Back in 1999 the world was scrambling to prepare for computer chaos and the Y2K bug, reformatting software and reentering data. The over-the-counter market too was in the midst of radical changes through both technological advances and regulatory reform. Senior Editors Hal Lux and Jack Willoughby explored these changes in Institutional Investor's February cover story, "May Day II." Enjoy the full feature below.
May Day II
By Hal Lux and Jack Willoughby
THE OFFICES ARE DARK, CLUTTERED, DIRTY. HUNDREDS OF of twisted cables dangle from punched-out ceiling panels in a backup communications room. In the main conference area, a little-used vacuum cleaner stands beside stacked cartons of plastic soup spoons.
These are the premises of a private computerized trading outfit that matches up customers looking to buy and sell Nasdaq-listed stocks. It doesn't guarantee instantaneous execution, though that's what it often provides. Its clients pay no more than one quarter of a cent per share, a fraction of what they would pay to trade through a brokerage firm.
The company is called Island ECN; it has 19 employees--average age, 25 - none of whom trade. And each day it claims to turn over some 95 million shares, or 10 percent of the daily volume in Nasdaq stocks.
Welcome to the future of trading.
These are extraordinary times in the over-the-counter stock markets. Newspaper headlines trumpet the exploits of madcap day traders; market indexes swing on the manic volatility of hot Internet issues; trading glitches prompt near-daily cautions from regulators. Just last month 28 of the biggest OTC market makers signed off on an agreement with the Securities and Exchange Commission to pay $26 million in fines on top of the $910 million they had previously paid out to settle private class-action lawsuits, based on charges that they had essentially fixed prices for years.
But these are just the most visible signs of what may prove to be the most sweeping transformation of Wall Street's trading business since the first shares changed hands. Dealer resistance and regulatory inattention held back the forces of change for years; now SEC-mandated reforms have unleashed the power of technology to dramatically alter the dynamics of the business, seemingly overnight. Island, whose electronic communications network, or ECN, functions as quasiexchange-quasibroker, did not exist until three years ago, when it was spun off by on-line brokerage Datek Online Holdings. Knight/Trimark Group, a technology-intensive cooperative of dealers formed just four years ago, today commands 11 percent of the OTC market--posting orders for more block-size trades on a given day than Merrill Lynch & Co. and Salomon Smith Barney combined.
The hype of Internet stocks will fade, and today's enormous trading volumes may wither--perhaps taking upstarts like Island with them - but Wall Street will continue to confront these changes. Trading is all about information and communication. No technology is proving more powerful than the Internet, and no business is more ripe for transformation than Wall Street's trading and execution function: not book selling, not airline ticketing, not even the auctioning of collectibles. It's no surprise that Instinet Corp., the precursor to today's ECNs (see box, page 50), is owned by Reuters Holdings; or that Bloomberg launched Tradebook, another ECN; or that Dow Jones & Co. has invested in an alternative trading system called OptiMark Technologies.
"The impact on our lives of the changes going on in technology and communications will be as significant as the industrial revolution," says Arthur Pacheco, onetime co-head of Nasdaq trading at Bear, Stearns & Co. and now chief executive of Strike Technologies, a newly formed rival to Island, owned by 18 brokerage firms and Sun Microsystems. "Why wouldn't those changes affect the trading business, which is so much about technology and communications?"
Call what's going on May Day II. The first May Day for Wall Street came on May 1, 1975, when the practice of fixed commissions on listed stock trades was ended. The clubby world of the New York Stock Exchange was shattered, and a new era was born. Institutional investors rose to power; newborn discounters, such as Charles Schwab & Co., seized retail market share; lower margins forced a wave of consolidation among old-line, mainstream firms.
Just as it was then, today's balance of power is in flux, new players are emerging and the economics of the business have radically deteriorated. Spreads have shrunk, and execution costs have dropped to almost nothing. "When spreads were one eighth, you used to trade flat 40 percent of the time, lose money 10 percent of the time, and make money 50 percent of the time," says Fredric Rittereiser, former head of Nasdaq market maker Sherwood Securities Corp. "It's no longer possible, in a world of sixteenths, for a trader to make money."
