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February 16, 2007

Big Change at the Big Board: Where is the hybrid market heading?

By Robert A. Schwartz

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  • Big Change at the Big Board: Where is the hybrid market heading?
  • Page 2

The New York Stock Exchange is the last of the major markets to go electronic. The move was substantially completed last month with the rollout of its Hybrid Market. The Big Board's leap into electronic trading was inevitable. Technology has enabled it, competition has pressured it, and regulation has compelled it.

The Big Board is finally joining the club of market centers that have gone electronic. Nasdaq's transformation occurred in 2002, when it launched SuperMontage. Earlier, London introduced its electronic order-driven platform, SETS, in 1997; In continental Europe, Deutsche Brse launched its electronic platform in 1997; Stockholm went entirely electronic in 1990; and Paris started trading electronically back in 1986. It was only a matter of time before the Big Board jettisoned its mostly manual method of trading, which dates back more than 200 years.

It's New

But New York's transformation is different from that of the other exchanges. The NYSE is introducing something new (a fast market, electronic trading platform) while attempting to retain something old and familiar (a slow market, human-intermediated, floor-based trading venue). That is why it is called the "Hybrid Market," with a capital "H" and a capital "M." Will it work? With regard to technology, the answer is "yes." With regard to customer demand, for at least some stocks and orders, the answer is "yes" again. With regard to the continued presence of human intermediaries on a trading floor hmmm, with this one, maybe not. Not if the new pricing, cost and volume structure do not support floor operations as a profitable business model.

The floor died quickly in London when SEAQ was introduced its fate was known in a matter of a week or so. The floor still exists in Frankfurt, but its role is markedly reduced. There are not many trading floors to be seen around the world any more and, as of this writing, the NYSE floor is shrinking.

The NYSE has always been a hybrid. Historically, it has offered a limit-order book, dual-capacity specialists, other floor traders and call auction openings, all while being connected to the upstairs markets. Markets, though, are typically hybrids. Nasdaq handles limit orders, runs two fully electronic call auctions a day (referred to as Nasdaq's opening and closing "crosses"), and includes active dealer participation. The European markets have continuous limit order-book platforms, periodic call auctions, and market maker intervention. A hybrid is good. It gives customers a choice. It is like plywood: When the grain goes in different directions, the board is strengthened.

So, what will life be like after the Big Board offers a fully electronic automated platform? I have addressed this question with Paul Davis (recently retired from TIAA-CREF) and Mike Pagano (a Villanova School of Business professor) in a paper accordingly titled and published in the September/October 2006 issue of the Financial Analysts Journal. Clearly, the broader market for NYSE stocks will remain hybrid, with the Big Board running a fast electronic trading platform. The question is, where will the rest of the hybrid reside partially on the floor or entirely off-board?

German Market

To gain insight from a different perspective, Davis, Pagano and I assessed the euro value of trading in Germany that did not occur electronically on Xetra, the company's fast market, limit order book platform.