Tech and the Euro:
Revamping the Securities Industry
The securities industry is presently
undergoing an immense change triggered by technology. The
move to a single currency by the countries in the European
Union is providing an additional impetus. Together these
changes are causing a reconfiguration of much of the
securities industry.
The Internet and more secure private
networks enable investors to transmit trading orders
directly to securities markets, bypassing brokers and
national boundaries. Institutional investors have had this
capability for some time. The Internet provides it to retail
investors as well. Numerous players are taking advantage of
this capability. In so doing, they are increasing the number
of market participants, lowering the prices investors pay for
market access, and posing major threats to the price
structures of leading securities firms. Because they enable
access by issuers and investors in one country to markets in
others, they subject national markets to more intense
international competition.
Alternative trading systems match
buyers and sellers, execute trades electronically, and offer
low-cost alternatives to traditional markets (including both
registered securities exchanges and over-the-counter dealer
markets).1 Because these alternative trading
systems are linked to the Internet and more secure private
networks, they have the ability to shift significant traffic
away from traditional markets. In the U.S., these shifts are
causing a drop in exchange seat prices, prompting the
consolidation of key traditional markets, and forcing
survivors ever closer to electronic trading.
The move to a single European currency
facilitates the growth of a single unified European capital
market that will rival that of the U.S. The impending
introduction of the Euro has already led to a consolidation
of European exchanges. Not surprisingly, one of the winners
in this consolidation, Deutsche Borse, is also the operator
of one of the most automated trading systems. Again not
surprisingly, that winner is also enthusiastically allowing
U.S. member firms—linked to it via a secure private
network—to initiate trades. This dynamic has intensified
the U.S. markets' embrace of electronic technologies that
support trading. It has also triggered unprecedented interest
on their part in alliances with European exchanges.
Thus, the competitive environment of
established U.S. securities firms and markets is changing
dramatically. The bull market has largely insulated them from
the negative effects of these changes. If the bull market
ends, that insulation will disappear as well.
The Internet and More Secure Private
Networks
Approximately one-quarter of retail
securities trades in the United States are now initiated over
the Internet. Retail accounts with online trading capability
hold more than $230 billion. In 1996, the number of such
accounts stood at 1.5 million. By the end of 1998, that
number is expected to rise to 5.3 million. More than 70
stockbrokers offer online trading via the Internet.2
The emergence of dozens of Internet brokers
has caused a dramatic decrease in the average trading
commissions of online discount brokers. In the first quarter
of 1996, the average commission per trade for the 10 largest
online discount brokers was over $50. By the end of the
fourth quarter of 1997, it was about $15, according to a
study conducted by Piper Jaffray.3
The tremendous public enthusiasm for
Internet trading has placed significant pressure on
traditional full-service brokers, which charge higher trading
commissions than discount brokers. Reluctant to reduce the
attractive revenue scheme generated by these commissions,
full-service brokers have attempted to meet their customers'
needs by offering information-rich Web sites, where customers
can monitor their portfolios. In some firms, notably
Travelers Salomon Smith Barney and Paine Webber, the users of
these sites have on average more money in their accounts than
their non-using counterparts do.4
Prudential Securities and Merrill Lynch
have announced plans to offer online trading to customers of
accounts that charge annual asset-based fees. Beginning in
the fall, Merrill Lynch plans to let investors with balances
of at least $100,000 initiate New York Stock Exchange and
NASDAQ trades online.5 In June, Merrill Lynch's
vice chairman and executive vice president of its private
client group, John L. Steffens, delivered a rousing defense
of the firm's 14,000 financial advisers and called Internet
trading a "serious threat to Americans' financial
lives."6
Institutional investors are significantly
more important than individual investors from the point of
view of the securities industry. They execute $3 trillion in
equity trades each year or 80 percent of the total. They have
long used secure private networks to initiate trades through
broker/dealers in the established markets. They are now using
these networks in a number of new ways:
-
To trade directly through the
established markets, paying commissions to their
broker/dealers only for clearing and settlement. For
example, some NYSE members allow their institutional
investor customers to route their orders directly
into the SuperDOT system. This system was previously
used exclusively by New York Stock Exchange members
to transmit trading orders to floor specialists.