For now, record volumes are keeping most trading desks happy and profitable, but fierce competition has led such oncedominant OTC dealers as Merrill and PaineWebber to slash their marketmaking activities and cut the number of OTC stocks they trade by nearly half. When volumes drop, the advantage will swing even further toward the low-cost executors. That's one reason so many cheap electronic systems have been created in the past two years; nine ECNs (including Instinet) now compete for orders.
"For the dealer community what has been going on in the last 24 months is a bigger deal than May Day," says William Lupien, formerly head of Instinet and now chairman of OptiMark, which late last month launched the newest electronic trading system for institutions to trade blocks of OTC and NYSE-listed shares. "I haven't seen anything that comes close to this for dealers."
Change is messy - and the fast-evolving market reflects that. One thing appears certain: The trading world won't look anything like it did yesterday- or today. "You will not recognize these markets in five years," promises Frank Zarb, chairman of the National Association of Securities Dealers.
Five years? Try five months. Consider
Sometime this summer the NASD will have decided whether to propose a plan to convert Nasdaq into a forprofit system that might include spinning it off as a public company (see story, page 67).
Island is applying to become a fullfledged exchange to rival Nasdaq, a move that will allow it to pursue institutional investors and trade NYSE-listed stocks.
Scrambling to profit--somehow! - from the radical restructuring of their business, Wall Street's leading firms are lining up to back rival electronic start-ups, in some cases placing bets on more than one system. One example: Goldman, Sachs & Co., a backer of OptiMark, joined with on-line broker E*Trade Group early last month to each invest $25 million in a fledgling ECN called Archipelago. Goldman already had a stake in another ECN called Brut.
The changes that first swept through the Nasdaq retail market are just about to break out into the institutional and NYSElisted business. But they may yet extend much further, for Wall Street is, after all, a bundled business where research, trading and banking often are sold together.
"I'm not arrogant enough to say that what we are doing is necessarily the endgame," says Matthew Andresen, the 28-yearold president of Island. Well, maybe a tiny bit arrogant. Each day, he walks past the floor traders huddled outside the New York Stock Exchange swapping stories and smoking cigarettes. He says, "I always think, `If they only knew what was going on a couple of doors away.' "
THE MARKETPLACE FOR THE NEXT 100 years, as Nasdaq used to call itself, was, not long ago, yesterday's news. Until Nasdaq was created in 1971, the over-thecounter market was merely the place where Wall Street dealers traded shares too small to be listed on the NYSE or other stock exchanges. As recently as the 1960s, one of the few sources of centralized price information was a list that the NASD, the dealers' self-regulatory organization, arranged to distributeon paper, each morning. The list included only the 3,000 most active companies among some 8,000 OTC stocks being traded.
A closed, private world, the OTC market minted money for dealers. Bid-offer spreads remained wide thanks to informal collusion. Even on the most actively traded stocks spreads almost never narrowed between "even eighth" increments- in other words, 2/8 to 4is to 4/8 to 6/8 - which works out to a dealer's take of 25 cents per share per trade. Investors complained bitterly about OTC trading costs, but regulators looked the other way, devoting their attention to the NYSE, where by far the greatest dollar volume of shares traded hands.
The disjointed over-the-counter market was ripe for technology's efficiencies, particularly given the near-fatal paper crunch on Wall Street in the late 1960s. But major dealers resisted change. In 1969 two entrepreneurs, Jerome Pustilnik and Herbert Behrens, introduced a system called Institutional Networks Corp., later renamed Instinet, which allowed the burgeoning class of institutional investors to trade over-the-counter stocks among themselves, without a middleman. But unable to generate initial liquidity, the system floundered.
Nonetheless, regulators did help push technology into the OTC market. In 1971, under pressure from the SEC, the NASD signed up Trumbull, Connecticut-based Bunker Ramo Corp. to build and run Nasdaq, a telecommunications network running on a Univac 1108 mainframe that displayed quotes in the trading rooms of more than 500 market makers. To execute a trade these dealers still had to call each other by telephone, but Nasdaq began to unify a market fragmented among wholesalers like Herzog, Heine, Geduld, which made markets in thousands of OTC stocks, and the integrated firms or wire houses like Merrill Lynch, which made markets in the larger Nasdaq stocks to accommodate their customers.
