Source: Tabb Group
The merger between the New York Stock Exchange and Archipelago is a truly great deal for both markets, bringing together one of the greatest pools of liquidity and one of the most aggressive forces for change in the equity trading business, says Larry Tabb of the Tabb Group.
For the Nyse this deal is extremely important, but not from a traditional point of view. Our thoughts are the Nyse will not leverage ArcaEx to turn off the floor. I side with the Nyse on this. I don’t believe that this merger will hasten, slow, or radically alter the Nyse’s desire to move to a hybrid market structure or force the Nyse to jettison the floor and go fully electronic. Nyse already has a matching engine for electronically matching orders – Direct Plus. Direct Plus currently matches approximately 10% of the Nyse order flow. The reason they don’t move to a more electronic platform is not that they can’t; it’s because they believe it to be in the benefit of the auction model.
Nyse firmly believes, whether correctly or not, that the auction process and the interaction between the floor brokers and the specialists add value for investors. Investors, while complaining bitterly over the specialist system have not overtly challenged this notion as ArcaEX, INet, Bloomberg’s TradeBook and others have tried with little success to make inroads into listed flow, and have not dramatically altered the Nyse market share.
What has taken the Nyse so long to move to an electronic model was not the ability to trade electronically, but politics (namely the SEC NMS debate), governance, and developing new technology to allow floor brokers and specialists to interact with electronic order flow. While NMS is behind us, and governance is addressed by the merger, developing the capability for floor brokers and specialists to interact with electronic flow will take time – time to develop and time to adapt. And while folks may say that the Nyse was under pressure to speed up its transition to a fully electronic market, it is our belief that only a ground shaking event would drastically impact Nyse market share between now and the implementation of the hybrid market - and the INet/Nasdaq merger was not it.
What The Nyse Buys
What the Nyse buys from the Archipelago merger is a new governance model and front-end technology. The merger changes the exchange from a Self Regulatory Organization (SRO) to a 'for profit', publicly traded company (albeit listed on the ArcaEx or the Pacific Exchange – something that I am sure will change). While the 1,366 seat-holder member ownership model has benefited the Nyse over its 200 year history, the structure over the past few decades has become a challenge, as the seat holders have very different and competing interests. Some seats are held by competitors (Brut), some are held by brokers (whose livelihood is not commission-dependent), and many are held by retirees that lease seats to others. This makes it difficult to add new products, and services or to alter market structures that may in the long run benefit investors, brokers, or the markets but disadvantage the seat holders.
The new governance structure will enable the Nyse to be more flexible, more reactive to customers needs, and generally align the interest of the Exchange to its customers and not its members.
The addition of Archipelago provides the Nyse with an expanding product set as it gives entry into the listed options business. This allows some very interesting cross-derivative and cash product capabilities that could draw liquidity from the ISE, BOX, Amex, Philadelphia Exchange, and the CBOE. Derivatives may very well be the next battleground, as a combined cash and derivatives business provides interesting product, arbitrage, and profit possibilities.
The merger also provides the Nyse with very good front-end technology. Archipelago has good aggregation and direct market access technology allowing both buy and sell-side traders to better manage order flow, control new and flexible order types, route orders to multiple trading venues, and take advantage of trading opportunities. The Nyse has typically not had any front-end technology, preferring brokers to connect directly.
While the Nyse has not needed front-end technology, the OTC markets have. These platforms have allowed traders to aggregate a fragmented liquidity and better manage their trading. As the Nyse through Archipelago makes a broader play for OTC flow having a front-end becomes more important, without which the Nyse would be at a disadvantage to front-ends from Instinet and others. Also as order types become more complex and markets speed up, having front-end routing technology becomes more important and is a bigger factor in how and where orders are routed.
Unification of the market is also a benefit to the exchange as the fragmented ECN panorama is effectively gone. From a high-point of nine ECNs in the 2000 timeframe we are now down to one major ECN – TradeBook. This will effectively relieve the markets from the excessive price wars and market centre competition experienced over the past seven years. This I will follow-up on a little later in this commentary.
The advantage to Archipelago in this transaction is survival and shareholder value. The merger of Nasdaq and Instinet (INet) would effectively make Archipelago less relevant. While ArcaEx sill controls approximately 22% of the over the counter market, the acquisition of INet effectively gives Nasdaq a 60% to 65% market share or more. As noted in the old adage 'liquidity begets liquidity', the combination of Nasdaq’s SuperMontage, Brut, and now INet makes the Nasdaq liquidity pool the first destination, boxing out ArcaEx and threatening their market share and their stock price.
Joining forces with Nyse, Archipelago can now leverage Nyse order routing and connectivity to cross OTC flow before hitting Nasdaq, rather than the reverse.
While this merger is absolutely great for both the Nyse and Archipelago it may not be good for investors. With the Archipelago acquisition the market has effectively centralised, inter-market competition is virtually dead, declining execution fee pressure will be relieved and we believe spreads will increase.
The implementation of the SEC’s 1997 Order Handling Rules fragmented the US Equity markets into a series of linked but competing execution venues. This competition while making it a little more challenging to match buyers and sellers, has reduced the cost of execution, reduced spreads, accelerated execution speed, increased clearing and settlement efficiency (STP), and drastically lowered the cost to transact. Was this accomplished by the Nyse and the traditional Nasdaq dealer markets competing against each other? No. It was accomplished by inter-market competition. The smaller ECNs, such as Island, Instinet, Brut, Strike, and TradeBook, pushed the traditional exchanges to cut costs, increase speed and provide more certain execution.
With the consolidation of the US Markets back into effectively two liquidity pools, inter-exchange competition is effectively dead. While market centre competition will still exist between the Nyse and Nasdaq there are effectively no upstarts left to challenge the status quo, knock down barriers, push market centre change, and reduce cost.
As the markets centralise, liquidity will also flow out of the market, spreads will widen and market makers will enjoy a resurgence. Centralised markets will provide less opportunity for investors to statistically arbitrage the different market centres because there will be fewer market centres to arbitrage. While this will remove those pesky folks that pick off the slower movers, it will mean that there will be less stat/arb money in the market. With fewer players in the market, spreads should widen and trading costs will rise, but it will also give market makers the opportunity to re-enter the market.
With the fragmentation battle over, the new war will be multi-fold: listings, market data revenues and the trading cross-listed products – the Nyse trading OTC products and Nasdaq trading listed flow. While I will pass on the discussion over listings and data, the trading battle will morph from a battle between the ECNs over OTC flow to a war between Nyse and Nasdaq over trading each other’s products.
The first shot was announced two weeks ago when Nasdaq announced plans to offer free Nyse order routing. However, as nothing is truly free, these listed orders will be passed by Nasdaq’s electronic order books before landing on the Nyse floor. This is an overt attempt by Nasdaq to grab listed flow. By merging with Archipelago, the Nyse will incorporate a platform to trade OTC equities within the listed infrastructure and possibly offer the reverse – attempting to siphon off OTC flow before it hits Nasdaq.
Equilibrium will be the next question. Where will it balance out? Is there still a need for multiple exchanges, or is one enough? The answer to that question will take time to sort out and will be contingent on front-end technology, the success of the hybrid market, and each exchange’s ability to not only maintain share but grow it. The one thing that is certain is that inter-exchange competition is dead. The big question is who cares?
Larry Tabb is founder and CEO of financial technology advisory firm The Tabb Group