No one said it would be easy.
Duncan Niederauer and Larry Leibowitz, electronic trading professionals hired this year to manage NYSE Euronext’s U.S. trading operation, have taken the helm at perhaps the most difficult time in the storied franchise’s history. A combination of regulatory change, stiff competition, and the expansion of automatic executions at the New York Stock Exchange has driven the company’s U.S. market share to an all-time low.
The Securities and Exchange Commission’s Regulation NMS effectively ended the organization’s 200-year-old monopoly, forcing it to adapt to an unfamiliar world of automatic executions.
With the Big Board functioning more like a small-order ECN than the block-trading powerhouse it once was and NYSE Arca’s stature in Nasdaq trading under assault, the veteran electronic trading professionals have their work cut out for them.
“For us to be competitive going forward,” Niederauer told Traders Magazine, “we will have to leverage the brand and think like a technology company. We have to evolve our culture to one that insists on innovation and, most importantly, is very customer-focused.”
Two Decades
Both execs are newcomers to NYSE management. Niederauer joined the company in April as co-president, sharing the duties with a Paris-based Catherine Kinney. The Goldman Sachs alumnus is sometimes mentioned as the heir apparent to NYSE Euronext chief executive John Thain, who could step down in the next year. Leibowitz joined in July as an executive vice president and chief operating officer for U.S. products, replacing Jerry Putnam, who remains an adviser.
The two new executives each have two decades of Wall Street experience under their belts, having made their marks as electronic trading whizes at prominent bulge-bracket firms. Both are also steeped in market structure and have played leading roles in charting strategy at their previous firms. Niederauer spent 22 years at Goldman, ending his days there as co-head of the firm’s equities execution services business. He was also head of portfolio trading at one time.
Leibowitz has worked at a number of firms during his career, lastly as the COO of UBS’s U.S. equities group. He was co-head of Schwab Capital Markets when the trading division of Charles Schwab & Co. was acquired by UBS. Earlier in his career he was a block trader.
Within NYSE Euronext, Niederauer and Leibowitz are responsible for the trading businesses of NYSE Group, the U.S. subsidiary of the trans-Atlantic exchange operator. That includes both the New York Stock Exchange and NYSE Arca, which the NYSE bought in April 2006. With 85 percent of NYSE orders now filled electronically, the profiles of the two markets havebecome similar. Some observers believe NYSE Arca will become the sole trading platform, but that is not yet the case. Despite the closure of three of its five trading rooms, the NYSE is still doing about one-and-a-half billion shares per day. Niederauer, Leibowitz, and Thain continue to voice their support for the specialist model.
Room for Both
Is the floor going to be part of our model?” Niederauer asked rhetorically at a recent industry conference. “You bet it is.” Leibowitz seconds him. “Arca is a direct competitor for Nasdaq,” he said. “It is fully electronic. It is order-driven. Fast. It is maker-taker. It is Nasdaq essentially. But New York is a different animal. It has a floor. It has price discovery. It has a specialist, someone who is responsible for a market. We think there is room for both models.”
One brokerage exec notes that while the specialist may not be the most beloved trader on Wall Street, his presence is a critical differentiating factor for the NYSE. “If the New York were to get rid of the specialists and the floor brokers, it wouldn’t be able to differentiate itself from other markets,” says Dan Mathisson, head of Credit Suisse’s electronic trading group, AES.
Still, specialists are involved in fewer trades than they ever have been and many pros outside the exchange find it hard to tell the difference between the two marketplaces. On top of that, in NYSE-listed trading, NYSE Arca is growing while the NYSE is shrinking. Since the New York bought ArcaEx, the latter’s market share in NYSE-listed names has jumped from 5 percent to 12 percent. The NYSE’s has declined from 76 percent to 44 percent.
Complementary Models
The two marketplaces are, of course, separate and distinct stock exchanges, but they are managed as two halves of a whole. “We’re one team with one dream,” Niederauer has said. When NYSE Group releases its monthly statistics, for example, it does not break out NYSE trading data from NYSE Arca data.
While many complain the NYSE has become indistinguishable from NYSE Arca, there is at least one critical difference-pricing. NYSE Arca’s rebate policy is positioned to appeal to liquidity providers. The NYSE is oriented toward liquidity takers, with the lowest take charge in the industry.