Though May Day 1975 rule changes were aimed mostly at the trading of NYSE-listed stocks, they also gave a boost to the Nasdaq market. A national market system took shape in which all trades, whether listed or OTC, began to be reported on a single electronic "tape," adding transparency to the market. Rule 19c-3, which went into effect in 1980, allowed NYSE member firms to trade new listed stocks off the exchange floor- in the so-called third market--prompting greater business for dealer desks. Trading volumes on Nasdaq soared almost fivefold, from 1.4 billion shares in 1975 to 6.7 billion shares in 1980.
Wall Street's OTC business came of age in the 1980s. Volume shot up, but spreads remained wide, because regulators had never specifically addressed them. The equity bull market began to roar, and one hot young technology company after another--Apple Computer, Intel Corp., Microsoft Corp. listed on Nasdaq because they were too small or risky to qualify for the Big Board.
With Nasdaq spreads so wide, some dealers realized they could actually pay any of the hundreds of smaller, often regional, brokerage firms to send them their customers' orders; these wholesalers could execute the orders within the spread and make a killing on the volume. Bernard L. Madoff Investment Securities pioneered this practice, first in the OTC market and later with NYSE-listed stocks in the third market (see box below). Payment for order flow was controversial, because brokerage firms, not the retail customers that placed the orders, received a rebate for sending orders to a particular dealer.
Payment for order flow was only one of the odd business practices that fat spreads and illiquidity allowed. There were other such "preferencing" arrangements that ensured that many Nasdaq stock orders were sent to specific market makers - even if they were not the first trading desk to put up the best quotes. Market makers could attract order flow, for example, by guaranteeing to fill order sizes larger than those promised in their quotes or by promising to improve the prices on orders.
By 1987 Nasdaq was averaging some 150 million shares traded per day, arguably approaching the 189 million on the NYSE. (The data are not strictly comparable, because of the structural differences of the NYSE auction system and Nasdaq's multiple-dealer system.)
Then came Black Monday, when OTC market makers showed how flimsy much of the market structure really was. As stocks plunged, many traders refused to pick up their phones, freezing liquidity and exacerbating the rout in share prices.
The NASD reacted to this unmitigated- and very public -disaster by introducing new electronic trading links designed to ensure orderly trading in falling markets. The systems - like many new technologies- soon proved to have dramatic, unintended consequences.
After the crash the NASD tried to win back skeptical individual investors by forcing dealers to participate in a little-used electronic automated trading system called the Small Order Execution System. Customer orders of fewer than 500 shares sent through SOES were routed to market makers with the best posted quotes and automatically executed. The NASD also expanded an electronic system called SelectNet, which allowed market makers to negotiate and execute trades over their Nasdaq terminals, rather than by telephone, in the largest stocks.
SOES and SelectNet looked like simple fixes. But they weren't. Its automatic execution feature meant that SOES was now the fastest way to trade Nasdaq stocks. As a result, a new group of traders--quickly dubbed SOES bandits by their critics--began using this automated execution feature to earn profits by picking off quotes that dealers had not had time to update in the fast-moving market.
The Nasdaq community boiled over as market makers tried to force SOES bandits out of the marketplace, lobbying for new regulations. They met with some resistance from regulatory officials. "I remember back when we were going down to Washington to complain about the SOES effect," says Peter DaPuzzo, former head of Nasdaq trading for Shearson Lehman Brothers and now head of equities at Cantor Fitzgerald. "There were some at the Securities and Exchange Commission who regarded these SOES fellows as true arbitrageurs and beneficial to the market."
No matter: Pandora's black box was open. Nasdaq's wide spreads, formerly open only to Wall Street's market makers, had attracted a new, technology-savvy crowd determined to find ways to extract profits from it. Many of the creators of the ECNs now springing up first got a taste of the spoils of the OTC market as SOES bandits. Datek's three young founders, Jeffrey Citron, Joshua Levine and Peter Stern, made their first fortune developing software for SOES traders.
As it happened, however, it was not the SOES traders, but a couple of then-obscure finance professors, who sparked the current metamorphosis of Nasdaq. In 1994 Vanderbilt University professor William Christie and Ohio State University professor Paul Schultz published an academic paper in The Journal of Finance noting the unusual absence of odd-eighth quotes in the Nasdaq. They concluded that this was evidence of implicit collusion among Nasdaq market makers to keep spreads artificially high.
