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Trading places

Blue chips now cost more to trade on the Big Board than small caps do--one reason institutional investors are defecting to electronic markets. Knocking down regulatory barriers could turn the battle of the exchanges brutal.

Memo to John Reed: You may have bigger problems than you thought.

Now that Richard Grasso has been ousted as New York Stock Exchange chairman, everyone from his interim successor -- ex-Citibank co-chairman Reed -- to his predecessor, Securities and Exchange Commission chairman William Donaldson, is trying to patch up the exchange's woeful governance apparatus, which blithely allowed Grasso to amass a Powerball-size pay package of nearly $190 million.

But beneath all the uproar about outrageous compensation and director conflicts at the Big Board lies growing unrest among its largest customers. They are assailing the NYSE's very structure: the so-called specialist system in which humans intermediate trades to, in theory, maintain an orderly market. This unprecedented attack could prove far more damaging to the exchange's long-term prospects than any flap over pay.

Institutional investors are increasingly frustrated by undue delays in executing trades and by allegedly blatant self-interested behavior by specialists purporting to serve investors. But another mounting source of exasperation is the curious fact that transaction costs on the Big Board are actually higher for big, actively traded stocks than they are for small, lightly traded shares.

When fixed expenses that are the same for all stocks, such as commissions and fees, are excluded, the cost to trade NYSE stocks with market capitalizations of more than $25 billion is three times as much as that to trade small- and microcap stocks, according to a new study by Elkins/McSherry, the New York­-based subsidiary of State Street Global Advisors. The analysis examines transaction costs globally for 220 big institutions, focusing on that proportion of the overall costs that comes from "market impact" -- the effect that large trades have on stock prices. (It measures these implicit costs by subtracting the volume-weighted average price of a stock from the actual prices at which trades were executed.)

The higher cost of trading blue chips confounds logic as well as annoys institutional investors. These big, popular stocks should be the easiest and cheapest to trade because the market abounds with buyers and sellers, increasing the likelihood of a natural match. Conversely, thinly traded, small-capitalization stocks with fewer buyers and sellers ought to be more expensive to trade. Indeed, on the Nasdaq, giant-cap stocks are actually a bit cheaper to trade than mid- and large caps.

Not surprisingly, institutions are shifting more and more of their trading from the NYSE to other venues, notably electronic exchanges. The Big Board's share of trading volume in its own listed shares fell below 80 percent last November -- the lowest level in more than 15 years. To be sure, that still represents a near-monopoly of the market in NYSE stocks, but it's down from more than 86 percent in 1988 and 84 percent as recently as two years ago, according to figures compiled by Putnam Lovell NBF Securities. Electronic upstarts, such as the Archipelago Exchange and the Nasdaq InterMarket, are siphoning trades away from the 211-year-old NYSE.

As a result, numerous alternative networks are for the first time showing up in the ranks of the cheapest destinations for executing listed orders. In Elkins/McSherry's annual survey of institutional transaction costs for this magazine -- its seventh -- Instinet, Island ECN, Liquidnet and Redibook took four of the top ten positions in the rankings of top NYSE brokerage firms, besting such trading powerhouses as Morgan Stanley and UBS Securities. Last year only Instinet appeared in the ranking for listed trading. Liquidnet, which was launched in April 2001, has never before cracked the top 20 because it did not meet the minimum $500 million in principal traded. (Most alternative systems are registered with the SEC as broker-dealers rather than as exchanges, with the exception of Archipelago; Redibook is part of Archipelago, and Instinet operates an agency brokerage in addition to its electronic trading book and Island, which it bought last year.)

"We're making the most of all the alternatives available to us," says John Wheeler, head of trading at American Century Investments. "The biggest thing the New York Stock Exchange has to do is to eliminate the mechanisms built into the system that allow its members to trade ahead of public orders."

Last month one powerful investor -- Fidelity Investments -- urged the Big Board to do away with specialists altogether. Doing little to ingratiate themselves with investors, five big specialist firms currently face as much as $200 million in combined penalties in connection with an investigation by the NYSE and SEC enforcement officials that revealed what many institutions had long suspected: Specialists routinely have traded for their own accounts rather than allowed buyers and sellers to meet without their intermediation.