Both market centers combined traded on average 1.8 billion of the industry’s 3.2 billion NYSE-listed shares per day in September. That gave NYSE Group a market share of 56 percent. Of the total, the NYSE did 44 percent and NYSE Arca did 12 percent. NYSE Group’s total is down from 66 percent in January and 78 percent two years ago.
The slide is worse on the Nasdaq front. In September, NYSE Arca had 14 percent of the market, down from 19 percent in January. Its all-time high came in May 2006 when it traded about 21 percent of all Nasdaq shares.
Holding Its Own
Much of this year’s damage can be attributed to Reg NMS. The ruling, which went into effect in March, was pushed through by the SEC largely to cut the NYSE down to size. It has succeeded, forcing NYSE Group to share the market with a slew of trading venues and broker-dealers.
Niederauer is optimistic that the NYSE can reverse the trend in NYSE-listed trading. “We believe we can get that number as high as 65 or in the high 60s,” he said at a recent conference. “I think a lot higher than that is probably pretty unrealistic in this competitive environment.”
Despite the hits, NYSE Group is holding its own, aided by an overall surge in NYSE-listed trading. In the first half of this year, the two marts traded a combined average of 2 billion NYSE-listed shares per day, up 6 percent from an average of 1.9 billion shares in the same period in 2006. Over that same period, the industry’s average daily volume increased 23 percent.
The group’s Nasdaq volume shrank slightly, going from an average of 417 million shares per day in the first six months to 379 million. Overall industry Nasdaq volume was stagnant during this period.
The group has also managed to keep its head above water financially. In the first six months of the year, the spread on NYSE Euronext’s U.S. cash equities and derivatives trading operations was $175 million, up from $151 million in the same period last year. The spread is the difference between the payments NYSE took in from liquidity takers and those it made to liquidity providers and other exchanges for routing.
Still, time is not on its side. Right now a rising tide is lifting all boats, but the surge is unlikely to continue forever. And if the erosion of NYSE Group’s market share continues apace, the firm could find itself marginalized.
“What has killed the NYSE’s market share is the perception that the equities markets have become commoditized,” Credit Suisse’s Mathisson says. “Once New York went electronic under Hybrid, in many traders’ minds, it became the same as all the other ones.”
New Culture
To regain lost ground, Niederauer and Leibowitz are taking steps to make the NYSE, NYSE Arca, and the organization itself more competitive. Within the company, a for-profit, publicly traded corporation since last year, the two are trying to transform what was traditionally an inward-looking, exchange floor-dominated culture into an outward-looking, customer-focused culture. Instead of running the organization for the benefit of specialists, for example, Niederauer and Leibowitz say they are trying to satisfy the people that deliver the order flow-the broker-dealers.
“In my 20 years on the sellside, I never felt like a client of the New York Stock Exchange,” Leibowitz told attendees at this year’s Security Traders Association annual conference. “That’s despite the fact that at Morgan Stanley, Credit Suisse, and UBS, I represented a pretty good chunk of their order flow.”
The exchange was run for those who had the most seats, Leibowitz told Traders Magazine. And those weren’t the house brokers such as UBS. The result was poor communication between the exchange and the upstairs desks, he said, since the exchange neither took their recommendations seriously nor consulted them before making changes. “The attitude was: We are a monopoly and you have to trade here,'” Leibowitz said.
With its market share slipping away, the New York can no longer afford such arrogance. It has had to reconnect with the sources of its order flow. To that end, Niederauer and Leibowitz spend much of their time talking with traders-both sellside and buyside-to get a handle on their needs.
In their discussions with traders, Niederauer and Leibowitz say, they found that the biggest problem was getting blocks done. The problem is not new, but the advent of Reg NMS exacerbated the difficulty, Leibowitz said. With the movement of liquidity away from the NYSE and toward other marketplaces, no single venue has enough liquidity to support an efficient price discovery process. That has meant that pricing blocks is now done on individual trading desks that must get by with less information.
Brokers on and off the floor tell Traders Magazine part of the problem is that trading a block on the NYSE floor has become slower under Reg NMS. The relatively slow auction process is part of the reason, along with the inability of floor brokers to efficiently comply with the new trade-through rule. Floor brokers lack the technology to send out crucial intermarket sweep orders and must rely on specialists to do so. Upstairs traders can do it faster.
Diminishing Blocks
Whatever the case, the impact of the NYSE’s block dirge can be seen in the statistics. In September, NYSE Group did 107,800 trades of 10,000 shares or more, matching about 222 million shares per day on average. A year earlier, NYSE Group did 257,600 block trades, matching about 358 million shares on an average day. Today, shares traded in blocks at NYSE Group account for only 12 percent of total volume. A year ago, they represented 20 percent.
