Hybrid Market, Myriad Challenges

Chief Technology Officer Roger Burkhardt has the unenviable task of automating the New York Stock Exchange and putting it on a level playing field with electronic competitors by creating a hybrid market. The caveat is that Burkhardt must do it while preserving a key differentiator from electronic exchanges - the NYSE's floor brokers and specialists, who play an important role in stabilizing volatility and order imbalances during tumultuous markets.

NYSE CEO John Thain, who filed his plan to create a blended electronic and floor-based auction market in August, is driving the move. It's Burkhardt's job to build an infrastructure that can handle the unpredictable volume that results and help floor brokers adopt the hand-held technology they'll need to interact with the automated market.

The NYSE's plan calls for the expansion of the NYSE Direct + order system, which was first launched in 2000 after Burkhardt's arrival and accounts for 10 percent of the trades executed on the exchange. The market will also undergo structural changes, such as lifting restrictions on the number of shares that can be entered into Direct + and lifting the 30-second time restriction on consecutive executions for the same order. The proposal creates a new order type, an auction limit order; designates a far-larger share of orders, including marketable limit orders, for automatic execution; and adds a volatility moderator called Liquidity Replenishment Points (LRP).

That function, if triggered, converts the automatic market to an auction market so specialists can work with floor brokers to find liquidity and the right price. Once market conditions settle down, the market will flip back to automatic execution mode. One of the major innovations is a sweep feature that lets a trader sweep the book at a price at which the order can be filled in its entirety, within price limits.

It's all part of what attracted Burkhardt to the New York Stock Exchange in 2000 - "the plan to introduce a lot more electronic choices in the marketplace," he says. "For me, the hybrid market is moving up into top gear, or another level of electronic trading, to bring those new choices into the market."

The challenge of building a hybrid market is to provide the choice of trading automatically or through the auction market without fragmenting the liquidity, says the cello-playing Burkhardt. He says the NYSE is well down the hybrid road. "In terms of defining it from a business perspective, I think we're 90 percent there," he says. "We have already started building many of the components. We're at about first base in terms of delivery."

While the NYSE started down the hybrid road, the journey that remains will surely be the most difficult. It's making the move in large part due to competitive challenges from electronic communications networks and the demands of institutional customers, who want, for example, more automatic executions rather than risk an auction process in which an order might not get filled because it's broken up for a small price improvement. The NYSE is also reacting to Reg NMS - the SEC's far-reaching proposal to modernize the U.S. equity markets - which could allow ECNs to ignore the NYSE's price, even a best price, if the NYSE remains a slow market. ECNs are clamoring for the SEC to scrap the rule to get a piece of the NYSE's 80 percent share of listed stock trading.

Since the NYSE has a hybrid market already, though with significant limits on the size, timing and types of order, the bulk of the IT is in place, including tools such as wireless handhelds that floor traders already use. They'll simply be upgrading those to the latest wireless standards.

But a major challenge, he says, is predicting capacity needs for a hybrid environment. "We invest in a lot of extra capacity to ensure we can deal with anything that happens. But with a market change of this magnitude, you clearly have a discontinuity in capacity requirements," he says. "Every market that I know of that has been through a change like this has seen a very large increase in capacity. One of my challenges is how do I predict this new capacity in this new world and how do I architect my systems so that if I have to dramatically and radically increase capacity I can do it very quickly?" That's a question Burkhardt and his team are still assessing and modeling.

He says from a technology perspective, the biggest obstacle is the scale of the change. "We are providing new tools for all the participants so it's a very large project with a lot of interdependencies," he says. And, as the exchange scales up the availability of automatic execution, the IT group will play a role helping floor brokers and specialists understand how to react electronically. Among the major changes is the ability of brokers to layer the book with limit order interest, which is already in place. Next up is introducing technology that allows them to layer the book with non-disclosed interest.

"We're moving from a situation where most of the time they're reacting with a human judgment call in reaction to an order or event to a situation where they need to pre-position themselves or react electronically," he says.

Burkhardt touts the hybrid market as the "best of both worlds," combining the human judgment of face-to-face negotiating with the speed and efficiency of the electronic world. "It's much harder to do that than one or the other," he says.