This Year’s Crystal Ball

Eight Calls on Market Structure for 2009

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.

With the SEC in disarray after the Madoff scandal and all of Washington pushing for “reform,” Mary Schapiro takes the last chairmanship of the agency as we now know it. Her futures background, political acumen and NASD + NYSE Reg = FINRA merger experience prove valuable as long-awaited SEC-CFTC merger plans take form. The new combo is principles-based, consumer-focused and has many more boots on the ground. Hedge funds join the ranks of the fully regulated. The OTC derivatives business receives a makeover à la Nasdaq in 1996: organized pre- and post-trade transparency, mandated central clearing and detailed regulatory reporting. (Congress doesn’t make the mistake of an outright ban on the ability to transact over-the-counter.) The upshot: a simplified, expanded regulatory regime with more intermediary-oriented enforcement, less exchange-focused policy-making.

No. 7: CME & ICE Enter Equities.

As the regulatory underbrush is cleared during the first half of 2009, historical differences between the futures and equities businesses begin to disappear. With NYSE operating two futures exchanges and Nasdaq sniffing around derivatives clearing, both CME and ICE announce plans to enter the equities business by year-end. Acquisition is the most likely route; BATS, enhanced with an options launch, is an attractive possibility.

No. 8: Long Modesty, Short Complexity.

A battered financial industry returns to basics in 2009. Humbled for obvious reasons, aggregate employment and compensation drop as “the business” begins to look more like the rest of the corporate world. Big firms get less relevant; boutiques more so. Financial types regain the ability to explain their work to their children and mothers. A year of realism and honest self-reflection provides the basis for rebuilding. We’re still a long way from bright and bon vivant at year-end, but you’ll be able to cop to a financial career in polite company again.

Recap: 2008 Scorecard.

Perhaps in line with everything else, our performance slipped in 2008: four rights, two wrongs and two pushes. The heavy volume and high volatility of the bottom half of 2007 continued-and grew-in 2008. On Jan. 17, NYSE announced it would buy Amex; CME’s bid for Nymex came 11 days later. Both CME and ICE end 2008 with much-ballyhooed plans in train to trade and clear credit default swaps-while the product itself jumped the shark. (First came daily discussions on CNBC, then a reference on Saturday Night Live and finally a mention by President Bush-who nailed the pronunciation, incidentally.) An SEC-CFTC merger was suggested by Treasury Secretary Henry Paulson’s “blueprint” for reforming financial regulation, but politics-and a financial emergency or two-prevented action in 2008.

In terms of our misses, NYSE didn’t buy BIDS, and a rationalization of dark pool redundancies remains on our industry’s “to do” list. Equities and options didn’t converge to the extent we thought, and the SEC actions we envisioned-execution-quality disclosure and permanent pennies across the board below $3-didn’t come to pass. We pushed on our BATS/Direct Edge call-BATS made its exchange bones in November, while Direct Edge pursued exchangehood via a partnership with the ISE announced in August. Our equity-exchange market-share call was also half-right: While NYSE successfully launched reserve orders, automated its open and beat specialist swords into (less-constricted) “designated market maker” plowshares, we gave both NYSE and Nasdaq too much market-share credit. And we were wrong that NYSE’s grant of “parity” to rebranded specialists would mean further market-share pain.

Jamie Selway is founder and managing director of White Cap Trading in New York. This year’s annual rite, predicting the top stories of the year, is his fourth.

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