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January 13, 2009

This Year's Crystal Ball

Eight Calls on Market Structure for 2009

By Jamie Selway

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As we bid good riddance to 2008, we offer eight predictions for the coming-and, we hope, much better-year. An honest "mark-to-market" of last year's list follows.

No. 1: NYSE Finishes Job.

Four years after the Arca merger and one year after Nasdaq reached parity with the floor on listed market share, the New York Stock Exchange completes its transformation. Reserve and hidden orders grow in popularity. An expanded roster of rebate-seeking SLPs, or supplemental liquidity providers, contribute increasing liquidity.

While unfriendly to limit orders, the secondary priority "parity" benefits to the floor don't matter much in a volatile environment in which primary priority-price-is dispositive. Most importantly, the "unified trading platform" is launched by year-end-replacing both NYSE's systems and Arca-and reduces latency to industry standards. At long last, speed and rebates make NYSE a viable proposition for black-box market makers. Competitors keep the heat on, but NYSE turns the corner on share loss, and has modest gains. The bottom is in.

No. 2: Shifts to Broker-Exchange Balance of Power

. As major firms continue to suffer from record losses, the death of wholesale financing and post-TARP ward-of-the-state status, the balance of power begins to shift from brokers to exchanges. Lower risk appetite means no more anti-incumbent exchange launches, which marks the end of the era of frenetic exchange price cuts. Reduced capital translates to less technology investment, allowing exchanges to enter data-intensive businesses such as algorithmic trading. Regulatory pressure to exchange-ify OTC derivatives-and not just credit default swaps-provides growth opportunities at the expense of traditional dealer markets.

No. 3: Another Year of Tough Trading.

As sellside proprietary desks and hedge funds continue to retrench, equities traders face another year of difficult markets. After years of technological ascendancy and a commoditization trend, a smaller industry begins to place more value on skills and services needed to meet these challenges. Liquidity providers that emerge from 2008 intact and risk-seeking new entrants with dry powder enjoy the volatile ride.

No. 4: Equities Clearing Gets Competitive.

With tightened rules for closing out fails in place and the industry hungry for cost savings wherever they can be found, once-sleepy back-office operations become a focus for competition and innovation. Nasdaq receives approval for its new clearing agency by midyear; by year-end, it takes half of the National Securities Clearing Corp.'s business through competitive pricing and better capital efficiency. Turmoil on both the sellside and buyside creates opportunities for new entrants to shake up the prime brokerage oligopoly. As custodians rethink relationships in an environment with more counterparty risk, a transparent market for securities lending-possibly operated in conjunction with exchanges-begins to gain traction.

No. 5: Short Selling: Disclosure Yes, Tick Test No.

After 2008's unfortunate experience with short-selling rules-including liquidity-destroying bans, Orwellian "interim final temporary rules" and protectionist populism from investment banks-the Securities and Exchange Commission moves to permanent rule-making. After a period of public comment, which benefits from empirical analysis of trading data and findings from the Commission's investigation into possible manipulation by shorts, the SEC adopts a public disclosure requirement for short positions on a quarterly basis. Ignoring the pitchfork-and-torch crowd's calls to bring back the tick test (including places where it never applied, such as ETFs and Nasdaq names), the SEC opts instead for a circuit breaker that throws substantially less sand into the gears of price discovery.

No. 6: Regulatory Revamp.