On January 31, Gerry Putnam gave his final analyst briefing as chief executive of Archipelago Holdings. On March 7, he became president and co-chief operating officer of the newly formed New York Stock Exchange Group. The questions he fielded at the briefing go right to the heart of the business of running a stock exchange: market share, pricing pressures, new competitors, operational issues, etc. Traders Magazine has excerpted some of the lengthy interview. Due to the raw nature of the transcript, the questions have been streamlined and, in some cases, the answers have been made clearer.
Analyst: Why the decline in Archipelago's Nasdaq market share?
Putnam: The market share decline in Nasdaq securities seems to have stopped in January. We are encouraged [by Nasdaq's move to] rationalize pricing. They decided that being a price leader wasn't a winning strategy. As new rates come into effect in February… Again, we are already seeing a turnaround in the market share decline. So we're encouraged by that.
Analyst: Does competition from the new crop of ECNs concern you?
Putnam: As far as the competition goes… Citicorp seems to have… there is a fair amount of internalizing that's going on in the marketplace anyway. And as Nasdaq becomes an exchange and separates out the print facility volume from its exchange base volume, we'll get a better view of exactly how much of that takes place. But that's kind of where I see the new competition unfolding. I don't imagine that a Citicorp owning an ECN is going to attract a lot of volume from its customers. I just never felt that, just to pick a name, Morgan Stanley, would like to write a big check to CSFB for trading on its [ECN]… in a market center exclusively owned by a competitor. Those of us in the ECN business that were successful took the consortium approach. So I don't think that changes. But there are signs of more internalization, or at least automating the internalization. Collecting some revenues as a result of the new trade-through rule that will apply to Nasdaq securities. So I think that's part of that strategy. I don't think we feel overly threatened any more [than we do by] UBS [directing] more order flow to its system and crossing it internally.
Analyst: The New York Stock Exchange is seeing a decline in its market share. Is that a concern?
Putnam: Overall, NYSE listed volume is up. If you go back a couple of years when we got into the listed business, our initial listed-trading customer was someone with a strategy that just could not trade on the floor of the New York Stock Exchange. So liquidity has built from those players trying to trade baskets of GE and IBM and everything else listed. So, I would suggest there is new volume in the marketplace because of being able to trade in a more seamless way on both the new Nasdaq platform and then on the Arca platform. It dilutes the NYSE's market share. But not much of the market share of what was its customer base is going into Instinet and ArcaEx. So basically, we're making the pie larger, and I think NYSE Group with Arca is positioned to capture from both worlds. If New York can-with the floor… If we can maintain our share with our core customer base and Arca continues to pick up where there is demand for electronic trading and we do a good job of connecting the two systems to one another, we should be well positioned to deal with the evolution of the listed trading market.
Analyst: Do you need to respond to the aggressive pricing by the new BATS ECN?
Putnam: We have seen that before and Bob Greifeld [CEO of Nasdaq] decided to change his pricing because that model wasn't, as he said, a long-term workable strategy. So I don't know why it would work any better for BATS. There's an awful lot of work for them to do. We have always been pro-competition, so we will see another competitor come in. But [because of] the level of service our customers expect from us, we could not deliver at those prices. And I don't think the level of service our customers expect is any different than what they expect from Nasdaq. So there is a problem with scaling the business and delivering the level of service that customers are looking for at those kind of numbers. So I am not feeling overly threatened by that either. There's an awful lot of connectivity work that needs to be completed in order to achieve critical mass. It took us years and years to get to where we got in trading OTC stocks. And I don't expect that it's going to be any easier.
Analyst: Nasdaq's new pricing for trades in NYSE-listed securities pays liquidity providers five mils per share and charges liquidity takers seven mils. Arca does not offer a rebate on listed trades. And it charges 10 mils to take liquidity. Do you see a need to adjust to Nasdaq's pricing?
Putnam: We're always looking at it. We went three years without changing our prices on the Nasdaq side. Of the Nasdaq business, we feel as though our price and service… our service levels are appropriate. Whether we make an adjustment to a liquidity rebate [on the listed side]… that's the kind of thing we always talk about around here. So we're always thinking about it. But it will be well thought out before we make any sort of a move there. So there's nothing to report right now.
Analyst: Is it even necessary for Arca to pay rebates to liquidity suppliers to maintain volume?
Putnam: Any economic incentive back to the liquidity provider will impact volume. If it was solely the trading credits, then you could argue that it was going to have a huge impact, but it's not. The traders aren't just making money on the rebates. And there are not many customers that actually get a check at the end of the month. So the trading profitability is based on the order flow and the characteristics of that order flow. That is why you have a Knight or a UBS internalizing retail order flow and making tighter prices or providing rebates back to those sending that flow. There's certainly profitability available in our marketplace that's at times better than in our competitors. It just has to do with the mix of business.
Analyst: So, then are you unlikely to offer rebates on listed trades?
Putnam: I think… and this is not a statement about where the pricing is going, but as the marketplace gets more electronic, I would start to look at what sort of incentives-taking into account the specialist-what incentives there are for that liquidity provider to do what he does. In hybrid, there are some place and time advantages… the system will allow the specialist to see orders before anyone else does… he can price improve and react. There are rules that go around that process. And again [hybrid] is not approved yet by the SEC. But as the marketplace becomes more electronic-and this is something that we're really working with on the new NYSE/Arca listings [initiative]-what incentives can we put in place? And as you start to tear away at those place and time advantages, the incentives have to be rebates. So, we're definitely looking at financial incentives to compensate someone for standing there and being a liquidity provider of last resort. And I would argue that, if hybrid moves into a more electronic mode, that sort of thing will be applicable to that platform as well.
Analyst: Will you combine Arca's trading platform with the New York's?
Putnam: I'm up to my elbows in that process. I've been learning a lot. Spending a lot of time understanding their systems and how they operate. There is a schedule that New York is working on for [its hybrid platform.] The first phase of this process is to get hybrid to market as soon as possible. And as we said early on, it wasn't possible for us to [combine our system] with their platform and rule set. They were further ahead than any help that we could have given them. But longer term, after hybrid is launched, the next phase is simplifying New York's trading system. That's something that is going to be very, very worthwhile. They've patched onto it over the years. The opportunity to overhaul the architecture of the system is going to present itself. I would expect our investors would expect us to look at that and at the cost of operating that system and the benefit and synergies that come from combining technology platforms. So it is definitely on. We plan to attack that as soon as possible.
Analyst: Could the ArcaEx platform be modified fairly easily to provide all the functionality that hybrid is proposed to?
Putnam: Mike Cormack [Arca's president] will just crunch down on my instep here if I say fairly easily.' It's a fairly complex rule set under which hybrid is going to operate. And we don't even know what it is yet because the SEC hasn't approved a final version or any version of it. My view is that [within a fairly short] time, we're going to see where the value of the floor, the hybrid system and then as it relates to a fully automated system converge. You're going to end up with something that is different than what it looks like now but we're not quite sure what that is.
New York is an enormous market. It is multiples larger than its next biggest competitor. John [Thain] took the right measured approach to changing things there. So we'll get to see the value that is being delivered. And just like we said [when we bought] the Pacific Exchange: if the marketplace is delivering value, then the customers will trade there. And if not, you have to make changes to accommodate what the customers want. At NYSE, we just don't know what that is yet. But I do expect there are things we can contribute.
