Investors drive Wal-Marting of Wall Street

The NYSE is dead. Long live the NYSE.

The same can be said for the Nasdaq Stock Market, the American Stock Exchange and the Philadelphia Stock Exchange; the derivatives exchanges, such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange; and alternative trading venues such as Liquidnet Holdings Inc. and ITG Inc.

This upheaval in U.S. capital markets, which industry executives agree is just beginning, is directly linked to the influence of money managers — and their pocketbooks.

"In the last five years, there's been a major shift in terms of institutions' ability to execute orders themselves," said Seth Merrin, chief executive officer of New York-based Liquidnet. "In 2000, their only access to liquidity was sell-side (brokers), but now the buy side (money managers) has the same access to liquidity as the sell side.

"There's been a huge shift in value."

The influence of investors has not been lost on securities regulators, who earlier this year approved sweeping market regulations that arguably started the ball rolling.

Facing these new regulations, which made price and speed the top priorities for trading stocks, exchanges and other market players have been scrambling to find ways to remain relevant to money managers. Much of the early activity has involved exchanges becoming for-profit enterprises, acquiring competitors or snagging investments from clients or others. Other players are making investments or making acquisitions.

The biggest splash was the April announcement that the 212-year-old New York Stock Exchange would acquire the all-electronic Archipelago stock exchange in Chicago and transform itself into a publicly traded company. Nasdaq followed quickly with a deal to acquire the INET electronic trading platform of Instinet Group Inc., New York.

More recently, regional stock exchanges have gotten into the act. The Philadelphia Stock Exchange, which made its name in the options business but holds licenses to trade stocks and futures, captured investments from Merrill Lynch & Co Inc., New York; Citadel Investment Group, Chicago; Morgan Stanley, New York; Citigroup Inc., New York; Credit Suisse First Boston, New York; and UBS AG, New York.

That was followed by news that the Boston Stock Exchange, which bills itself as the nation's third-oldest exchange, struck a deal with Boston-based Fidelity Investments, Citigroup, CSFB and Lehman Brothers Holdings Inc., New York, to create the Boston Equities Exchange, an electronic trading venue for stocks that will still offer order handling by specialists if a client wants that service.

Chicago's derivatives exchanges have not been idle, either. The Merc went public in 2002, giving it plenty of currency to make a significant investment or acquisition. Meanwhile, the other Chicago derivatives centers — the Chicago Board of Trade and the CBOE — are considering plans to go public.

"All of us are planning for the future," said Ian Domowitz, a managing director at New York-based ITG, which has acquired order management system vendor Macgregor Group Inc., Boston, and upgraded its Posit electronic order-matching system.

"We're still seeing a continuation of the trend toward the empowerment of the buy-side trading desk with respect to control of their orders," he said, referring to money managers. "The trend is stronger than ever.

"That trend has also been toward more electronic trading and toward the notion of electronic trading across different asset classes — foreign exchange, fixed income, equities and derivatives. All of that is part of the package that's being demanded by the buy side."

Electronic trading is burgeoning in the fixed-income and currency markets and, to a lesser degree, commodities.

Mr. Domowitz stopped short of forecasting a day when money managers trade multiple asset classes in one place, calling that "a little more speculative" because traders at money management firms typically do not have responsibility for more than one asset class.

But others didn't.

"From the institutional manager's perspective, they are going to have one-stop shopping," said Mr. Merrin at Liquidnet. "It will get that way."

It will get that way in four or five years, driven by the world's big, for-profit exchanges seeking revenue opportunities, predicted William F. Cline, a managing partner at Accenture, New York, who heads the management consulting firm's global capital markets group. "In five years, you're only going to see four or five major exchange trading platforms, and those will operate across asset classes. You can very clearly see that trend in progress."

At the Big Board, for example, "instead of being satisfied with the equities market and having a 50% or 60% market share, they need to expand, either overseas or to other asset classes, or vertically into clearing and settlement services or custody or brokerage," added Larry Tabb, CEO of consulting firm Tabb Group, Westborough, Mass.

"I think (expanding into) asset classes is certainly the easiest because there are other electronic markets available for acquisition or takeover," he said.

Howard J. Schwartz, chairman and CEO of Tradeware Systems Corp., New York, a company that provides electronic order management and trading connectivity systems, said he sees the evolution to multiple-asset-class trading driven by firms like his.

"No one's going to accurately predict that, but my gut feeling is it will be three to five years before vendors have established the ability to trade multiple markets, with multiple institutions, in multiple currencies, in a fully transparent, electronically driven fashion," he said.

But for institutional investors, the melding of trading multiple asset classes comes with risks, he added.

"As long as it's not one broker's platform," Mr. Schwartz said. "The last thing an institutional investor would want to do would be to trade multiple asset classes in multiple countries on one broker's proprietary platform."

The risk of such a structure, he explained, is that the broker would have access to too much information from the investor and would be able to profit from it.

Still, money managers are likely to be in the driver's seat for some time and continue to push for more efficient execution models and trading venues.

Mr. Tabb said institutional investors have been increasing their volume of trading, "which gives them a much larger say in how things are done and how things operate."

"Institutional investors already have a tremendous amount of power and they're using it," he said. "That's not going to stop."

Ed Nicoll, CEO of Instinet, said he isn't sure institutional investors would be attracted to a one-stop shopping center, a sort of Wal-Mart for Wall Street, but that cash and derivatives trading on one platform is likely as exchanges seek to keep institutional trading costs down.

"It seems to me we will have some convergence between the cash and derivatives side simply because a central place (to trade them) can have structural advantages in minimizing the friction between the derivative and its underlying cash instrument," he said.

Indeed, part of the NYSE's attraction to Archipelago was its pending ownership of the options-based Pacific Stock Exchange. On Aug. 25, Nasdaq announced plans to offer connections and order routing to the major options exchanges in the first quarter of 2006. Nasdaq officials specifically cited investors' growing interest in seeking low-cost trading venues for multiple assets like stocks and options as a reason for the move.

Convergence of cash and derivatives markets, however, is not likely to take the form of a derivatives exchange acquiring a stock exchange because the growth is in derivatives, not in cash securities.

"There's little doubt you will be able to trade cash and derivatives in the same place in more and more instances," said Accenture's Mr. Cline. "When you're an exchange, you have finite ways to grow, and I think it would be flawed logic to solely depend on volume growth in your core asset class."

The blending of cash and derivative markets will not only keep costs down for money managers, but it also will give them greater flexibility in creating and instituting strategies to improve their returns.

William Brodsky, chairman and CEO of the CBOE, which has had a hybrid trading system running for more than a year, said new products and greater flexibility in trading are key for investors.

"It's constant modification and innovation and really trying to stay ahead of the competition," he said.