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EXCHANGES - Out in the Cold

American Stock Exchange CEO Neal Wolkoff tries to reverse the steep, steady decline of a once-proud exchange.

Equity markets have come a long way since the American Stock Exchange began on a curbside in lower Manhattan 165 years ago. From utilitylike cooperatives where brokers met to trade face-to-face, exchanges have become big, for-profit companies that execute transactions electronically and crave global dominion. Today seven U.S. exchanges are publicly traded, sporting an average valuation of 39.2 times estimated 2008 earnings. NYSE Group, parent of the New York Stock Exchange, just bought Paris-based rival Euronext for $14 billion.

The Amex, by contrast, has fallen off the curb and is all but lying facedown in the street. Once the nation's second-biggest exchange, executing 30 percent of U.S. trading at its 1968 peak, it now handles just one half of 1 percent. Though scrappy and inventive, it has failed to exploit or hold on to its innovations. From second in the trading of stock options -- a market it helped create in the mid-1970s -- it has plunged to fifth out of six exchanges. It invented exchange-traded funds in 1993 but has lost control of that business to the Nasdaq Stock Market and the NYSE; today it trades just 10 percent of the volume in its own ETFs. The exchange hasn't turned a profit for years. Its 834 seats are worth just $350 million -- a pittance compared with competitors' soaring valuations. The Amex hit rock bottom in 2004, when NASD, which had acquired it six years earlier, gave it back to its members for free -- having failed to find a buyer.

"The only reason the Amex survived is that they were innovative," says William Freund, professor emeritus at Pace University and a former NYSE chief economist. "But in this business, innovation is easy to copy. It's a short-lived advantage."

In April 2005 downtrodden seat owners recruited longtime New York Mercantile Exchange executive Neal Wolkoff as CEO in a desperate effort to find ways to capitalize on the Amex's few remaining assets. These include an exchange license, which permits it to sell its market data and to avoid paying high fees to clear the transactions it executes; its roster of about 1,260 stock, ETF and structured product listings that generate annual fee revenue; and its 250,000-square-foot headquarters on Trinity Place in New York.

Wolkoff, who left the Nymex after he was passed over for CEO, has been hustling at Amex since day one. He has directed his staff to build a new trading platform, develop new products and rethink long-term strategy.

The trading system, dubbed Auction and Electronic Market Integration, was fully rolled out for stock and ETF trading in February. Much like the so-called hybrid market that the NYSE introduced last year, AEMI offers fast, automated execution of most trades, with the traditional floor auction acting as a backstop for more-complex orders or during periods of volatility. About 95 percent of the orders sent to AEMI are executed electronically. Next year the Amex will transfer options trading to the new system. To pay for AEMI,Wolkoff sold the Amex's 33 percent stake in Securities Industry Automation Corp., a developer of trading technology, to the NYSE for $40 million in November.

Wolkoff has also tried to restore the Amex's reputation for innovation. Last year it lost 81 ETFs sponsored by Barclays Global Investors to the NYSE; since then the Amex has introduced nearly 200 new ETFs, bringing its total to 280. The exchange is currently working on the world's first actively managed ETF, in the hopes of creating an entirely new asset class. Wolkoff has filed with regulators to start a microcap stock market, to be called the American Platform, which would list companies with market values of as little as $10 million; he plans to get it under way this year. He says he would like to open a futures exchange next year, but is vague on details.

The CEO has hired a real estate adviser to look at alternatives for the Amex's headquarters; experts estimate the current property could fetch $70 million or more. He acknowledges that the steady march of electronic trading could render trading floors superfluous.

And Wolkoff has started the Amex on the road to demutualizing -- converting member seats to shares and becoming a for-profit enterprise. In late January he hired Morgan Stanley to advise on the process, which could lead to an IPO, a sale or minority investments by outside entities. Partly in anticipation of a public offering, the price of a seat recently hit $420,000, up from the $78,000 low reached in late 2004.

Most of all, the CEO hopes for a big boost from a package of new stock-trading rules that went into effect March 5. Known as Regulation National Market System, the measures mandate that orders to buy or sell stock be executed electronically at the best quoted price nationwide, regardless of exchange. The rules throw trading volume in NYSE and Nasdaq stocks up for grabs among a host of market centers. (Today the NYSE executes about 67 percent of the volume in its listings; Nasdaq's share of trading in its own stocks is roughly 50 percent). The markets with the fastest technology and most customers quoting prices have the best chance of winning business under Reg NMS. Wolkoff sees it as a chance for new life for the Amex.

"Reg NMS changes everything," says the 51-year-old native New Yorker.

The Amex's decline dates to the 1980s, when Nasdaq embraced electronic trading and marketed itself as a destination for growth IPOs. Clinging to its slow floor trading model and bureaucratic ways, the Amex lost listings and volume. A 1998 sale to Nasdaq's then-parent, the National Association of Securities Dealers, only made matters worse. NASD largely failed to make promised investments of $175 million to upgrade the exchange's technology and marketing. The Amex's hemorrhaging spread to options after the all-electronic International Securities Exchange launched in 2000, prompting other options exchanges to improve their trading systems.

"We were sold a bill of goods," says exchange member Peter Doyle, president of brokerage firm Professional Execution Service, of the NASD deal. "It didn't turn out the way it was presented to us."

