Dempsey & Co., shaped by the convulsions in trading over the past five years, is a market making survivor.
From its roots as a tiny Chicago specialist, to its growth into one of the country's largest trading houses, to its acquisition by a national brokerage, Dempsey was whisked along by one of the hottest trends in the industry only to get sideswiped by another. It rode the surge of online orders in the 1990s, but had to run for cover in the face of the growing passion for internalization.
In July 2001, Dempsey capped a tumultuous four-year growth spurt by selling itself to E*Trade Group. The scrappy trading house was faced with a dwindling supply of order flow as major retail brokerages began to buy or build greater market making capacity so as to trade against more of their own orders.
E*Trade itself concerned about the shrinkage in its rebates, was casting around for a market maker so as to wring more profits from its orders. Dempsey could either join forces with the large online broker, or risk losing a large chunk of order flow.
"We recognized that internalization by some of the larger order-sending firms was, for us, a potential threat," said Lou Klobuchar, Dempsey's chief executive.
Internalization, or brokers filling their own orders rather than shipping them out to wholesalers such as Dempsey, is a trend that started in the last few years. The three largest retail brokerages in the country – Merrill Lynch, Salomon Smith Barney and Morgan Stanley – have each either bought or built more trading capacity.
But if internalization spells the death of the independent market maker, for Dempsey, at least, the last four years have been a good ride.
Rapid Growth
Since 1998, Dempsey has ballooned from an eight-trader, 135-stock specialist on the floor of the Chicago Stock Exchange to a 100-trader, 2,500-stock house with a presence in five market centers in the U.S. and abroad.
Its acquisition by E*Trade further pushed the firm into the big leagues as the deal locked in a large source of order flow. E*Trade is the country's third largest discount broker after Charles Schwab and Fidelity. (E*Trade had revenues of $1.2 billion last year). Dempsey's share of E*Trade's flow has jumped from over 20 percent, when E*Trade was its largest customer, to 40 percent today. That number is expected reach 50 percent, according to E*Trade executives.
In the first two months of this year, Dempsey and its GVR unit traded 1.2 billion Nasdaq shares and 375 million listed shares, according to AutEx/BlockData. Those figures give it a ranking of 22nd in the Nasdaq market and 27th in the listed market. That puts it on a par, in both cases, with Thomas Weisel and U.S. Bancorp Piper Jaffray.
Behind Dempsey's hot streak is Klobuchar. The 44-year-old became Dempsey's CEO in late 1997, following a stint as executive vice president at the Chicago Stock Exchange. Klobuchar was brought in by Jack and Jay Dempsey (kin to founder Joe Dempsey, Sr.). They recruited him after observing Klobuchar's success in aligning the CHX with the growing online brokerage industry in the mid-90s.
Klobuchar was instrumental in restructuring the business model of the CHX to accommodate the high-speed, low-cost execution requirements of such online pioneers as E*Trade and Ameritrade. The CHX caught the online boom at just the right moment, becoming the country's second largest stock exchange in the process.
Magic Spell
The Dempseys hoped he would repeat his magic on their small, but respected specialist unit. A Chicago Stock Exchange specialist since 1954, Dempsey & Co.'s history as a brokerage began in the 1930s.
"Early on, we recognized that no matter how slowly the specialist business had evolved over the past 40 years," Klobuchar recently recounted, "the change during the next few would be revolutionary."
At the time, volume in the market was spiking hard. Orders from online brokers were pouring into market centers. Many desks were overwhelmed. Dempsey concluded that to succeed it needed to get bigger. Economies of scale and strong relationships would win the day, Klobuchar believed.
In 1998, Dempsey embarked on an acquisition binge. With funding from Chicago's William Blair, it roped in 14 specialists and market makers over the next three years. Now it is the largest specialist on the CHX, boasting 130 brokerage customers and annual revenues of about $100 million.
Total staff is some 150 people. Rounding out the top management team is chief financial officer Dave Grove, a former accountant to many CHX specialists, and chief operating officer Tony Kemper, a well-known industry figure formerly with Prudential.
Unlike specialists at the New York Stock Exchange that leave the marketing up to the exchange itself, specialists at the CHX are individually responsible for relations with order-senders. In that way, they have more in common with Nasdaq wholesalers.
The CHX does some marketing, but its chief role is to provide a technology platform and a physical space. The parameters of execution quality, for example, are left to the individual specialist. That is why, Klobuchar says, some specialists at the CHX get by with a one percent market share while others thrive with an eight percent share in the stocks they trade. CHX specialists compete individually against other regional specialists and Nasdaq market makers.
NASD Membership
Most of Dempsey's new capacity during this period came on the floor of the CHX, but its acquisition of market maker GVR & Co. gave Dempsey membership in the NASD.
That was important because the rules of the CHX permit only one specialist per stock. If Dempsey wanted to broaden its roster of stocks outside its allotment it had to operate from market centers besides Chicago.
GVR is the largest market maker of Bulletin Board stocks and ranks 32nd in Nasdaq trading, according to Nasdaq. Dempsey, through GVR's upstairs operation, trades those Nasdaq stocks it does not handle at the CHX.
