The idea to build a barnesandnoble.com-like electronic trading unit–which would be separate and distinct from the CBOT’s open outcry trading pits–was sparked by a whirlwind for-profit ownership trend that is sweeping through the world’s futures and stock markets. The CBOT, Chicago Mercantile Exchange (CME) and New York Mercantile Exchange (NYMEX)–the three largest member-owned derivatives exchanges in the U.S.–are all evaluating whether they should convert to for-profit, shareholder-based ownership structures. What’s more, the London International Financial Futures and Options Exchange (Liffe), the CME’s newest strategic partner, has already converted its members’ seats into shares.

These maneuvers, Brennan explains, are mainly being driven by the threats posed by electronic competitors. "The competitive landscape out there is changing quickly and the lines are getting very blurred as far as what business everybody is in," he says.

Indeed. That statement rings especially true in the U.S. stock market. Faced with threats stemming from the burgeoning electronic communications network (ECN) market, the Nasdaq Stock Market and the New York Stock Exchange (NYSE) are, like their futures colleagues, considering conversions to stock-based ownership models.

The question of whether these markets should make such a transition has been fueled not only by the rise of ECNs–which now account for roughly 30% of Nasdaq’s overall volume and 5% of NYSE’s–but also by the fact that the exchanges’ major broker/dealer member firms have taken minority equity stakes in a variety of these electronic competitors.

For example, Fidelity Investments, Charles Schwab Corp. and Donaldson Lufkin and Jenrette (DLJ)–a trio of Nasdaq market makers–recently decided to team up with Spear Leeds and Kellogg to launch an improved version of Spear’s Redibook ECN. DLJ is also a minority investor in Strike Technologies, an ECN that lists Bear Stearns and Salomon Smith Barney among its owners. Goldman Sachs, not to be outdone, has minority stakes in a pair of ECNs: The Brass Utility and Archipelago–a Chicago-based network that is also partially owned by J.P. Morgan.

Moreover, as if the growing volume and ownership composition of ECNs did not pose enough challenges for the big stock markets, Nasdaq and NYSE also have to contend with the fact that at least three of the nine existing ECNs have filed for exchange status with the Securities and Exchange Commission (SEC).

TOP

As mandated by the SEC’s new rules for alternative trading systems, ECNs can now register as exchanges–an option that likely puts more for-profit pressure on the NYSE than Nasdaq.

Buoyed by the SEC’s January 1997 implementation of the order handling rules–which were designed to improve price transparency for retail stock investors–ECNs have been able to build a significant presence in the decentralized, electronically oriented Nasdaq market.

But these networks, traditionally registered as broker/dealers, have not had much success banging heads with the Big Board, an auction-driven market with rules authored, in part, to protect the exchange against electronic rivals. By registering as exchanges, however, ECNs would for the first time have the ability to list companies, enabling them to compete on a more level playing field with the NYSE.

"If the most active stocks on Nasdaq can trade in large liquid volume on ECNs, without the benefit of an intermediary, why couldn’t NYSE listed securities?" Lon Gorman, president of Schwab Capital Markets and Trading, asks rhetorically. "Getting into the listed business is a question of when, not if, for many ECNs."

TOP

Nimble Dreams

However, Richard Rosenblatt, president and chief executive officer of Richard A. Rosenblatt & Co.–an execution-only institutional brokerage member of the NYSE–says that potential encroachment of ECNs is not the driving force behind the Big Board’s for-profit evaluation. Rather, he says NYSE’s ownership structure talks revolve around the exchange’s desire to "streamline" its managerial decision-making process and react more quickly to general changes in the market.

"I don’t think ECNs registering as exchanges will have much of an impact on the NYSE," he says. "Markets have only one function: to discover price... and so far nothing the world has shown itself to be able to discover price for equities nearly as effectively as the NYSE’s auction system."

Under NYSE’s current setup, Rosenblatt notes, member politics sometimes get in the way of smart decisions. Not surprisingly, eliminating member politics and streamlining decision-making is a vision shared by just about all of the exchanges on the for-profit bandwagon.

"You have so many competing vested interests in a mutual structure that it is very difficult to move at a speed which the market is dictating," says Liffe CEO Hugh Freedberg. Liffe’s new stock-based corporate structure–which went into effect on April 12–has allowed the exchange to exercise a more "nimble" and efficient decision-making strategy, Freedberg says.

