NYSE: Fast Market or No Market?

For a report that my firm, The Tabb Group, is writing on U.S. Equity trading - "Trading the New Market Structure: Buy-Side Takes Charge" - the firm interviewed nearly 60 head traders of buy-side investment managers and hedge funds and was incredibly surprised at the sheer animosity these professionals have toward the New York Stock Exchange. More than 70 percent complain about the NYSE and its specialist-based trading model. In all my years of talking with financial-market professionals, I do not believe that I have ever hit a vein like this. It is truly remarkable - and upsetting.

The traders generally feel that trading on the NYSE is opaque (put politely). Be it good or bad, the traders believe that when they send orders to the floor, especially in highly liquid stocks, they do not get equitable execution. They believe information leakage moves the market away from their bias; they watch as the market ticks up before execution and ticks down afterward. Or, delays in market-data distribution disadvantage them as they attempt to trade on stale prices. While many of the traders believe the specialist-based trading model adds value for low liquidity issues, they feel that an electronic market would benefit the highly liquid, competitively priced issues.

But, will the negative consequences of turning the NYSE into a "fast market" be greater than the problem itself?

Reducing the constraints of Direct +, by doing away with the 1099 shares-per-trade limit and the 30-second delay in routing orders to the NYSE, would speed the market dramatically. The elimination of the 30-second rule would allow greater use of algorithmic trading to electronically work orders. Algorithmic trading models take large trades, carve them into smaller pieces and feed them into the market according to a specific trading strategy. A VWAP (Volume Weighted Average Price) algorithm, for example, would carve an order for 25,000 shares into 100 (give or take) orders, which would be placed over several hours, providing the trader with an average execution price rather than a single snapshot, which can be above or below average.

Currently, these orders are executed by brokers or sent to Direct + on a very limited basis. But once the timeliness restrictions are lifted, these orders will flow much more directly into the market and will increase the number of program trades executed on the NYSE beyond the current 40 percent.

These changes will make it more difficult to run both a floor brokerage as well as a specialist business as privately held order-flow will need to be listed on the exchange to interact with increasing electronic volume. As floor-broker business moves online, there is less of a reason to use a floor broker, forcing the brokers to cover the less liquid and slower-moving issues. But how many floor brokers are needed to cover a stock that only trades 100,000 shares a day? Declining floor brokers will force the floor to consolidate eventually, making the need for a floor questionable.

But what option does the NYSE have? If it fights automation, the SEC will almost certainly eliminate the trade-through rule, accelerating off-floor execution. If the NYSE becomes more electronic, its owners (the specialists and floor brokers) will be disadvantaged, and possibly jobless. It is between the proverbial rock and a hard place.

It looks like John Thain understands this and is ready to embrace the new world of "fast markets." Apparently, Thain has realized that order-flow kept in the Exchange (even if it by-passes specialists and floor brokers) is better than market-share lost to competing exchanges.

Personally, I hope the NYSE survives, but either way, the current animus toward the floor must end soon. We cannot have a market where the bulk of participants hate a trading venue and are only locked in by anti-competitive market structure regulations.

Hopefully, the NYSE can adapt, because if it doesn't, the SEC will surely step in (it looks like it may anyway). Regardless, one thing is certain: There is no lack of competition waiting for the NYSE to falter. While it hasn't stumbled in over 200 years, it will be interesting to see what happens next.

Larry Tabb is founder and CEO of Westborough, Mass.-based The Tabb Group, a financial-markets strategic-advisory firm. [email protected]