Regulatory barriers built into the U.S. equity market may be all that prevent the Big Board's share of trading from declining even further. Consider the so-called trade-through rule, which prohibits brokers from executing transactions away from the NYSE at prices less favorable to either buyers or sellers. Conceived 25 years ago, when prices routinely varied by 25 cents to 50 cents per share, the rule was intended to protect investors from brokers executing trades at subpar prices -- often with affiliated floor-trading firms at regional exchanges -- when better prices were available at the NYSE. But now, with the minimum variation in price only a penny, the rule can stand in the way of investors willing to forgo one or two cents per share on the price of a stock in return for electronic systems' lower commissions, speed and anonymity.

Rival markets allege that NYSE specialists adjust their quotes to trigger the trade-through prohibitions and thereby thwart competition. Big Board competitors are aggressively lobbying federal officials -- who may be more receptive to their entreaties than in the past because of the scandal at the NYSE -- to repeal or modify the rule. Alternative trading systems have captured more than one third of the volume on Nasdaq, which does not have a trade-through rule.

"People on the buy side are getting fed up, and they want to do more business away from the floor," says Richard Repetto, an analyst who tracks trading firms for Putnam Lovell. "But the trade-through rule still puts the NYSE and the specialists in a pretty favorable position. If that goes, you'd see the market share fall through the 80 percent level permanently."

"People attribute the higher costs for the giant-cap stocks to pennying," says Elkins/McSherry chairman Richard McSherry, referring to NYSE specialists' and floor brokers' putative practice of bidding a stock up or down by one cent and trading for their own accounts ahead of investors. This can be the source of easy short-term profits: Large buyers keep increasing their bids until floor traders will no longer step ahead of them; those who engaged in pennying can then sell the small quantities of shares they bought to the institutional buyer at a higher price.

Pennying (also known as penny jumping) is highly controversial but difficult to prove. It is one of the practices being investigated in the NYSE probe. Although specialists are expected to use their own capital to make trades in a stock when there aren't enough buyers or sellers to do so, they're supposed to refrain from trading when buyers and sellers match up and transactions can occur without a specialist's intervention. Still, specialists' sly proprietary trading can be hard to detect in stocks that see millions of shares changing hands daily.

Whatever the cause, the high cost of trading large, liquid stocks on the NYSE has driven institutions to alternative markets. Robert Gasser, CEO of Nyfix Millennium, an alternative execution platform for NYSE stocks, says he's shocked at the amount of large-capitalization trading that occurs in his system. "We very much positioned Millennium as a place to find liquidity in secondary and tertiary stocks, but five of our top ten names this morning were Dow [Jones industrial average] stocks," he told Institutional Investor last month. "I would never have thought that would be the case in a million years. And it's in large part because people sense that they're not getting a fair shake when they send those orders to the floor."

Nyfix Millennium executed an average of 16.5 million shares per day in October, up 14.5 percent from 14.4 million in October 2002. It handles only NYSE- and American Stock Exchange­-listed securities. The Archipelago Exchange, nicknamed ArcaEx, executes approximately 63 million listed shares per day -- more than three times its volume one year ago. Liquidnet, a private electronic network in which institutions trade large blocks of stock directly with each other, currently processes about 15 million shares daily, up from less than 5 million one year ago. More than two thirds of the volume is in NYSE-listed stocks, according to marketing chief Alfred Eskandar. Liquidnet's average execution size -- 46,000 shares -- dwarfs the Big Board's approximately 450 shares. Average daily volume on the NYSE hasn't changed much on a percentage basis over the past year. In September, 1.44 billion shares traded per day, compared with 1.41 billion in September 2002.