Similarly, the CME is hoping to unify its different constituencies. Jim Oliff, second vice chairman of the CME’s board of directors, says that the Merc wants to "capture the equity values" of its members. In order to do that, he says, it may be necessary for the CME to demutualize. "There has to be some sort of commercial interest to unite all of the owners on one page," says Oliff, who also serves as chairman of the CME’s strategic planning committee.

Even the all-electronic London Stock Exchange (LSE), which maintains a more dominant position in its home country than either the NYSE or Nasdaq has in the U.S., is pondering demutualization. Tradepoint Financial Networks–a London-based, for-profit equity trading system backed by the likes of J.P. Morgan and Morgan Stanley Dean Witter–has emerged as the only electronic competitor of LSE to date.

TOP

The LSE still executes roughly 97% of all equities traded in the U.K. But despite that impressive figure, the LSE is wary of equity crossing networks and smaller electronic exchanges that are popping up in Europe. "For us, it’s a case of looking ahead. We are the dominant exchange in Europe ... but we’re not just going to remain status quo," says an exchange spokesperson. A for-profit model, the spokesperson adds, may allow the LSE to be "more nimble" in responding to competitors.

Still, despite all the talk about nimble, more streamlined markets, the trend toward demutualization has thus far yielded as many questions as answers. Will demutualization, for example, once and for all bring about the end of open outcry trading at the world’s largest remaining auction markets? What technology systems and/or partnerships will spring to life as a result of the for-profit ownership conversion? And is there any chance that for-profit-driven versions of the CBOT and CME can finally–sans member politics–come to an agreement on common clearing?

CBOT chairman Brennan would only offer a cryptic answer to the latter question. "I think under a for-profit business model things get looked at in a very business-like fashion, with a very business-like approach. And you’re right, the politics would be out of it," he says.

The CBOT and CME have been talking about merging their respective clearing arms for years, and in March 1998 they signed a letter of intent to do just that. Unfortunately, that deal fell apart when the CBOT’s board voted against the planned merger last September. Many insiders cited member politics as the primary reason for the dissolution of that agreement. But only time will tell whether common clearing will fair any differently if the Chicago markets demutualize.

TOP

Adios Open Outcry?

Electronic trading systems, of course, have built their niche by offering cheaper and–in most cases–faster trade executions than their more established exchange brethren. And those nuances have led some market observers to opine that demutualization will result in the death of auction-style trading in Chicago and London–and possibly even New York.

"For-profit, by definition, is anti-open outcry, because the only way you’re going to be able to achieve the profitability is to go to total electronic trading," says Les Rosenthal, a managing partner at the Rosenthal-Collins Group, a clearing member of both the CBOT and CME.

Rosenthal, a former chairman of the CBOT, acknowledges that he was an "early proponent" of the Chicago markets adopting for-profit structures. But he says he changed his mind after witnessing the success of open outcry trading over the last couple of years.

Part of the problem with all of the for-profit speculation, he adds, is that members don’t truly understand the ramifications of a stock-based ownership structure. "If the membership at both the CBOT and CME vote for a for-profit model, that means they’re voting out open outcry," says Rosenthal. "I think once they do understand that, it’s going to be very difficult to get membership approval on a for-profit model."

To ameliorate members’ concerns about the future of open outcry, the exchanges may offer some kind of guarantee that they will keep their pits. Rosenthal says if the CBOT and CME asked its members to cast their ballots on demutualization today, he would vote against it. He would, however, vote for a plan that guarantees open outcry for a set period of time.

CBOT chairman Brennan says that the exchange’s for-profit "task force" has already held preliminary discussions about creating a separate e-company that would be devoted solely to electronic trading. If that plan were put into action, the CBOT would at least for the short term keep its pits. But Brennan says that regardless of what the exchange does, futures market participants will ultimately decide the course of open outcry trading in Chicago.

TOP

"I don’t think it’s a call that anybody can make today. Nobody has that crystal ball," he says. "The marketplace will evolve to whatever is the most-liquid and cost-efficient trading mechanism. That said ... our pits make money for the exchange, so I don’t know that necessarily we would evolve to an all-electronic format."

