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What Paulson hath bought

After a couple of years agitating loudly for dramatic changes at the New York Stock Exchange, Goldman Sachs Group chairman Hank Paulson spent $6.5 billion last month to buy the firm that in many ways epitomizes the Big Board's old-fashioned specialist system: Spear, Leeds&Kellogg.

NYSE traditionalists may be breathing a sigh of relief. But it may not be for long. Says Bob Steel, Goldman's co-head of equities, "We continue to believe in an enlightened NYSE, with an electronic capability to complement the existing marketplace, and we'll do our best to help make that happen."

One thing is certain: Goldman is determined to retain control of trading markets, at whatever cost. In the last few years, new electronic trading systems that process retail orders from online brokerages have come to dominate trade execution in many Nasdaq technology stocks. These so-called electronic communications networks, or ECNs, now handle more than one third of all Nasdaq trading, cutting investment banks off from information flows that are crucial to working block trades, making a secondary market in the stocks of banking clients and pricing IPOs. "This transaction puts us at the center of price discovery, which is very, very important to us," Paulson told analysts during a September 11 conference call.

SLK certainly gives Goldman a unique window on the retail market. The 69-year-old firm acts as the specialist in 411 NYSE stocks - more than any of the 20 other specialist firms on the floor - and makes markets in some 6,400 Nasdaq and over-the-counter securities. In contrast, Goldman's Nasdaq desk handles only 300 stocks. To be sure, Goldman was forced to pay up for SLK, in part because its political campaign to restructure NYSE trading failed. Prompted by the Securities and Exchange Commission in September 1999 to come up with a solution to the fragmentation of stock trading among exchanges, market makers and newfangled ECNs, Goldman, Merrill Lynch and Morgan Stanley Dean Witter officials proposed a consolidated limit order book, or CLOB, that would match virtually all buy and sell orders. Senate hearings were held, speeches were given, and politicians were lobbied, but in the end Congress blocked the big investment banks' initiative (Institutional Investor, April 2000), leaving those firms groping for alternatives.

Even with its stake in a traditional NYSE specialist operation, Goldman may benefit from automating exchange trading and passing on the cost savings to institutional clients. In addition to the SLK specialist business, Goldman has ownership stakes in ECNs Redibook and Archipelago. Goldman officials say they've yet to work out how all these pieces might fit together, but it's not too much of a stretch to imagine Goldman's specialists sending orders in AOL or IBM away from the Big Board floor to be executed at the better prices that might be available on these ECNs. If enough volume in extremely liquid NYSE stocks migrates to electronic platforms, SLK's highly skilled human traders would still add value by acting as intermediaries in more thinly traded issues, which are less appropriate for automated systems, and during times of market stress.

"There's no doubt that market structure will continue to evolve and become more automated, but it's hard to predict exactly the way the world's going to go," says Eric Mindich, head of Goldman's equities arbitrage department, who served as the firm's point man for the SLK negotiations. "We feel that a combination of strong technology and experienced human talent is going to be the winning combination."

The duo's biggest upside, however, may lie overseas. Goldman hopes to expand SLK's market-making prowess into Europe and Asia, where it already has the infrastructure and client base missing at SLK. "They've created a business that generates billions of dollars of revenue in the U.S., and they haven't really scratched the surface abroad," says Goldman's head of equity derivatives and convertibles, Eric Schwartz, who is working on integrating the two businesses. Back on the home front, look for Goldman's political influence at the Big Board to become even greater. SLK has been buying up smaller specialist firms for the past several years, and Paulson hinted to analysts the day the deal was announced that such acquisitions likely will continue. How the SLK deal plays out on the highly politicized floor of the NYSE floor remains to be seen. But like everything else in the insular, secretive world of trading, things are not always what they first seem.