In December 2004, after unsuccessfully trying to sell the Amex -- a $110 million deal with private equity firm GTCR Golder Rauner fell apart earlier that year amid a federal investigation of Amex floor traders -- NASD simply gave up and handed the exchange back to its members.

Valiant as Wolkoff's efforts may be, some critics think the Amex has fallen too far to come back. In stock trading the exchange is playing catch-up with a host of rivals that began preparing earlier to take advantage of Reg NMS. Beginning in August 2005 regional markets in Boston, Chicago and Philadelphia sold equity stakes to Wall Street firms like Citigroup and Merrill Lynch & Co. to raise funds to build souped-up automated execution systems; the brokerage houses pledged to send orders their way. The Amex lacks any such backing.

Nor are the ranks of Reg NMS­inspired competitors limited to the regionals. Last year the ISE and prominent industry backers set up a stock exchange that is competing for NYSE and Nasdaq flow. The Chicago Board Options Exchange, the leading U.S. options market, started a stock exchange last month. Kansas City, Missouri­based BATS Trading launched a superfast matching engine in January 2006, offered cut-rate fees and had amassed about 10 percent of Nasdaq volume before Reg NMS took effect. As these upstarts target the NYSE and Nasdaq, the Amex isn't even in the game; it currently doesn't trade NYSE and Nasdaq stocks and may not be ready to do so until the second half of this year, when it may be too late.

And the AEMI system doesn't appear to give the Amex much of a competitive advantage. It has reduced the time it takes the exchange to execute a trade from as much as six seconds down to about four milliseconds. But that merely brings the Amex into line with other fast platforms like BATS, Nasdaq's INET and NYSE Arca, which already have significant market share.

Another problem is that the Amex's fee structure remains in the dark ages, with tiered rates based on order size. Wolkoff says he wants to adopt the model other markets have had for years: Users pay to execute market orders, which drain liquidity from the exchange, and get rebates for posting limit orders, which add liquidity. But Amex members, who still own the exchange, worry that the move could hurt their profits.

The first batch of securities that began trading on AEMI, including shares of Westmoreland Coal Co. and Vanguard Group's utilities ETF, have posted volume gains of about 15 percent. That sounds encouraging, except that the Amex needs to double its pre-AEMI volumes just to get to a 1 percent market share in stock trading.

The launch hasn't grabbed much attention on Wall Street. "Usually, there's a buzz around these kinds of things, and there's an absence of buzz around it," says Jamie Selway, head of institutional brokerage White Cap Trading. "Can Amex differentiate itself from that pack? I wouldn't understate that problem."

"Turning on a dime is not the strength of this organization," admits Wolkoff. "The world still needs to discover us to some extent."

But being nimble is exactly what's required in the new exchange world, in which markets are seeking to maximize profits by trading multiple asset classes across geographies -- as evidenced by the NYSE-Euronext deal, which creates the first trans-Atlantic exchange trading stocks, options and futures. The Amex soon will have to deal with another aggressive competitor in options: Nasdaq, which aims to claim a 20 percent market share by 2010. Wolkoff's plan for a microcap market also faces a crowded field: The London Stock Exchange's AIM is now the favored destination for many growth companies; the over-the-counter market Pink Sheets just launched a new quoting and listings system for microcaps; and Nasdaq is planning a similar business, dubbed the Portal Market.

Wolkoff has yet to articulate a plan for futures trading, where he will face even tougher going. Exchanges like the Nymex and the Chicago Mercantile Exchange, which is battling the IntercontinentalExchange, is seeking to acquire the Chicago Board of Trade. All have quasimonopolies over their own products as a result of the laws and regulations governing futures.

The Amex has been caught in a self-destructive rut. It has been far too slow to modernize its technology and business model, in large part because its member-owners fear losing their livelihoods. Thus, it is falling even further behind the competition. Its $200 million to $300 million in annual revenues (as a private company it does not release financial statements) are dwarfed by those of its rivals, and Wolkoff doesn't expect to get the exchange back into the black until 2008. That will only make it harder to do an IPO.

"Their technology is going to have to drive volume improvements before their financial results are worthy of public investment," says Sandler O'Neill & Partners analyst Richard Repetto.

That's not to say that the Amex isn't worth something to someone out there. Most who follow the exchange see it as a takeover target, not a long-term survivor, whether it goes public or not. Its exchange license might be attractive to a foreign rival looking for a cheap entry into the U.S. or to a domestic market like BATS that craves the economic benefits of exchange status. The Securities and Exchange Commission is notoriously deliberate about approving new exchanges -- the ISE in 1999 was the first since the CBOE launched in 1972. An outsider can get into the game more quickly by buying an existing exchange. Archipelago Holdings, now part of the NYSE, did just that two years ago by acquiring the Pacific Exchange. A private equity firm could buy the Amex to slash costs and then reap the steady cash flows generated by listings, market data and trading fees.

Andrew Schwarz, founder of big Amex floor trading firm AGS Specialist Partners, sees the exchange being swallowed up after an IPO. "It's going to be extremely difficult for the American Stock Exchange to remain independent," he says.

Wolkoff doesn't rule out a sale. But, he says, "I dispute the premise that that's the only way the Amex can survive."

However, while Wolkoff continues trying to get the Amex's house in order, regional and upstart markets are positioned to better exploit Reg NMS and gain market share, leaving the old Curb Exchange in the gutter.