The CME’s Oliff says the Merc’s board will seriously consider putting some sort of open outcry guarantee language into its for-profit proposal. However, he also thinks the exchange’s customers will have the final say on what trading mechanism works best. "I think, quite frankly, that open outcry is the best form of price discovery. But the marketplace is going to dictate whether or not people are prepared to sacrifice the great efficiencies of open outcry for the economics dictated by an electronic platform," says Oliff.

Besides evaluating its own ownership, the CME also plans to launch a for-profit joint venture with Liffe. The joint venture, which will develop derivatives products and services, is part of the strategic partnership the exchanges agreed to in August.

Liffe, of course, has a jump on the CME in terms of knowing how to run a for-profit business. In addition, the exchange is well on its way to executing its pre-corporate restructuring strategy to convert all of its products to screen-based trading.

This February, Liffe’s members unanimously approved a plan to convert their seats into shares. Combined with the success of the exchange’s Liffe Connect trading platform, the corporate restructuring could expedite the elimination of open outcry trading at Liffe.

To date, Liffe has successfully migrated most of its products–including its equity options, equity index, index futures, and long-term bond contracts–to full-time electronic trading. Surprisingly, says Liffe CEO Freedberg, the exchange is "seeing bigger volumes on screen than we saw in the six months before these products were put on screen."

TOP

However, he cautions that the exchange’s electronic trading platform still has to prove its ability to trade short-term interest rate (STIR) contracts. Liffe plans to list STIRs and financial futures–its last two exclusively open-outcry-traded contracts–intraday on Liffe Connect in the near future.

"All financial derivatives products can pretty easily be listed on an electronic trading system. But STIRs are more complex ... It’s difficult to replicate on a screen the functionality and special magic that goes into trading these products in a pit," says Freedberg.

Liffe expected to begin parallel trading of STIRs in late August, but–despite the confidence the exchange’s shareholders have expressed in electronic trading–Freedberg says this does not necessarily signal the beginning of the end for pit trading in London. "Side-by-side trading is fine if we can make the economics of it work," says Freedberg.

TOP

Hypothetical Hybrid

The NYSE, like Liffe, could some day run a truly hybrid exchange where it trades contracts electronically and auction-style intraday. In order for that to happen, the NYSE may have to partner with or buy an existing ECN–a strategy NYSE chairman Dick Grasso earlier this year said the Big Board was considering.

By striking a deal with an ECN, the exchange–which has had difficulty convincing Nasdaq-listed firms to jump to the Big Board–could create a NYSE-sponsored network for trading Nasdaq stocks. At the same time, the exchange could also conceivably list its own stocks on the network.

Mark Smith, director of strategic relations at NexTrade–a small ECN launched in November 1998–says that if and when NYSE launches its planned after-hours trading sessions, a Big Board-sponsored ECN could be the exchange’s primary trading platform. "I think that ECN would work intraday, in typical market hours. But it would also be the NYSE’s main vehicle for after-hours trading, because you certainly don’t want a specialist sitting at a desk at one in the morning," he says.

NYSE officials declined to comment for this story. But Rosenblatt, a NYSE floor member, does not think an alliance with any existing ECN would benefit the Big Board. Rosenblatt says he can’t understand why a market with "the finest price discovery mechanism in the world" would want to partner with a "less efficient" electronic competitor. An alliance with an ECN, he says, would only help the NYSE if that competitor offered better prices than the exchange.

Moreover, Rosenblatt says as long as the NYSE’s prices have "credibility," the exchange will attract order flow and its pits will continue to thrive. "The NYSE has always had an unbelievably efficient price discovery mechanism–that’s the reason they haven’t tried to automate it," he explains.

That said, Steve Randich, CIO of the Chicago Stock Exchange (CHX), says it would make sense for NYSE to partner with an ECN–if only to "snuff out" its competitors. "I would think they might partner with an ECN... without necessarily cannibalizing its traditional floor business," he says.

The CHX, Randich adds, automatically executes roughly 90% of its orders, and has therefore not been subject to the same pressure ECNs are applying to Nasdaq and the NYSE. The CHX is so comfortable, in fact, that it is leaning towards keeping its member-owned structure intact.