Overall, the cost of executing institutional trades around the world declined slightly in 2002. Across the 42 countries in which Elkins/McSherry analyzes its clients' trading data, the average trade cost 54.25 basis points -- a little more than one half of 1 percent of the value of the transaction -- to execute. In practice, this means that an institution seeking to buy 100,000 shares of a $10 stock would pay not only $1 million for the shares themselves but also an average of $5,425 -- .05425 percent of that $1 million -- in transaction costs. Most of these costs, such as per-share brokerage commissions and exchange fees, are explicit. But nearly as large a proportion are implicit, created by the effect that large orders entering the market can have on a stock's price. Elkins/McSherry measures this market impact by comparing a block trade's average execution price with the volume-weighted average price of that stock on the same day.

A number of factors have combined to drive down transaction costs. Perhaps most important, more pension funds and investment managers are measuring transaction costs -- either by using proprietary systems or third party services from Elkins/McSherry and its competitors, such as New York-­based Abel/Noser and Los Angeles-­based Plexus Group. Since the wrenching bear market of 2000­-02, institutions have learned that transaction costs can be a significant drag on performance, and they have begun managing them as intently as they research stocks (Institutional Investor, April 2002). Additionally, a move globally to electronic markets instead of floor-based exchanges, particularly in Frankfurt, London and Paris, has cut costs.

In 1996, the first year that Elkins/McSherry analyzed global trading costs for II, the average trade cost 73.2 basis points. That number has declined in all but two of the six annual surveys since then, for a cumulative reduction of 26 percent.

For all the buy-side rancor, average costs actually declined on the NYSE in 2002, to 29.30 basis points from 32.18 in 2001. Still, that's far higher than the 24.55 basis points the Big Board registered in 1999, when the global average, at 60.84, was higher than it is today. And as of the second quarter, the most recent period for which Elkins/McSherry has figures, the cost of NYSE trading had climbed back up to 30.70 basis points. In other words, although markets as a whole have been getting cheaper for investors, the NYSE has become more expensive.

To be fair, costs have also increased on Nasdaq, from 33.28 basis points in 1999 to 40.36 in 2002 and 43.14 as of the second quarter of 2003. And it remains costlier to trade on Nasdaq than on the Big Board. Yet investors are far more satisfied with trading on Nasdaq than they are with sending their orders to the exchange floor. In a survey of nearly 50 large institutions last year, Liquidnet found that 85 percent preferred doing business on Nasdaq, compared with only 15 percent that favored the NYSE.

Why would traders look more favorably upon a higher-cost market? There are a number of possible explanations. More of Nasdaq's stocks fall into the small- and midcap categories than do the NYSE's, so it is a more volatile market. Rapid price swings, of course, often escalate transaction costs. That makes for difficult comparisons with the NYSE and its larger, more mature companies.

Additionally, the true cost of executing an order to buy or sell a single stock on the Big Board may be obscured in aggregate data by the growing proportion of NYSE volume done via program trading. These computerized trades, which typically group together a basket of stocks for bulk execution at a discounted commission rate, have grown from about 16 percent of the exchange's volume in 1999 to approximately 40 percent today. Once the preserve of indexers and arbitrageurs, program trading -- more often called portfolio trading today -- is increasingly being used by active managers to minimize transaction costs.

The practice is much more prevalent on the NYSE than on Nasdaq. The lower explicit and implicit costs of these trades may be masking what many traders suspect are higher transaction costs for single-stock trades on the NYSE. "I don't know how you can prove that, but it could be a plausible explanation for why the costs look so low on the New York," says Putnam Lovell's Repetto. Adds Paul Bennett, senior vice president and chief economist at the NYSE, "This is one of the reasons why our numbers really look very good."

Institutional traders view Nasdaq as a level playing field but are suspicious of how their orders are likely to be handled at the Big Board. Says American Century's Wheeler: "There are just too many instances when you're trying to trade a listed stock and you see so many executions that you feel should have been yours but instead went to an intermediary or a competing order. And the barriers to competition inherent in the NYSE system mean you don't have a viable choice other than to expose your order to the floor. Nasdaq provides us with a platform where we have control, where we have alternatives."

