would raise spreads or fees, the other would follow; or, if one successfully resists pressure to cut fees or spreads, the other would as well." Econometric models are already being tweaked to analyse the potential effect of this behaviour.

If this analysis is supported by data and rigorous models, it would refute the exchanges' argument that the Nasdaq and NYSE complexes would ensure the public interest by vigorously competing with each other.

Such non-collusive collusion could be mitigated or prevented by new exchanges starting up to take advantage of a duopoly's pricing umbrella. "The barriers to entry in the form of technology and compliance costs are too high, particularly if the order flow is directed by people who control the exchanges," says another source.

In this context, a report from another industry source is interesting. "A focus of their [the DoJ's] inquiry is the potential conflicts Goldman Sachs may have from being on so many sides of these transactions. Those include their shareholding in Archipelago, ownership of a large NYSE specialists, the order flows they direct, and share of Nasdaq business." I asked Goldman Sachs to reply to these statements: no comment.

There is some thought that the DoJ could simply derail the mergers. However, there is another possibility. DoJ could go along with the mergers on the condition that new entrant exchanges or electronic platforms get a better shot at competing with the Big Two. The regional exchanges are trying to make the case that they are the potential saviours of competition in the securities markets. "

Investors have a lot at stake here. If the Antitrust Division's economic models are correct, there could be a serious deleterious effect on transaction costs and, potentially, liquidity as trading activity dries up. In the meantime, it may well be that the various forms of equity in the exchanges are overvalued. I would not go buying any NYSE seats until after the DoJ makes its position public.

johndizard@hotmail.com