Thirteen years ago the nations oldest exchange, founded under a Buttonwood Tree, was struggling. At that time, the Big Board was an embattled institution, toying with the idea of an auction market system and moving to a more hybrid market. Also, the NYSE was losing a public relations war – eyed as the an evil empire that kept rivals out and wanted to rule the exchange world with an iron fist. Fast forward 13 years and the bourse is alive and still changing with the times.
The only constant in the world, some say, is change. And the NYSE, as well as its rivals have been forced to embrace change. Market participants have pointed to myriad driving forces pushing the exchanges to evolve; changes in market structure, new entrants such as high-frequency traders, IEX and new regulations, to name a few. Whether or not the resultant changes at the NYSE or other exchanges has been good is the subject of another article – but the fact remains that the NYSE remains in business and as one of the nations largest exchanges.
The NYSE names still carries a certain amount of clout, said one trader. When many people think of stock exchanges they see Wall Street and the NYE faade. Or they envision the trading pits seen on CNBC and countless movies. Aside from the bull statue on Broadway, the NYSE remains the iconic image of Wall Street and stock trading.
This article was originally published in July 2004
By Nina Mehta
The Big Board will change for the better in more ways than one, according to supporters of the exchange, an embattled institution that may be slowly emerging from a dark and difficult period.
These New York Stock Exchange diehards – floor traders and brokers, and an assortment of other professionals both inside and outside the exchange who are proponents of the auction market system – concede missteps. They agree that the much-maligned NYSE has taken several black eyes over the past year, much to the delight of its electronic competitors.
But now many of the Big Board’s members say that it is ready to make constructive changes, which will transform it into a hybrid market. And it will also battle back in a public relations war that it has been losing. This is a media contest in which the old market has been depicted as a virtual evil empire.
“We’ve got to fight it, move through it,” says Ed Rode, an NYSE floor broker with Capital Institutional Services (CAPIS), an agency broker. “The industry is so huge that we don’t have the right to play with this prototype.”
At stake are the jobs of hundreds of NYSE trading pros. These jobs are threatened by a dynamic marketplace and the NYSE’s public relations problems. The exchange is now pulling out the stops to win the hearts and pocketbooks of the investing community.
Floor pros say the biggest attraction of the 212-year-old NYSE is price discovery. “Here, it’s not about exchanging ownership of shares,” Rode says. “Our whole raison d’etre is responsible price discovery – to determine the price of a given company’s shares at a particular point in time.”
Richard Volpe, a specialist with Van der Moolen Specialists, agreed. “The NYSE gives all investors equal opportunity to participate in the auction market system,” says Volpe, a 25-year floor veteran. “We are here to maintain fair and orderly markets.”
Traders Magazine recently was down on the floor of the Big Board to witness these markets in action. Rode and Volpe were two of the trading pros who were interviewed while they were on the front line.
These pros have weathered many storms. It has been a controversial 12 months. Indeed, the grand titan of stock exchanges has been out of work for more than a year. Dick Grasso was hounded from his job as chairman of the NYSE after revelations surfaced about his huge $140 million pay package. This fueled an impression of the NYSE as a private clubhouse run amok. Blame for the scandal was running deep, so the Big Board reformed its governance structure.
The problems didn’t end there.
Earlier this year, the NYSE’s five largest specialist firms were forced to pay $241 million in a settlement with the Securities and Exchange Commission and the NYSE. Regulators found that the firms had ignored their fiduciary duties by trading ahead of customer orders between 1999 and 2003.
But criticism of the NYSE has been widespread. The critique of the Big Board – which has come from delighted competitors who have enjoyed every faux pas – has also surfaced from another group: buyside traders. They have become much more outspoken about what they see as the failures of the exchange.
Many of these critics charge that the exchange is too tired. It reminds some of an aging superstar ballplayer who can no longer hit the fastball. The Big Board, critics say, was once great. However, now it is too slow, too manual, too conflicted and too protectionist.
Some buysiders say nothing has changed in recent months. “I’m unaware of how the NYSE has improved over the last year. We’ve heard about all the changes that are coming in the future, but I’ve yet to see any of them,” says Holly Stark, director of trading at Kern Capital Management. “Right now I’m going to take a wait and see approach with the NYSE.”
Another buyside trader had a similar view. “Personally, I haven’t seen any improvement in the executions I am getting at the New York Stock Exchange,” says Tim Blastek, a trader at Provident Investment Council. “There is lots of NYSE PR but the fundamentals of trading have not improved.”
Still, the dynamic of the NYSE changes is complicated by another external factor. The regulators are considering the most important market structure proposal in decades. Reg NMS is a proposal with a crown jewel – a reform of the trade-through rule – that potentially could allow NYSE’s hungry electronic competitors to eat big portions of the Big Board’s listed lunch.
Yet, despite these problems, Big Board members insist their institution will do what it has done many times before: It will adapt and face down the latest regulatory and competitive threats.