The NYSE's Bennett says that traders are frustrated because decimalization has changed the nature of trading, often requiring new strategies. It has been difficult for many to adapt. NYSE studies, he adds, show that most penny jumping is done not by specialists and floor brokers but "by all kinds of traders who are watching the market and who are able to move quickly in and out of stocks."

Bennett also notes that studies by the SEC and academics comparing similar NYSE and Nasdaq stocks -- including one survey he himself did earlier this year comparing the costs of stocks that transferred from Nasdaq to the Big Board -- show that the NYSE's auction market results in lower transaction costs. "People may have a better sense of control on Nasdaq, but that doesn't necessarily lead to a better trade," he says. "The benefit of the NYSE is that you centralize all the orders and arrive at a better price."

Still, rival markets are primed to capitalize on the NYSE's troubles. Instinet, for example, is introducing a new method for handling listed-stock orders that it calls "proactive smart-routing." Rather than forcing institutions to choose whether they want to send their orders to the NYSE floor or through electronic systems, Instinet's new technology will slice large orders into smaller pieces that will be represented simultaneously on the Big Board floor and in electronic systems like ArcaEx, Instinet's own ECN and the Nasdaq InterMarket. Whenever one slice is executed, it will automatically "reload" from the remainder of the large order, until it is completely filled.

Instinet is combining this new process with a Liquidnet-like system called Continuous Block Cross. Institutions will be able to take portions of a large order that are held "in reserve" -- not exposed to the market -- and put them into the CBX system, where they can negotiate large block trades with other investors. The company expects both systems to be available by year-end.

"The buy side wants to do more listed trading electronically," says Natan Tiefenbrun, co-president of Instinet's institutional brokerage division. "But they're afraid of missing out on the liquidity on the floor. What we're doing is telling our customers, 'You don't have to choose between one or the other anymore.'"

Breaking up large orders into many small pieces and using computer algorithm-­driven trading systems to execute them -- a phenomenon first seen in the mid- to late 1990s -- is becoming more popular as technology improves and frustration with traditional order-execution grows. ArcaEx and Instinet have concentrated on facilitating this kind of trading strategy. Major brokerage houses like Credit Suisse First Boston, as well as smaller boutique trading shops, offer similar services. "Instead of walking a cow down to the floor, you shoot a bunch of hamburgers down there," says Matthew Andresen, head of trading at Sanford C. Bernstein & Co.


The bigger companies are, the more expensive they are to trade on the NYSE. The chart below shows the difference, in cents per share, between the actual transaction costs for stocks in five different market capitalization segments and the costs investors would have incurred if the trade had been executed at the volume-weighted average price (a standard benchmark for measuring market impact and other "hidden" transaction costs). The bigger the number, the greater the cost of executing the trade. The higher cost of trading giant-cap stocks at the NYSE, compared with smaller names, runs counter to the conventional wisdom that large, actively traded stocks have lower transaction costs than smaller, less liquid ones.

Difference from

volume-weighted average

Market price (in cents per share)*

capitalization NYSE OTC

Giant cap ($25B+) 1.9 1.5

Large cap ($5B-$25B) 1.6 1.9

Midcap ($1B-$5B) 1.3 1.9

Small cap ($250M-$1B) 0.6 1.5

Microcap ($250M or less) 0.5 0.8

Average 1.2 1.5

*Figures are for Q2 '03.

Source: Elkins/McSherry.

How the top brokerage firms and investment managers rank in execution costs around the world

Global trading

Brokerage firm Principal Difference vs. Investment manager Principal Difference vs.

2002 (No. of countries traded E/M universe 2002 (No. of countries traded E/M universe

rank firm traded in) ($ millions) (basis points) rank firm traded in) ($ millions) (basis points)

