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A New NYSE: The Winners and Losers

Market structure change is taking center stage, and the national market system debate occurring now in Washington will have profound impact on our business for years to come.

Labor Day is over, the convention is gone, kids are back to school, and the New York commute is back to the traditional grind. While our summer vacation fades into memory, this is a good time to take stock as we approach the backstretch of 2004 and head into 2005.

As I look at the industry, I continue to see market structure change taking center stage. I believe that the national market system debate occurring now in Washington will have profound impact on our business for years to come. The impact of these changes will be greater than the regulatory challenges we had last year and the market downsizing we experienced three years ago, and it may have even more impact than decimalization. It will affect how we how we trade, process and price, and even how we organize.

For those not following the debate, the SEC and Congress have invited discussion on the merits of how the markets should work. These hearings have focused on the elimination of the trade-through rule, the automation of the NYSE, and the general structure of the U.S. financial markets.

From an outsider's perspective, as the discussions started, it seemed almost a certainty that both the trade-through and the NYSE were in trouble. Much of the early discussion focused on the NYSE's anti-competitive bias. Debate centered on how the trade-through and the NYSE stood in the way of a more equitable and open marketplace.

Over the summer, however, the discussion in Washington changed tack. The trade-through/NYSE tide turned as the SEC and Congress had, it seemed, become more comfortable with new management and more frightened of the consequences of radical NYSE change.

In late July and early August, the NYSE came out with its long-awaited proposals around a hybrid market structure and the improvements to Direct Plus. These modifications proposed to eliminate size and timeliness restrictions, enable immediate or cancel, sweep, and marketable limit orders, as well as implement "liquidity refreshment breaks," which will turn off automatic execution if nickel plus tolerance bands are broken.

The NYSE proposal has appeared to quell regulators and legislators, and it has taken the ire off the buy-side firms looking for radical change. It also, from my perspective, appears to be a good compromise. The changes will provide traders faster access to liquidity and reduce the specialists' influence over the order book, two major buy-side complaints. These features will operate until the market becomes unbalanced, at which time Direct Plus will be halted while the specialist, floor or other order flow arrives to add liquidity. While there are reservations on this specific point, the industry seems to generally embrace the overall theme.

While the NYSE as an organization seems to have come out a survivor, not all at NYSE comes out unscathed. As Direct Plus restrictions are eliminated, and as more order flow is electronically matched, there will certainly be less work for specialists and floor traders. Both of these constituents may need to redefine their value.

ECNs and the more traditional non-electronic regional exchanges will also be disenfranchised by this new market structure. A steadfast trade-through rule hurts ECNs' entry into the listed market as the promise of faster executions may not be enough incentive to pull liquidity away from a more hands-off NYSE. While the ECNs will continue to dominate execution in the over-the-counter business, their penetration into the listed business may be stunted.

Traditional regional exchanges (such as Boston and Chicago) will also be hurt. While not specifically from the new NYSE market structure, regionals will continue to lose liquidity. Faster executions and commission compression will reduce the value of preferencing and will draw firms toward the primary market and to faster venues. Even the more advanced regional exchanges may be challenged as the NSX is so heavily dominated by INET (Instinet/Island) that any liquidity shift could put the Cincinnati-based exchange in jeopardy.

While the matching venues will be challenged, there will also be beneficiaries to this new market structure. The most obvious winners are institutional firms wanting more certain and quicker listed executions. Firms looking to electronically trade over the NYSE infrastructure will also benefit. These are buy- and sell-side firms that have integrated model-based trading algorithms into their execution strategies. Black box modelers who parse market data looking to take advantage of pricing abnormalities will also be able to better leverage the new NYSE infrastructure. Groups that take greater execution control will also benefit by paying significantly lower commission rates.

Another casualty of this structure will be trade size. As of July, the average U.S. Equity trade size is only 401 shares, down from 500 in January and down from 1,500 shares per trade in 1997. A more electronic and faster NYSE will only apply downward pressure on trade size as more algorithms and electronic arbitrage continue to push this number lower.

This increase in market velocity and reduction in trade size will make it more difficult for firms to find large liquidity blocks. This brings us to another market structure winner: crossing networks. Crossing networks match buyers and sellers based upon liquidity, not via the traditional price/time priority. Crossing networks such as Liquidnet, Posit and HarborSidePlus match large buyers and sellers together anonymously and average significantly larger executions. Liquidnet executions average greater than 40,000 shares while HarborSidePlus promotes a 70,000 share average.

As liquidity becomes more fragmented and scarce, buy-side firms will turn to crossing networks to execute their larger and more difficult trades. While not all trades can be matched over a crossing network, many times it pays to check.

The last of my winners and losers are the technology vendors and service providers. These are the firms that provide market data, execution technology, storage and processing capabilities to both buy- and sell-side firms. This will be a mixed bag of both success stories and flaming burnouts. Differentiating the winners from the losers in this space is difficult. Change challenges firms. The ones that can capitalize on change and reposition themselves will win, the others will not be so lucky.

Market data is one industry impacted directly by market structure change. The data business is radically morphing from a screen-based method to spot opportunity and becoming an automated way to parse voluminous data for arcane relationships and opportunities that can be captured in the blink of an eye. While the historic screen-based data paradigms will change, that is not to say that the powerhouses in this space will crash and burn. The challenge for industry vendors will be to understand these trends, change their offerings and adjust their value propositions before they are overtaken by new or more flexible providers.

This radical industry change will leave virtually no one unscathed. Not only will market structure change but virtually everything surrounding it will as well. Like a stone thrown into a pond, the ripples will flow in concentric circles, affecting all. If not directly, change will be felt through pricing, volumes or new features and functions that are needed to leverage this new marketplace.

Anyway you look at it, change is coming, and as it is time for our children go back to school, it is also time for us to learn how these new market structure changes will impact us, our firms and our clients as well. As our children learn to adapt to a new grade, a new teacher or a new school, so must we learn to adapt to a new NYSE, a new market structure, and a new trading environment that will absolutely impact us for many years to come. Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio

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