To expand its listed roster Dempsey became a member of the Boston Stock Exchange in January. The BSE operates a competing specialist system, allowing Dempsey to trade any stock it chooses. At the Boston, Dempsey will trade those large-cap listed stocks it can't at the Chicago.
Finally, its alliance with E*Trade has taken it to markets overseas. In February, E*Trade snapped up a team of traders from Nomura International in London. The group will form the core of a new U.K. market making operation to be overseen by Dempsey.
All told, Dempsey now trades in five market centers: London, the CHX, the BSE, Nasdaq and the Bulletin Board marketplace. It trades 700 listed stocks at the CHX and the BSE; 150 Nasdaq stocks at the CHX; a comparable amount of Nasdaq stocks at GVR; and about 1,500 bullies at GVR.
Klobuchar is not satisfied though. "We don't intend to stop with just those market centers," he said. "There could be some important opportunities in a few of the others – perhaps other regional exchanges."
Further expansion, however, is no longer predicated on the need to pick up new stocks. What Dempsey wants is flexibility. It wants to be able to trade in the most competitive locale. "Once you reach a certain size it's awfully important not to put all of your eggs in one basket," Klobuchar said. "The capabilities of market centers are an important competitive issue."
Key selling points for Klobuchar are better and more robust trading systems; greater capacity; efficient operations and low transaction costs.
So, is the trading house walking away from the CHX, its home since 1954? "Not at all," Klobuchar said. "We haven't pulled a single stock off the Chicago. We're just growing. Those guys are doing a splendid job."
And despite the trend towards internalization, Dempsey clearly has growth on its mind. The firm's affiliation with E*Trade was not entirely a defensive maneuver. Klobuchar cited three non-traditional order flow possibilities with E*Trade: institutional, international, and options.
Buyside Desks
E*Trade services 650 institutional customers worldwide. That is expected to ease Dempsey's entrance into the block business. Dempsey is traditionally a retail shop, but has started to make its presence felt on buyside desks by advertising on AutEx. The move is not without precedent. Knight Trading Group, for example, has, in recent years, successfully leveraged its role as small-order aggregator to win block trades.
"If we can't be the first," Klobuchar said. "We don't mind being a well-implemented second. And remember, Knight started from scratch whereas E*Trade has hundreds of customers."
E*Trade is keen on offering its buyside customers market making services. "With Dempsey we have this great liquidity pool," said Jarrett Lilien, E*Trade's chief brokerage officer and Klobuchar's boss. "But, to date, all we offer our institutional clients is an agency execution."
E*Trade got into the institutional business in 1999 when it purchased the international agency brokerage TIR Securities. Lilien was CEO of TIR.
But do E*Trade's institutional clients want it to be a market maker? Typically, a buyside shop executes through an agency broker because it will not trade against its orders.
"That's a fair point," Lilien said. "We will let our customers choose between agency brokerage and principal brokerage. They can choose the type of execution they want."
Lilien notes that many of E*Trade's institutional customers only direct their listed business to the broker. They typically execute their Nasdaq orders through a market maker. "We have a lot of great institutional clients who've always said: If you were a market maker we could double your flow.'"
Role in Europe
Lilien also expects Dempsey to play a crucial role in making E*Trade's new European venture a success. In fact, he sees Dempsey as the "glue" that makes all its disparate brokerage activities come together. The e-broker has bought 18 companies in the past four years.
The main reason E*Trade bought Dempsey, however, was to "realize the full value of its order flow," according to Lilien. At its inception in 1996, E*Trade was a member of the Roundtable, a group of online brokers with stakes in Knight Trading Group. It sent the wholesaler a large chunk of its orders and profited from rebates as well its equity stake.
But with spreads declining, Knight and other wholesalers have become less inclined to pay for order flow. In some instances, now, wholesalers even charge brokerages to execute certain orders.
Under such circumstances, Lilien says, it makes more sense to hold onto the order rather than pass it along to a third party. "Going forward, the power of being an order flow originator means to be able to control it from front to back," he said.
(Buying Dempsey meant diverting its order flow away from its other transaction suppliers, of course. Lilien won't say how much less order flow Knight now gets, only that "everybody lost a little.")
Lilien adds the above is true in a strong market as well. Even if rebates aren't declining it makes sense for E*Trade to handle the order itself and make the dealer's turn, rather than just a small piece of it. "Why not own the whole pie and control how it is split up between ourselves and the customer rather than have a third party in there as well?" Lilien asked.
Would E*Trade eliminate commissions altogether and rely completely on trading as does online newcomer Brokerage America? "That's not in the cards right now," Lilien said. "But never say never."
Actually, Brokerage America does not execute 100 percent of its orders. The trend towards internalization has its limits. Klobuchar expects the market to evolve in a somewhat schizoid fashion. Brokers with market making and/or specialist operations will still vie for retail investors. But, for the sake of best execution and profitability, their trading desks will outsource at least some of those executions.
"Firms that compete against one another for order flow on the front-end will still route orders to one another," Klobuchar said.
