Change is at hand for the
New York Stock Exchange
. But retooling the board of directors and ending the Big Board's status as a "self-regulatory organization" will prove merely cosmetic without fundamental change in the way listed stocks are bought and sold.
Electronic trading would arguably be more efficient for big buy-side institutions, perhaps the only constituency with the financial clout to break the specialists' grip on NYSE stocks. So why don't more buy-side firms use electronic alternatives for trading NYSE stocks, something academic studies suggest would be more cost-effective?
As with everything involving the NYSE, that seemingly simple question isn't so simple. The answers range from funds' fear of the unknown, to the entrenched, and some say conflicted, relationships between mutual funds and the broker/dealer industry, to what electronic advocates say are regulatory impediments to competition on the Big Board.
A Herd of Chickens
Because a critical mass of institutions isn't using electronic communications networks, or ECNs, for listed stocks, the liquidity -- or depth of market -- necessary to facilitate larger-sized trades often isn't available. No buy-side firm wants to be first into the electronic pool, fearing it won't be able to find counterparties for large-sized trades. Bigger players then become discouraged from using ECNs.
"Everybody might be better off if they can all trade
electronically. But until enough move, they're better off staying at the NYSE," said Terrence Hendershott, assistant professor at the University of California Berkeley's Haas School of Business. "You want to go where everyone else is, so you're sure to find the person with the best price."
Inertia also inhibits institutions' use of electronic alternatives, according to Ted Oberhaus, director of equity trading at Lord Abbett, which manages nearly $60 billion. "A lot of buy-side traders feel ECNs are labor intensive, and it's easier to give an order
to a broker over the phone and pay 'em 5 cents to mastermind an order," he said. "Desks have to have systems that can interface with ECNs and people aren't willing to take the time
and effort to hook them up."
A crucial reason some firms aren't willing to take the time and effort is the issue of "conflicts of interest on buy-side desks," Oberhaus conceded.
These conflicts include distribution deals between mutual fund firms and broker/dealers with large retail clientele. There's also the more controversial issue of soft-dollar agreements, through which broker/dealers provide a host of services and equipment (and goods unrelated to business, critics contend) to buy-side firms in exchange for their commission business.
"If they're paying for your PCs and research, you give those guys the business," said Scott Curtis, managing director of equity trading at Kinetics. "If you have soft-dollar agreements, you're beholden to give
sell-side firms a certain amount of commission business."
Securities and Exchange Commission
banned fixed commissions in 1975, Section 28(e) of the 1934 Securities Act was enacted to enable the practice of using soft dollars. Commonly, mutual funds receive $1 in soft-dollar services for every $1.70 in commissions they directed to the broker/dealer providing those services. (Full disclosure: Some of
premium services can be obtained via soft-dollar agreements.)
The use of soft dollars is so commonplace that about 80% of all mutual funds accept such agreements, as outlined
here. While legal, some critics say the use of soft dollars encourages mutual funds to "churn" their portfolios and generally create excessive trading costs ultimately paid for by fund shareholders, i.e., the investing public. By cementing relationships between buy- and sell-side firms, soft dollars also may inhibit the use of electronic alternatives.
"We deal in subpennies commission on electronic services," said John Wheeler, equity trading manager at American Century, a Kansas City, Mo.-based firm with about $78 billion under management. "You can't enjoy that competitive advantage if you have to work off a huge soft-dollar chip."
American Century executives, including Chief Investment Officer Harold Bradley, are staunch advocates of electronic trading and are outspoken in their opposition to soft dollars. The firm's "view is we may cost the holding company money in direct expenses in salaries and equipment" by eschewing soft-dollar agreements, Wheeler explained. "But electronic trading is more efficient and, long term, we're saving shareholders money."
American Century estimates it saves about 50 basis points on overall trading costs every six months by using electronic alternatives. But Wheeler acknowledged it's hard to convince most buy-siders that it's cost-effective to assume the upfront costs of hiring a team of professional traders when higher commission expenses can be indirectly passed along to shareholders. He and other sources agreed most mutual funds would have to dramatically improve their trading talent if they were to stop shipping orders by rote to broker/dealers.
"The cost structure of mutual fund holding companies is not such
that there's a big incentive for mutual fund complexes to have large professional trading desks," he said. "If you do business with the Street, commissions you pay are borne by shareholders, not management. It's an inherent part of the process."
Litany of Obstacles
Liquidity concerns and the entrenched relationships between buy- and sell-side entities may explain why about 80% of listed stocks are still traded at the Big Board while the
Nasdaq Stock Market
handles less than 20% of the volume of over-the-counter stocks. Supporters of the status quo cite those figures as de facto proof that the specialist system is the best alternative for listed names.
But Andrew Goldman, executive vice president at
, believes the biggest impediment to electronic trading of NYSE stocks is regulatory.
Specifically, he cited the so-called trade-through rule, which dictates that even if an electronic marketplace gets an order for a Big Board stock, that order must be sent anywhere in the intermarket trading system that has the best price electronically advertised. Critics say the rule is an example of how the NYSE has erected barriers to competition against the entrenched specialist system, whose near monopoly on NYSE-listed stocks created the kind of insular atmosphere that led to Richard Grasso's outlandish compensation. (NYSE executives contend this is a canard, as detailed in an
article by Big Board co-President Robert Britz.)
Beyond simply the best advertised price, Goldman argued "true trading costs" also incorporate speed, anonymity and certainty of execution. Advocates say these are crucial advantages to electronic trading vs. a human-based system. Because the trade-through rule doesn't address such intangibles, the Big Board's institutional customers are being shortchanged, he said, insinuating that specialists might better the ECNs' best-advertised price by a penny in order to capture orders.
"If you have the ability to guarantee the attraction of an order by showing the best advertised price, that gives you an incentive that may not be coincidental with the customer's best interest," Goldman said.
The specialist system runs counter to the buy side's best interest because it often allows Wall Street's proprietary trading desks to "shoot against" their institutional clients, according to Jeffrey Linderman, a lecturer in finance at New York University and
The sharing of information among and between the upstairs block traders, specialists and proprietary trading desks is potentially as scandalous as conflicts of interest between investment banking and research, Linderman suggested.
"It concerns me that implicit in the system is the fact that proprietary desks on Wall Street all shoot against the big institutional orders no matter what kind of 'Chinese wall' is up."
Hard to know if securities industry regulators could handle yet another scandal. Meanwhile, Instinet's Goldman sees hope in the current SEC investigation of specialists. It was only after an investigation of price-fixing by Nasdaq market makers in the mid-1990s that the SEC mandated ECNs get an opportunity to compete in over-the-counter stocks, he recalled. Electronic alternatives could make similar inroads with listed names if institutions were able to choose where to trade regardless of price, Goldman argued. "We're all eagerly awaiting the SEC's next move on how to handle further steps to increase competition in listed trading."
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.