Brokering Deals With Exchanges

Hot cakes, get your hot cakes! CEOs of regional stock exchanges might as well be standing on a street corner hawking Philly cheese steaks or Boston funnel cakes judging from the recent flurry of deals with brokers.

Since June, the Philadelphia Stock Exchange sold equity stakes to six broker-dealers to make markets on its electronic options trading platform. Separately, the Boston Stock Exchange put together a joint venture with four securities dealers to own and manage an electronic stock exchange. And, the Chicago Stock Exchange and the National Stock Exchange are working on similar deals, officials at those exchanges indicate.

But, what is the impetus behind these deals? How did regional exchanges - which many sources say are fighting for their survival - suddenly attract the leading Wall Street players? [Editor's Note: For more on the transformation of the regional exchanges, see AT's cover story, page 38.]

Most people say the brokers view the regional exchanges as a hedge against the pricing power of the New York Stock Exchange/Archipelago and Nasdaq/INET mergers. Though fees charged by exchanges have declined over the past few years, there's a fear that as the NYSE becomes a for-profit entity, dispassionate shareholders - who may want to raise tariffs or other fees to increase revenues - will control it.

"They hope to use this as a stick to brandish before the NYSE - don't go too far. If you cross such and such line, we're going to move the order flow elsewhere," says Benn Steil, Andre Meyer Fellow and director of international economics at the Council on Foreign Relations in New York. "It's a cheap option because Boston and Philly were really in dire shape - they could have gone out of business," Steil adds.

For a mere $7.5 million, Morgan Stanley was able to buy 10 percent of the Philadelphia Stock Exchange, with warrants to increase its stakes. The actual investment "is pocket change" to the brokers, quips Steil. In fact, sources say PHLX practically gave away the warrants for free.

However, the brokers are investing in regional exchanges to allay their concerns about having only two alternative equity trading destinations. "They are desperate for alternatives," says one regional exchange source, who is convinced the brokers want to make sure their customers get the best execution at the cheapest price. "The dollars associated with that far exceed the numbers they're investing in any regional exchange," the exchange source asserts.

While that may be true, the brokers also are investing in regionals to capitalize on the economic incentive of being affiliated with an exchange. Under Reg NMS, the allocation formula for market data revenues is changing. As a result, brokers can earn market data revenues for posting the best prices on these exchanges. In addition, Reg NMS, for the first time, lets exchanges charge access fees and pay for posting liquidity - something that was only available to ECNs. So, rather than pay to trade elsewhere, brokers can post bids and offers on a regional exchange that they own and get paid to do so.

Investing in the Future

Still, brokers also are eyeing the regional exchanges from a pure investment standpoint. With nearly all of the regional exchanges demutualizing, IPOs could be on the horizon. For inspiration, brokers can look to recent examples of for-profit exchanges that went public, including the International Securities Exchange, the Chicago Mercantile Exchange and Archipelago. Their stock prices have soared since their IPOs.

"If you looked at CME and Arca, you have to say that investing in one of these regional exchanges looks pretty attractive," says Larry Leibowitz, managing director and chief operating officer for Americas Equities at UBS, which is an investor in the Philadelphia Stock Exchange deal. "How it all plays out remains to be seen in the long run."

So, while brokers are hedging their bets against the duopoly and seeing which regional can potentially become a third alternative, other deals no doubt are brewing. But no one knows who the next wave of deals could involve. Regionals could partner with hedge funds, retail brokerages or even options exchanges to further reinvent themselves. You can be sure of only one thing - everyone wants a piece of an exchange.

Ivy Schmerken is a 20-year WS&T veteran. As Editor-at-Large, she covers trading for both Wall Street & Technology and Advanced Trading. [email protected]

On The Net

www.nyse.com
www.phlx.com
www.nasdaq.com
www.chx.com
www.bostonstock.com
www.nsx.com
www.ubs.com
www.morganstanley.com