Nasdaq would never be the same. The Justice Department launched an antitrust investigation against dealers, and the SEC began a review of the NASD's performance in policing the markets. Class-action lawyers filed dozens of lawsuits against all major Nasdaq market makers. In December 1997 dealers paid $910 million to settle the private lawsuits, and last month they agreed with the SEC to pay back investors an additional $791,000, plus $26 million in fines. The SEC imposed an unprecedented censure on the NASD for failing to fulfill its regulatory responsibilities, setting in motion a thorough revamping of that self-regulatory organization. Most important, the SEC began to impose new rules on Nasdaq that would open the door for competitors.
Christie's Nasdaq paper made him famous, but the Vanderbilt professor insists that market makers brought the changes upon themselves. "There was a festering resentment against Nasdaq market makers because of their spreads," says Christie. "We just stepped into the middle of it."
IF THE CURRENT FERMENT IN THE MARKETS had begun on May 1, 1997, the symmetry with the '70s would have been exquisite. But May Day II dawned on January 20, 1997.
On that day the SEC imposed new order-handling rules on Nasdaq dealers that radically changed the market-making business. First, the SEC required the NASD to allow ECNs access to the Nasdaq trading and quotation systems- including SelectNet. And it also promulgated the Limit Order Display Rule, mandating that customer limit orders of between 100 and 10,000 shares that bettered a dealer's own price quote must be reflected in the dealer's quote or forwarded to an ECN that would display the order. ECNs are trading systems that collect commitments to buy and sell stocks. Subscribers enter anonymous limit orders, hoping to attract a matching price. "What we offer is a facility for working an order," says Island president Andresen. "Island is just a tool. Any time a customer meets a customer, two people have traded without a spread."
Before the rule changes, market makers could sit on customer offers that they found disadvantageous. Within weeks spreads on many Nasdaq stocks were cut by 30 percent.
The SEC had achieved its goal, but these rule changes produced unforeseen consequences. The new order-handling rules opened the door to competition just as Internet technology was exploding on the scene, creating the extraordinary new on-line brokerage businesses. These on-line operations redefined the retail discount market by pushing commissions below the old standard of $10 per trade, bringing an entirely new - and aggressive -class of retail customer into the market. "With the new order-handling rules, the commission effectively nationalized access to liquidity," says Kevin Foley, manager of electronic trading for Tradebook, Bloomberg's ECN. "They said liquidity belongs to the public, and that has lowered the barriers to entry for the new trading systems."
In essence, the on-line firms created a new breed of traders that would roil the market more dramatically than had the SOES bandits: individual investors powered by sophisticated and powerful technology. And this happened, of course, just as the national obsession with stock trading turned into a full-fledged mania, thanks to the exploding number of public Internet companies.
This new source of trading volume created opportunities. Knight/Trimark, a mid-tier market maker partly owned by on-line brokers Ameritrade Holding Corp. and E*Trade, saw an immediate and explosive jump in market share. ECNs sprouted up, and they too began to eat into Wall Street's business, led by Datek's Island ECN. Datek poured its tens of thousands of orders per day into Island, providing the initial liquidity that jump-started the ECN. With that initial liquidity, brokerage firms and even market makers were willing to send in more orders.
Retail customers came pouring into the market just as some market makers began to beat a hasty and anxious retreat. "In September 1997 we announced that we went from making markets in 850 down to 550 stocks as a result of a necessary realignment of our resources, as a result of the changing economics of the business," says Merrill Lynch's Thomas Wright, managing director of Nasdaq sales and trading. Since then the firm has eased back into the market, if not as deeply as before, and it acts as a broker for stocks in which it doesn't make markets. "We feel we are as big a factor to our important client constituents as we have ever been," says Wright.
Most of the firms with big retail operations followed Merrill's lead. Devoting capital to a business that offers diminishing returns makes no sense. Says Richard Sinise, senior portfolio manager for St. Louis-based Kennedy Capital Management, which manages about $2 billion in small-cap stocks and trades roughly 200,000 shares each day, "We've definitely noticed that the traditional broker-dealers have pulled back significantly--mainly because it's getting easier and easier to lose money in these stocks if you don't have someone on them full time."
Now, when a Merrill customer wants a stock in which the firm no longer makes a market, Merrill will outsource the trade to a wholesaler like Knight Securities, the OTC arm of Knight/Trimark. "Five years ago firms used to make $50 gross per ticket; today it's $8.60 gross per ticket," says Walter Raquet, chief operating officer of Knight/Trimark. "For the bulge-bracket firms, it's easier to have someone else do it that has a lower cost of trading."