“The fear is that we become some kind of ECN look-alike if we don’t have human intermediation in the mix,” Rode explains. “Human beings make decisions, and we have to answer to our clients.”
The NYSE is doing exactly that. It is building a hybrid electronic model to compete with its rivals. If the grand plan works, the so-called opt-out proposal in Reg NMS might be shelved. That’s what SEC Chairman William Donaldson has told lawmakers in Washington. “I would question why we need to have an opt-out rule,” he recently told the Senate Banking Committee.
The NYSE has even considered offering automatic executions on orders within a price-quote range of five, or several cents, of the best price. The customer could also aim for the best price. Either way, the idea, which is supported by institutions, could result in orders bypassing floor brokers. In the long run, however, it could discourage some orders from moving off the NYSE for executions by electronic and other competitors.
Rode acknowledges a multitude of execution venues for the buyside. ECNs may be good for a “quick order execution,” but a trader can’t effectively work an order on an electronic platform, he says. His biggest criticism of electronic systems: their reserve-order function isn’t dynamic.
Rode does not dismiss technology, but says in today’s world it is not always the silver bullet. “In a crowd I can sense the aggregate body language and I’ll offer higher and offer twice as much, rather than 700 shares every four minutes,” he says. “I’m being paid for my expertise. The best reserve-order system in the world is no match for a human being who can make a decision based on what’s happening at that moment.”
Today, buyside traders press for more automated trading, anonymity, certainty of execution, and speed. With decimalization – and the rise of penny trading – buyside traders must attempt to reduce market-impact and opportunity costs.
“The buyside wants minimal adverse stock price movements and the ability to execute large blocks of stock with minimal market impact,” according to Blastek
The potential changes in the regulatory structure of U.S. markets strike at the heart of the NYSE. The famous proposals in Reg NMS have put the NYSE in a tight corner. “In practice, the trade-through rule has operated to force investors down to the floor of the NYSE, irrespective of investor wishes,” says Benn Steil, a market structure scholar with the Council on Foreign Relations. “The rule, therefore, operates to discourage free and open competition among marketplaces and market structures. The rule should be eliminated.”
The NYSE has another idea. NYSE CEO John Thain is scrambling to introduce a “fast quote” system. It could be up and running before any SEC reforms might be enacted, Thain has told Donaldson. The SEC Chairman, himself a former NYSE leader, said the agency is seriously considering the fast-quote system as an alternative to the opt-out proposal.
The NYSE has much to protect. Its some 80 percent market share in listed stock trading is vulnerable.
Nevertheless, buyside traders insist that reform must come and now. Big Board officials say they hear this important constitutency. So the NYSE is expanding Direct+, its automated execution service, in response to criticism from the buyside. Direct-access floor brokers – who do no proprietary trading nor advertise their orders – are seeing more business. And sellside trading desks are falling over one another in their rush to offer customers new and improved electronic trading tools.
Floor traders, for their part, are now suited up with electronic gear. Nearly everyone on the floor carries cell phones with headsets, beepers, and either handheld iPods, or the larger, rectangular eBroker order management systems. Soon, floor brokers will be able to put quotes into their handhelds and route orders to Direct+ and DOT.
Will NYSE’s metamorphosis be enough?
Linda Jay, a specialist with LaBranche & Co., says she’s optimistic. “The hybrid model will work out,” she says. “We must change with the times.”
And change seems to be coming to many who work on the floor. For example, on June 30, as he does every trading day, Rode raced from specialist post to specialist post, working orders, keeping track of other brokers in the crowd, getting a look at the market, and providing color to his clerk. Periodically, he scrambled to the CAPIS booth on the outskirts of the Extended Blue Room.
Meanwhile, his clerk in the booth communicated to buyside traders on the phone and through Instant Messages. The laptop of every clerk in the CAPIS booth had about six IM screens open. This continued for several hours, until the market slowed down ahead of the Federal Open Markets Committee announcement that it would raise the overnight Fed Funds rate 25 basis points to 1.25 percent. This had been expected for months and the markets hardly noticed.
Volpe, the Van der Moolen specialist, described his market making responsibilities. But how does a specialist determine how much capital to commit? “It’s based on a sixth sense and on trends and price points I’ve researched and think are good levels at which to buy or sell the stock,” Volpe says.
Difficult though it may be to comprehend a specialist’s ability to make quick judgments, there is technology to assist his processes. This enables the specialist to blend order flow from his electronic book with the crowd’s institutional interest.
But, say NYSE pros, whatever the technical and regulatory complexity, nothing can replace professionals of good character.
“There are no walls, no shields, no cubicles down here,” Rode says. “If you conduct yourself on the floor like a weasel, everybody knows that you are a weasel.” At a specialist post a bit later, as he executed a 15,000-share order, he said to the specialist, “I work larger.”