1 Sanford C. Bernstein & Co. (19) 2,362 34.2 1 Genesis Asset Mgmt (16) 495 53.6

2 NCB Securities (4) 526 26.6 2 Pictet & Cie (37) 2,603 41.6

3 RBC Dominion Securities (6) 989 26.2 3 Delaware Investment Advisers (15) 476 31.1

4 Crédit Agricole (17) 643 25.7 4 UBS Global Asset Mgmt (38) 5,445 28.3

5 UBS Securities (37) 2,089 23.2 5 GMO (33) 1,516 21.3

6 BMO Nesbitt Burns (2) 588 22 6 Goldman Sachs Asset Mgmt (37) 20,475 20.3

7 Dresdner Kleinwort Wasserstein (28) 2,392 16.7 7 Clay Finlay (34) 1,950 18

8 Bank of America Securities (24) 4,032 13.7 8 Scottish Widows Investment Partnership (34) 3,811 17.9

9 Goldman Sachs JB Were (5) 931 12.8 9 Merrill Lynch Investment Managers (41) 5,940 16.8

10 Cheuvreux De Virieu (17) 3,645 12.3 10 Alliance Bernstein Investment Mgmt (37) 4,862 14.5

11 ITG (24) 1,304 12.2 11 Acadian Asset Mgmt (36) 2,156 13.9

12 Cazenove & Co. (29) 3,088 11.9 12 Franklin Templeton Asset Mgmt (34) 1,610 13.7

13 A & S Bleichroeder (32) 1,874 8.1 13 Deutsche Asset Mgmt (25) 5,411 9.6

14 Deutsche Bank Securities (40) 4,087 6.6 14 Morgan Stanley Investment Mgmt (37) 4,060 8

15 State Street Global Markets (31) 1,550 6.5 15 Putnam Investments (26) 3,809 4.6

NYSE trading

1 First Albany Corp. 767 47.7 1 Legg Mason Capital Mgmt 809 64

2 Pershing 3,111 17.8 2 Axa Rosenberg 941 38.9

3 Redibook 2,548 15.6 3 Vanguard Group 833 36.9

4 Jones & Associates 1,418 14.9 4 Harris Associates 1,130 26.5

5 Liquidnet 669 14 5 Southeastern Asset Mgmt 606 25.3

6 Instinet 6,348 11.6 6 Alliance Bernstein Investment Mgmt 1,927 25.1

7 Goldman, Sachs & Co. 711 10.5 7 Sound Shore Mgmt 744 24.8

8 Weeden & Co. 5,034 9.8 8 First Quadrant 2,014 24.5

9 Deutsche Bank Securities 724 9.7 9 Oppenheimer Funds 3,893 23.9

10 Island ECN 786 8.6 10 Goldman Sachs Asset Mgmt 5,285 22.8

11 Robert Baird & Co. 526 6.6 11 WP Stewart & Co. 1,708 20.5

12 Morgan Stanley 6,407 5.9 12 Jacobs Levy Equity Mgmt 1,647 20.2

13 UBS Securities 1,015 4.9 13 Citigroup Asset Mgmt 750 20

14 Merrill Lynch/Citation Group 1,708 4.7 14 NWQ Investment Mgmt Co. 1,163 19.1

15 Boston Institutional Services 532 4.4 15 Institutional Capital Corp. 1,592 18.6

Nasdaq trading

1 MJ Whitman 227 98.2 1 Munder Capital Mgmt 323 76.4

2 Instinet 701 44.9 2 SIT Investment Associates 330 54.9

3 Merrill Lynch & Co. 324 44.8 3 Axa Rosenberg 432 49.6

4 B-Trade Services 2,935 29.8 4 Dreyfus Investment Advisers 408 45.5

5 Keefe, Bruyette & Woods 323 24.9 5 Alliance Bernstein Investment Mgmt 3,197 39

6 Knight Securities 350 24.1 6 Goldman Sachs Asset Mgmt 966 38

7 Jefferies & Co. 435 18.3 7 Wellington Mgmt Co. 1,174 34.9

8 Investment Technology Group 4,170 18 8 Peregrine Capital Mgmt 631 34.2

9 Spear, Leeds & Kellogg 1,740 16.3 9 Jacobs Levy Equity Mgmt 306 29.1

10 Liquidnet 378 14.7 10 First Quadrant 1,280 28.6

11 Island ECN 558 14.2 11 Delaware Investment Advisers 1,743 23.1

12 UBS Securities 3,146 14.1 12 Numeric Investors 453 17

13 Banc of America Securities 961 11.3 13 Jennison Associates 358 16.5

14 State Street Global Markets 1,223 7.8 14 Fiduciary Asset Mgmt 652 16.1

15 Morgan Stanley 3,078 7.6 15 USAA Investment Mgmt Co. 2,388 12.9

Source: Elkins/McSherry.