The on-line trading firms and their legions of day traders have provided a flood of volume that has benefited all dealers. But many veterans worry that today's boomtown environment simply can't last. Kenneth Pasternak, Knight/Trimark's CEO, was shocked recently to meet a dentist who had converted one of his examination rooms into a trading room, so that he could punch in orders between drillings. Says Pasternak: "In the 20 years I've been in the business, I've known at least 20 traders who've tried to make it on their own. I don't know of one who has yet. If the pros have this kind of trouble, what chance do the dentists have?"
And some pros are indeed having trouble. Primary among them are many institutional investors who focus on over-the-counter stocks. To their chagrin, the so-called SOES bandits are still active, pummeling stock prices seemingly at random. "These days you can go to lunch, come back, find your stock SOESed and be losing money," complains Kennedy Capital's Sinise.
"The whole market has turned into a SOES shop," says Harold Bradley, vice president and senior portfolio manager for Kansas City, Missouri-based American Century Investment Management. "There's intense buying pressure placed in almost any situation."
In fact, some institutional traders now worry that retail traders are actually gaining an edge over them in the market. "Individual traders now have a lot of the same tools we institutions do: real-time quotes, push-button execution, the charts," says Peter Jenkins, managing director for global equity trading at mutual fund family Scudder Kemper Investments, which manages some $400 billion in assets. "But they can deal in small amounts. They have an advantage."
The big advantage: The new order-handling rules allow small orders to jump ahead of larger orders, picking off quotes in fast-moving markets and putting the big institutional orders of pension and mutual funds at a disadvantage. "The commission is in danger of putting too much focus on technology alone and not looking beyond the technology to look at what is being done with it," argues Douglas Atkin, 36, chief executive officer of Instinet. "The focus of the new rules has been on the individual investor as retail investor, but the individual is also served by mutual funds and pension managers. When dealing with market structure, we have to make sure the changes don't bring unintended consequences."
To be sure, retail investors, the SEC's prime constituency, have reaped tremendous benefits amid the confusion. The Nasdaq market today is fairer than it's ever been. Some big institutional investors have cut their trading bills dramatically too. Vanguard Group, which manages $125 billion of equity funds in-house, has saved between 10 and 20 basis points- or $100,000 to $200,000 per $100 million of trades as a result of the changes in Nasdaq spreads, estimates George (Gus) Sauter, managing director responsible for Vanguard's internally managed equity funds. Those savings exceed the gains from stock lending, a popular technique used to boost index returns, he adds. Another big investor, American Century's Bradley, who pays $80 million in commissions annually, says he may be doing 50 percent of his business electronically within three years.
While ECNs and market makers compete fiercely for business, the ultimate effect of these new trading systems on the overall market remains unclear. Already overloaded Nasdaq systems are straining to handle the growing volume of orders and electronic messages, and some observers worry that the whole system will just stall one day in a costly "brownout." Cheap execution is great, but the hidden costs to small investors from trading in and out of the market could easily exceed the price they paid for excessive spreads on the old Nasdaq. Nonetheless, academics and regulators who survey the market continue to insist that the benefits of cheaper trading far outweigh any supposed decline in liquidity.
In the meantime, market participants are struggling to find some way to contain- or at least make some sense of-market anomalies. The stakes, and tempers, are high. In recent months about a dozen representatives from a number of different Nasdaq constituencies have gathered four times at the request of Bernie Madoff, head of the Securities Industry Association's trading committee, to hash out ways to reduce the wild volatility in Nasdaq stocks. Among the participants: Jeff Citron, chairman of Datek; Richard Shenkman, vice president of Instinet; Emanuel (Buzzy) Geduld from Herzog Heine; and Tom Wright of Merrill Lynch. The result? Nothing. The ad hoc group broke up after failing to agree on a proposal for trading halts. Reports one attendee: "They were screaming at each other."
The immediate future may be uncertain, but American Century's ever provocative Bradley, speaking for many, certainly feels no nostalgia for the old ways. "The trouble, to my mind, comes because the big wholesalers refuse to change their business model to go with the times," he says. "Instead of blaming day traders, they should look at what they've wrought."