TOP

Gregor Bailar, CIO of Nasdaq-parent the National Association of Securities Dealers, says that Nasdaq welcomes the pressure being applied by competitors. In fact, he says, if it were not for the willingness of Nasdaq to cooperate with ECNs, the number of networks would never have grown from one in January of 1997 to nine today. "There is absolutely no doubt that there is a regulatory environment that is conducive to ECN ... operations in the U.S.," says Bailar. "But there was no capability for ECNs to operate without the liquidity engine of Nasdaq sitting behind every one of those."

Still, despite such confident talk, some industry observers see the for-profit trend as a clear sign that the exchanges are worried. "The crystal ball now says that it’s as easy to trade some securities in Brooklyn or Botswana South Africa as it is on Broad Street or Broadway," says Schwab’s Gorman. "So all of the exchanges are responding to a loss of market share in some way, shape or form–or the threat there of."

TOP

Regulatory Wrangling

By Robert Sales

As the world’s leading stock exchanges pontificate on transitioning to for-profit business models, one significant issue they will have to wrestle with is regulation. Specifically, the exchanges must determine whether they want to make their regulatory units part of the business they put up for sale.

In the case of the National Association of Securities Dealers, the parent company of Nasdaq, a decision has already been made. If and when the NASD’s members vote to demutualize Nasdaq, the NASDR–the regulatory arm of the exchange–will remain a separate, not-for-profit entity. The New York Stock Exchange, on the other hand, is leaning toward including its regulatory function in any for-profit offering.

The Big Board’s view on self-policing has fueled controversy, because some industry observers believe the NYSE could not fairly and objectively regulate its market while operating under a cost-cutting, profit-driven ownership model.

Lon Gorman, president of Schwab Capital Markets and Trading, expects that there will be a "groundswell of demand" for the NYSE to separate its regulatory function if its board approves a for-profit plan.

However, some industry observers believe there is no need for the NYSE to break from its regulatory role. While asserting that the "need for policing" will increase if exchanges demutualize, Chicago Stock Exchange CIO Steve Randich says that as long as the SEC holds its post as the top regulatory cop, it does not matter what the Big Board decides to do. "The market regulation departments inside of traditional exchanges are really policed by the SEC. So I don’t know that making the NYSE’s regulatory department outside and objective is going to make it any better or worse, quite frankly," Randich says.

Similarly, Chicago Board of Trade chairman David Brennan "doesn’t buy" the argument that an exchange’s regulatory function should be separated if the company demutualizes. Brennan says regardless of its future ownership structure, the CBOT–which reports to the Commodity Trading Futures Commission–will try to cost-effectively meet all of the rules and regulations it is subject to. "Today, we still have regulatory standards to meet, and we’re not spending extra money on it just because we’re a membership organization," notes Brennan.

TOP

That said, if the SEC eventually mandates that exchanges cannot include regulatory departments as part of their for-profit offerings, the NYSE would be forced to follow along. However, by doing so, the commission could also run the risk of alienating markets that are on the cusp of demutualizing.

Meyer S. Frucher, chairman and CEO of the Philadelphia Stock Exchange (PHLX), says that an exchange’s status as a self regulatory organization (SRO) is one of the key assets that separate it from electronic communications network (ECN) competitors. Therefore, he says that giving up that designation may be too high a price to pay to become a for-profit entity. "The downside is you may be throwing out the baby with the bath water if in fact you can’t retain your status as an SRO," says Frucher. "If by demutualizing you just become another ECN, then I’m not sure what it’s all about."

But the NASD, for one, is not worried about Nasdaq maintaining its separation from ECNs. A Nasdaq spokesperson says that as part of becoming a stock-based entity, Nasdaq would register as an exchange. After that, he says, the Nasdaq would then have to "turn around and contract" with its not-for-profit regulator–the NASDR. That entity, by distancing itself from Nasdaq, could also "potentially" provide regulatory services for "multiple" stock exchanges worldwide, says NASD CIO Gregor Bailar.

Bailar–who notes that the NASD could use the extra revenues its regulatory unit generates to provide more services and cost savings to its members–says that it is even conceivable that the NASDR could serve as the regulator for the NYSE. "It’s absolutely possible. There’s nothing that restricts that. It’s merely a small matter of politics," Bailar says with a chuckle.