The cost of executing trades in 42 countries

Country Average price of stock (dollars) Average commissions (basis points) Average fees (basis points) Market impact (basis points) 2002 total (basis points) Average 2001 total (basis points)

Argentina $ 0.53 31.65 2.94 106.70 141.29 69.27

Australia 4.50 24.19 0.28 9.14 33.61 50.95

Austria 18.82 20.43 0.11 11.76 32.30 37.93

Belgium 26.63 19.98 0.21 15.05 35.24 28.33

Brazil 1.62 28.89 1.47 14.76 45.12 55.22

Canada 17.49 19.92 1.35 11.35 32.62 45.15

Chile 4.28 60.15 5.05 36.80 102.00 68.01

Colombia 1.10 49.34 5.50 36.55 91.39 101.71

Czech Republic 8.04 40.05 9.13 12.72 61.90 65.83

Denmark 27.54 20.07 0.24 18.57 38.88 48.81

Finland 16.53 19.80 0.83 17.47 38.10 62.22

France 33.89 19.04 0.92 11.90 31.86 36.95

Germany 38.97 19.42 0.91 9.78 30.11 30.67

Greece 14.15 33.88 14.23 11.22 59.33 79.94

Hong Kong 1.98 23.30 10.70 13.10 47.10 47.61

Hungary 13.43 48.33 5.88 7.90 62.11 68.58

India 7.29 38.46 0.02 25.84 64.32 71.28

Indonesia 0.32 46.89 10.78 28.19 85.86 80.02

Ireland -- Buys 9.48 19.28 98.70 23.34 141.32 80.93

Ireland -- Sells 8.75 17.89 0.77 21.59 40.25 N/A

Italy 6.19 19.33 0.67 13.46 33.46 37.24

Japan 14.25 13.40 0.25 8.12 21.77 19.92

Korea 34.10 31.31 12.29 20.45 64.05 40.20

Luxembourg 10.36 12.77 0.07 47.14 59.98 70.18

Malaysia 1.76 37.15 5.80 17.11 60.06 41.37

Mexico 1.97 28.54 0.32 14.01 42.87 33.80

Netherlands 20.84 18.88 0.78 8.62 28.28 34.19

New Zealand 2.07 21.94 0.09 10.10 32.13 32.34

Norway 10.22 20.68 0.59 19.94 41.21 79.86

Peru 0.56 35.34 0.00 32.20 67.54 97.47

Philippines 0.26 48.77 29.81 9.30 87.88 39.19

Portugal 5.00 17.57 1.22 18.50 37.29 39.96

Singapore 3.82 26.39 1.88 16.14 44.41 56.74

South Africa 4.32 26.96 11.85 12.11 50.92 71.31

Spain 11.80 19.47 0.87 29.59 49.93 38.45

Sweden 8.85 19.69 0.24 14.54 34.47 41.00

Switzerland 52.89 18.40 0.96 15.08 34.44 36.65

Taiwan 1.72 25.91 13.73 18.61 58.25 58.40

Thailand 1.13 48.70 1.81 18.23 68.74 57.22

Turkey 0.00 30.12 3.73 20.10 53.95 55.21

U.K. -- Buys 5.43 14.61 49.45 8.41 72.47 69.01

U.K. -- Sells 5.23 13.72 0.56 17.27 31.55 35.93

U.S. -- NYSE 26.67 18.06 0.60 10.64 29.30 38.60

U.S -- Nasdaq 19.60 15.62 0.59 24.15 40.36 32.18

Venezuela 9.02 41.63 0.00 39.70 81.33 121.19

Overall 11.41 27.24 6.85 20.16 54.25 54.71

Source: Elkins/McSherry.