The company took a big step in tackling the block trading problem last month when it entered into a joint venture with the BIDS block trading facility to create a dark pool within the NYSE. Traders with orders on the NYSE display book will be able to represent those orders in the new facility simultaneously. And traders with orders in BIDS will be able to do the same. The goal is to match the two types.
The execs hope the move will increase block trading on the NYSE and serve the needs of frustrated traders. “The block marketplace has become fragmented and obtuse,” Niederauer said at a recent press briefing. “Traders have been looking for someone to re-aggregate block liquidity.” The NYSE’s new platform, which needs SEC approval, is slated to launch next year.
Michael Rutigliano, a managing director at WJB Capital Group, an NYSE floor broker, says he is cautiously optimistic about BIDS, but notes that the exchange is taking steps to make the floor broker more valuable as well. It is, for example, working on technology that will let floor brokers route out ISOs and print trades through their handhelds.
That will strengthen floor brokers and enable them to execute more blocks. “You want to transact at the post because liquidity may exist in the hands of a broker or specialist that’s inaccessible through the system,” Rutigliano says. “Brokers are still physical reserve providers.”
Revamping the floor’s technology is a big part of the strategy: Leibowitz is in the process of discarding most of the NYSE’s systems, including SuperDOT, and replacing them with systems from Arca and Euronext.
Better Quotes
Better technology is not enough, though. One of Niederauer’s main objectives this year has been to improve the quality of quotes on the exchange to attract more orders. Under Reg NMS, orders go to the exchange with the best protected quotes. And since the New York expanded automatic executions, the quality of its quoting has deteriorated.
Recent New York statistics show a decline in the frequency with which the Big Board sets the national best bid or offer. The study looked at the 420 NYSE-listed stocks that are part of the S&P 500, breaking them up equally into three volume categories-active, moderately active, and less active.
During the third quarter of last year, among the most active stocks, the NYSE set the NBBO two-thirds of the time. In the second quarter of this year, after Hybrid went into effect, that number declined to 55 percent. The results were similar in the other two categories. (The NYSE matches the NBBO set by other markets almost as frequently as before-roughly 85 percent to 87 percent of the time.)
Specialist Quoting
The level of price improvement is down on the NYSE as well. In July 2006, the exchange found, the percentage of orders price-improved by specialists was 1.47 percent. A year later, it was down to 0.03 percent. The amount of price improvement provided by floor brokers also declined. That figure was 10.66 percent in July 2006. It dropped to 1.39 percent in July 2007. Price improvement at the NYSE is at a historic low, the NYSE concluded.
Niederauer is focused on both metrics. And one lever he can utilize to produce better numbers is the specialist. So, through a combination of incentive payments and rule changes, the exec has been trying to create an environment conducive to more-aggressive specialist quoting. Remedial action is needed on this front, Niederauer maintains, because the specialist has lost many of the benefits once associated with his role and has seen a decline in his profitability.
By making $9 million monthly “liquidity provision payments” to the seven specialist firms and winning rule-change approvals from the SEC, Niederauer hopes to encourage them to make better markets. “The more you set the NBBO, the more liquidity you provide at the NBBO and the more flexibility I’m able to give the primary market makers in their ability to hedge their exposure,” Niederauer told analysts this summer. “You know, liquidity begets liquidity.”
The cash incentive program, Niederauer believes, will encourage specialists to post quotes more frequently at the NBBO and increase the size of their quotes. Half of the monthly liquidity payment is tied to the frequency with which the specialist is quoting at the NBBO. “NBBO is a key driver of market share,” Niederauer said at Lehman Brothers’ annual financial services conference. The other half is based on the specialist’s trading performance. The exchange will analyze how often specialist trades are done at better prices and/or sizes than were available. It will also look at how often the specialist’s trades stem from posted bids or offers and matches of other markets’ better quotes.
Negative Aura
Niederauer and Leibowitz also believe many of the rules governing specialist behavior are outdated. Because the NYSE floor has lost half of its order flow over the last few years, the specialist has forfeited much of his informational advantage. His post is no longer a central collecting point for the preponderance of orders. Therefore, he needs to lose some of his restrictions, the execs argue.
