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

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.

Granted, the market structure and regulatory environment are different in Germany, but the findings are suggestive nevertheless. The Deutsche Brse data revealed that roughly 45 percent to 50 percent of trading is off-book. Interestingly, the off-book percentage in Germany is an increasing function of cap size. For large-cap stocks, the exchange’s market share falls to roughly 41 percent.

In-house netting of retail orders is easier for large-cap stocks because frequent trading keeps quotes and prices fresh. Off-book trading also has much appeal for institutional customers who are more active in the large-cap segment. And, for all participants, frequent on-book trading in the large caps enables them to execute with more confidence in off-book markets that free-ride on exchange produced prices.

Where, then, does the appeal of off-board trading lie for institutional customers? The answer resides in their need to control market impact costs by properly timing, pricing and sizing their orders while maintaining anonymity and virtual invisibility. To this end, they wish to see the trades and quotes of others without showing their own hand. Accordingly, with an electronic platform, they slice and dice their orders and trade algorithmically.

But give institutions the alternative of transacting in size at prices they have confidence in, and they will take it. Institutions have found that they can get good size done with minimal spread or impact cost (if any) in a crossing network (such as POSIT) or in an ATS (such as Liquidnet or Pipeline) that offers dark liquidity and minimal information leakage (if any). The Big Board is moving in the right direction by itself providing a dark pool: In the first half of ’07, trading is expected to start on MatchPoint, the exchange’s own crossing network.

Floor Broker

The trading floor has played in a similar space. A floor broker using discretion (by taking a customer order out of his pocket for execution in relatively small pieces when conditions are right) can be thought of as a micro market timer, as a human algorithm, as a bearer of dark liquidity. In so doing, the floor broker offers a value-added service.

A 2004 Journal of Business paper that I produced with University of Iowa professors Puneet Handa and Ashish Tiwari, “The Economic Value of a Trading Floor,” presents evidence that floor broker intermediation on the American Stock Exchange results in better market timing and lower impact costs compared to orders entered through DOT.

From the perspective of market quality, does it matter where the various components of a hybrid reside? The answer lies in the intricacies of price and quantity discovery. The broad market needs accurate prices, and a 300,000-share buyer and a 300,000-share seller need to find each other.

In any standard economics text, price and quantity discovery are achieved simultaneously at the magic point where demand intersects supply. But in real-world equity markets, the two processes have partially decoupled. Price discovery occurs primarily in the centralized, transparent market, while much quantity discovery takes place off-book, or with a trading floor in close proximity to the book.

Removing the floor from the equation alters the interaction between price and quantity discovery. Upstairs markets and ATSs will receive more order flow and a market already fragmented in both space and time may-with penny ticks, time measured in milliseconds, and electronic capabilities-fragment further.

But given the technology available today, the separate venues will be interconnected. So, after the dust has settled, how will market quality be affected? To answer this one, industry participants and academicians alike will just have to see how the Hybrid Market (and marketplace) evolves.

Robert A. Schwartz is the Marvin M. Speiser Professor of Finance and University Distinguished Professor at the Zicklin School of Business, Baruch College, CUNY. His latest book, co-authored with Reto Francioni and Bruce Weber, is “The Equity Trader Course” (John Wiley & Sons, 2006).