Pension funds and other institutional investors should welcome a transformation of the New York Stock Exchange, but they should be wary of the deal with Archipelago Holdings Inc. because of the apparent conflicts of interest involving Goldman Sachs & Co.
Goldman Sachs was paid for advising both sides of the deal, and it owns 15.5% of Archipelago. NYSE CEO John Thain is a former Goldman Sachs executive, and Goldman owns Spear, Leeds & Kellogg LP, an NYSE specialist firm that owns NYSE seats.
Institutional investors should demand that regulators scrutinize the deal even more closely than usual because of these connections. And they should demand the exchange be open to other potential offers.
The institutions should also be concerned that the deal reduces competition for trades, and may eventually lead to higher prices than would exist if the NYSE developed its own electronic communication network to compete with Archipelago and others, rather than buying one of the biggest and most successful networks.
The NYSE has not always provided institutional investors with efficient, or fair, trading. As a result, for more than a decade institutional investors have been voting with their money, moving to electronic trading systems that offer more efficiency, lower costs and greater confidentiality than the NYSE-type specialist system.
As fiduciaries, pension funds have a huge stake in the success of the NYSE because they own more shares of companies on the exchange than any other investment group. But pension fund executives and money managers, as fiduciaries, are expected to seek the best execution and lowest possible commissions on trades. The existence of electronic exchanges has shown the NYSE frequently does not deliver either best execution or lowest cost.
In addition, because of a scandal involving specialists, there now are questions as to whether investors are treated fairly at the NYSE. Just before the proposed merger with Archipelago Holdings was announced, 15 specialists were indicted on charges they cheated investors.
Last year, the SEC settlements against all seven NYSE specialist firms in connection with unlawful proprietary trading resulted in disgorgement and penalty payments of more than $243 million, which will be distributed to customers.
The failure of the exchange to police the specialists has damaged investor confidence in the exchange, and the credibility and usefulness of the specialist system.
In addition, the failure of the exchange's board to challenge the outrageous pay package of former Chief Executive Officer Richard Grasso damaged trust in the NYSE.
The NYSE was built for a different era, when it virtually monopolized trading in U.S. companies. Though that dominance began to fade slowly after the May Day 1975 elimination of fixed commissions, it continued to dominate trading in the nation's largest companies. Because it had to protect the interests of its member firms and specialists, it resisted the move to electronic trading, even though such trading would have been better for its institutional clients.
Institutional investors must ask the regulators to examine the impact of the proposed NYSE deal on competition for stock trades. If the regulators prohibited the deal, would the NYSE not respond by building up its own electronic trading network, thus increasing competition? Institutional investors must also seek an inquiry into whether the many connections between the NYSE, Archipelago and Goldman Sachs affected the terms of the deal.
Investors want a structure than ensures their trades pass through the most efficient channels, whether a new NYSE or electronic communication networks or crossing systems. If specialists can compete fairly, all the better for them and investors. But if not, then they should be allowed to fade into history, like the ticker tape machine of old.