Competition has made the specialist more akin to a Nasdaq market maker than a monopolist. Partly for that reason, as well as the negative aura that hangs over the word, Niederauer and Leibowitz are considering replacing the term “specialist” with the term “primary market maker.”
Driving this broader transition has been a flurry of rule changes presented to the SEC this year. The regulator has approved a few. It is troubled by others. Among Niederauer’s successes is the elimination of the specialist’s price improvement guidelines. Previously, when price-improving an incoming order, the specialist had to provide a minimum number of pennies per share based on a stock’s spread.
Niederauer also won for the specialist the ability to hedge positions after the market closes, even if there are orders on the book that could execute at similar prices. He is seeking to give the specialist the same benefit during market hours. The prohibition is on the books because of fear that the specialist, with his informational advantage, might hedge in advance of incoming orders, rather than as a result of positions already taken. “If people are going to take more risk,” Leibowitz says, “they have to be able to hedge. If you don’t let them hedge, they might not provide much capital.”
Parity Issue
One of the most contentious changes Niederauer is trying to push through involves the issue of parity. In general, specialist trades must take a back seat to those of floor brokers at the same price, regardless of who set the price. Niederauer and Leibowitz want specialists to have parity with floor brokers. They argue that if the specialist sets the NBBO, he should not have to sit back and watch someone else match his quote and win the trade.
“Is that really fair?” Leibowitz asks. “If we want to encourage them to provide liquidity, are we going to tell them they are always the last guy in? Is that really fair?” The exchange is in negotiations with the SEC over the matter, Leibowitz says.
He is optimistic about winning over the SEC. “Look, if they want us to become an ECN, the easiest thing to do is to not make any changes,” Leibowitz says. “That is probably not what they want. It is probably not the best thing for the market.”
Given the mistrust many pros have for specialists, loosening their obligations is a controversial undertaking. Niederauer doesn’t want the industry to think he is favoring them with unfair advantages. The exec maintains the proposed changes are not so much about “relaxing” specialists’ obligations but “balancing the obligations with commensurate opportunities.” He adds: “We need to simplify our market structure, strike the right balance of obligations and opportunities, and effectively communicate our market structure going forward.”
In general, the structure of a market is largely a product of rulemaking. For individual exchanges, there are perhaps no rules more important than those dealing with pricing. To attract liquidity to their two markets, Niederauer and Leibowitz recently made some aggressive changes.
On the faltering NYSE Arca platform, Niederauer and Leibowitz cut in half Arca’s maker-taker spread for both Nasdaq- and NYSE-listed trades to 5 cents per hundred shares. “We decided the 10-cent spread was unsustainable,” Leibowitz said.
Pricing Strategy
For NYSE-listed trading, they increased Arca’s rebate from 20 cents to 25 cents for 100 shares, clearly targeting the liquidity providers. Despite growth in its share of NYSE-listed trading, Arca is still behind Nasdaq. Cutting the rebate below Nasdaq’s was seen as a smart move by some traders.
In contrast, on the Nasdaq front, they cut Arca’s take rate from 30 cents per 100 shares to 25 cents. “We thought going from 20 cents to 25 cents on the rebate wouldn’t get us more posting,” Leibowitz explained. “But by going 25 take and undercutting Nasdaq, we would be first on many people’s routers.”
On the Big Board, the execs decided to eliminate the traditional charge to provide liquidity. It is now free to post. They chose not to institute a rebate because that would require them to charge a much higher take fee. Such a maker-taker strategy would be largely unworkable, Leibowitz explains, because of the NYSE’s relatively slow turnaround time. Few traders would place the NYSE at the top of their routing tables. Traders are willing to accept higher latency today, Leibowitz explains, because the NYSE is the cheapest place to take liquidity. That, in turn, encourages the posting of limit orders. The combination of the two produces the industry’s highest fill rates.
At the same time the NYSE eliminated the charge for supplying liquidity, it increased the fee to take liquidity from 2.75 cents per 100 shares to 8 cents. More recently, Niederauer okayed an elimination of the take charge at the open. Traders using market and limit orders to transact at the opening price in all names except exchange-traded funds now trade for free.
At least one trader was impressed. “It’s another attempt to bring volume back to the exchange,” says Michael Fenske, a senior trader at ING Investment Management. “The move makes sense. They are being proactive in trying to be competitive with other exchanges. But I don’t think it will ever get back to the way it was a few years ago where the NYSE set the price.”
No one ever said it would be easy.
-Additional reporting by Nina Mehta and Michael Scotti