LAST MONTH GOLDMAN SACHS and E*Trade reportedly each invested $25 million to take a combined SO percent stake in a Chicago-based ECN called Archipelago. The move raised eyebrows, not least for the valuation it put on ECNs, given Archipelago's minuscule market share. For an online broker the move was natural, but what's in it for an institutional house like Goldman?
Certainly, there are considerable risks. New NASD rules, especially a proposal that would allow firms to post a separate quote on Nasdaq for customer limit orders, could eliminate some of the market maker orders flowing to ECNs. And ECNs remain young, raw and unproven in brutal conditions, not to mention a bear market. After studying the Asiarelated slide in stock prices in October 1997, the SEC concluded that several of the ECNs proved to be the weak links in the order-processing chain. And in a staff legal bulletin published in September, the commission hinted that it might prosecute firms that fail to build adequate capacity to handle spikes of up to three times average daily volume. "Broker-dealers who are unable to consummate all their securities transactions promptly," reads the policy statement, "increase the likelihood of action taken against them if . . . they advertise, employ additional salesmen, or take any other action designed to expand the volume of their business."
But Goldman isn't simply betting its money on a wild throw of the dice. Owning a stake in an ECN provides some clear-cut benefits. Institutional firms can, for starters, cut their monthly Instinet bill. For market makers looking to farm out customer limit orders, instead of incorporating them into their quotes, an affiliated ECN is a cheap place to send those orders.
The best reason, however, to invest in these systems is a more farsighted one: No one thinks the vast changes under way in the Nasdaq market are going to stop anytime soon, and the transformation of trading seems headed inexorably toward listed markets as well. ECNs may turn out to be a stopgap technology, built on the passing mania of a bull market, but the move to electronic trading is here to stay. "Firms are investing in all these different systems because of the uncertainty," says John Havens, head of global equity sales and trading for Morgan Stanley Dean Witter, which has itself invested in Brut and, through its Discover Brokerage Direct unit, in Knight/Trimark as well. "I think there are going to continue to be a lot of moving deck chairs."
It's not surprising that so many firms are betting on so many different operations. As Wall Street has changed over the past two decades, the major firms have come to have a variety of interests - at times conflicting- in the markets. They have money management arms that demand cheap, quality execution; they act as brokers for rival institutional investors; and they cater to retail clients. Now, too, they have direct pipelines to the on-line world. In 1996 Dean Witter Reynolds bought a tiny Internet brokerage company called Lombard Brokerage for $70 million. Internet brokerage was new, so the acquisition passed virtually unnoticed, but the renamed Discover Brokerage Direct would by current market valuations be worth north of $1 billion as a public company, and, of course, it's part of Morgan Stanley Dean Witter. Donaldson, Lufkin & Jenrette, once the quintessence of an institutional firm, owns DLJ Direct, one of the hottest on-line brokers.
Late last month what may be the boldest electronic trading venture of all went on-line. OptiMark, which was co-founded by former Pacific Stock Exchange specialist and ex-Instinet chief Bill Lupien, has perhaps the most intriguing backing of all. Its powerful partners include Goldman, Merrill and none other than Nasdaq itself- even though OptiMark will inevitably compete with NASD's own members. The new system aims to offer the most sophisticated means yet for trading without middlemen, allowing traders to enter "profiles" that indicate how many shares they would like to trade given different prices. OptiMark's proprietary algorithms will match the profiles to create supposed "optimal" trades. It will target NYSE-listed stocks as well as Nasdaq stocks.
OptiMark, like any new trading system, faces a chicken-oregg dilemma in attracting orders. Investors won't use it unless it offers liquidity, and it won't have liquidity unless lots of investors use it. But the markets have been changing in such a fast and furious manner that Lupien, age 57, now faces a host of new competitors that didn't exist when he started developing the notion in 1995. "This is my last trading system," he says. "I'm getting too old for this."
REVOLUTIONS EAT THEIR YOUNG. FIVE YEARS from now Andresen and his brash colleagues may be gone from the scene. They may or may not have cashed out for tens or even hundreds of millions of dollars. But the market revolution they helped foment will live on. "It's like rolling a snowball down a hill," says Credit Suisse First Boston electronic commerce analyst Bill Burnham. "The first hundred yards you have to push really hard. But eventually it starts crushing everything in its path."