“It’s not my intent to mislead the specialist,” Rode explains. “He’s trying to facilitate my stock. I’m exploring the possibility of getting an institution-sized bid for my client since I’ve got another 50 thousand to sell.”
Under the Gun
With specialists under the gun in some quarters, Rode is aware of the multiple and difficult roles they perform.
“There’s a risk/reward ratio that can’t be ignored,” he says. “To expect market making to be a public service is not the real world.” He added that pennies forced the issue because this required specialists to tie up the same amount of capital while earning much less on the spread.
On the floor, the biggest change in trading over the past two decades is indeed the shift in early 2001 to penny trading. Consequently, there now are – ironically – fewer natural pools of liquidity.
Decimalization spread the liquidity out into tinier pools, making it more difficult to put on trades in size. “It can be much harder to know where to go to get a trade done,” says Rode, referring to price points. He added that the reduction in trade size over the last three years has also affected how quickly a trader can execute an order.
Jay, the LaBranche specialist, highlighted another frustration. Traders continue to think in terms of ticks, she says. As a result, they sometimes judge trades by the number of ticks they pay up to buy a chunk of stock, rather than the price they pay.
Greg Winski, one of the floor brokers who works with Rode, agreed. “When we were in teenies [sixteenths], people were happy as a daisy to buy 10,000 shares and pay up a teenie,” he says. Now, value has been “somewhat clouded as to what a trader gets a nickel up from a specialist.”
The reason is that traders are “focused on increments, even though a nickel is less than six and a quarter cents,” Winski says.
Penny increments have been an “unmitigated disaster,” grouses James J. McGuire, Sr., a managing director and specialist at LaBranche, as he called out numbers to his clerk. McGuire said his comments did not necessarily reflect the opinions of LaBranche.
With many critics of penny trading on the buyside, sellside, and the floor, some still cling to the hope the SEC will have a change of heart. McGuire believes the SEC should run a two-month pilot program across all markets. He advocates a test in which a cross-section of 200 listed stocks trade in nickel increments. “If you’re running a hat shop and everyone’s head is itching, you’d want to try asking some questions,” he says.
On the other hand, McGuire dismisses the notion that a wider spread would put more money in the pockets of specialists. “It has nothing to do with the professionals’ advantage,” he says. “It has to do with the quality of the market we produce for the investing public. If we don’t serve the investing public, we might as well close our doors.”
If a pilot program showed that nickel increments increased market depth and visibility, and reduced trading costs for institutions, the market could benefit. “An additional advantage would be that it would render the trade-through opt-out discussion moot,” says McGuire.
Decimalization has also changed NYSE floor executions in another way. Penny increments led to algorithmic trading and new trading strategies. That’s while it became easier for both floor brokers and fast-money traders to step ahead of an order. Along with the growing use of transaction cost analysis systems, penny trading has caused many on the buyside to trade more defensively.
“People don’t want to look bad,” Winski says. “Often buyside customers enter orders with instructions to protect themselves rather than because it’s the best strategy. Sometimes they should put more trust in a broker who thinks on his feet.”
The strategy that most frustrates him is based on VWAP, or volume-weighted average price. In his view, trades benchmarked to VWAP over the course of a day, or over part of a day, frequently defy best execution.
“Participate’ is the worst order,” Winski says. “It puts handcuffs on me.” Yet one of the most prevalent order types sent to the floor is a percentage-of-volume order. On the days Traders Magazine was at the NYSE, many agency orders being worked by floor brokers appeared to fall into this category.
With VWAP-benchmarked trades, the goal is to go along with the trading volume as the stock price rises and falls. This ensures that the customer doesn’t get caught by an adverse move in the stock price. However, let’s say a stock gaps up or down because of a large buyer or seller and the price can be expected to revert. The broker cannot take advantage of his knowledge of a stock’s trading pattern to benefit the customer and his ultimate investors. Doing so would fly in the face of the VWAP parameters.
In that case, the customer is “not making a decision based on what the market is doing,” says Winski. “It’s based on what might happen later in the day.” Rode adds that trading should focus on what’s happening right at the point-of-sale.
In effect, Winski and Rode suggest, VWAP is a mixed blessing. Sure, it provides some of the benchmarks favored by the buyside. And it gives traders the criteria to reach their goals. But sometimes traders also get unintended execution results. Traders may be judged to be trading well – at least by predetermined best-execution parameters – but they nonetheless may be leaving money on the table. They may be doing so by turning their back on a better execution.
The debate about best execution won’t end overnight. In the meantime, traders on the floor are waiting for bigger volume to return to the market. On one of the days Traders Magazine was on the floor, around 1.1 billion shares traded. That was substantially below the average daily volume for the year.
“It was almost more quiet than a regular slow day,” Winski said after the market closed. “A no-nothing, unexciting day,” added Rich Brophy, one of the clerks in the CAPIS booth. “No news, narrow range.”
The battle for the Big Board’s future – what it will look like and how it will be configured within a new market structure – has just begun.