-
To bypass traditional markets in order
to trade in lower-cost alternative trading systems
described below.
-
To obtain direct access to foreign
markets. Deutsche Borse already has 17 U.S. members
with automated links to it.7 It is eager
to make such links available to U.S. institutional
investors. Investments by U.S. persons in foreign
securities has grown from $53.1 billion in 1980 to
$2,573.6 billion, an increase of 4700 percent.8
The vast majority of these trades currently go
through the investors' own U.S. broker/dealers, which
have relationships with members of foreign markets.
Nevertheless foreign markets are attractive enough to
provide an incentive for institutional investors to
establish their own links to foreign market members
and to foreign exchanges themselves.
Alternative Trading Systems
The established structure of the
securities industry is also being challenged but the
proliferation of alternative trading systems (ATSs). The
Securities and Exchange Commission (SEC) estimates that these
systems handle almost 20 percent of NASDAQ trades and 4
percent of the trades on the New York Stock Exchange (NYSE).
More than 140 alternative trading systems have registered
with the SEC.9 These systems are flourishing
because the low cost of the Internet and private networks
gives large numbers of issuers and investors access to them.
Electronic trading—which is in reality no more than a
form of data processing—allows them to undercut the
prices of established rivals.
Although both the New York Stock Exchange
and NASDAQ have automated important facets of their
operations, neither operates a completely electronic market.10
The New York Stock Exchange is an open-outcry auction market;
specialists who make markets meet one another in person to
make trades. Specialists receive trading orders
electronically.11
NASDAQ (the National Association of
Securities Dealers Automated Quotation System) is a
competitive dealer market; all trades must go through a
dealer. If Investor A wants to sell securities to Investor B,
he must first sell them to a dealer, who then sells them to
Investor B. Although NASDAQ quotes prices electronically,
most trades are executed by telephone. Small NASDAQ trades
are executed electronically through SelectNet and the Small
Orders Execution System (SOES).12 Because dealers
take positions in all NASDAQ trades, they add a layer of
costs to these trades. Investor desire to circumvent these
costs has been an important institutional catalyst for the
development of alternative trading systems.
Alternative trading systems (ATSs) tend to
operate in front of traditional markets; only the trades ATS
users cannot execute among themselves are executed through
traditional channels. Thus, the flow of trades through
traditional markets is reduced. In design, ATSs resemble
traditional markets in that they "centralize orders and
give participants control over the interaction of their
orders."13 However, because they are
privately operated, ATSs also resemble brokers, and the SEC
currently regulates them as such. Developers of alternative
trading systems have tended to be either outsiders
(information vendors, service bureaus, and routing services)
or enterprising individual broker/dealers themselves.
The most important ATS is Instinet's
Real-Time Trading Service. Instinet is owned by Reuters.
Instinet allows "participants to display firm, priced
orders to other participants and to execute automatically
against other orders in the system."14 Other
similar systems include Island operated by Datek Securities
(a registered broker-dealer) and Tradebook operated by
Bloomberg Tradebook LLC.
POSIT, operated by ITG, Inc (a registered
broker-dealer) is a cross system that allows
"participants to enter unpriced orders, which are then
executed with matching interest at a single price, typically
derived from the primary public market for each crossed
security."15 AZX is a single-price auction
system that allows "participants to enter priced orders,
which the system then compares to determine the single price
at which the largest volume of orders can be executed. All
orders are then executed at that price."16
One of the most frequent criticisms leveled
at electronic markets is that they limit liquidity.17
This problem may be severe in the case of very large trades
because the number of potential bidders on a large offer is
limited. The human trader who perceives this problem breaks
up the large offer into multiple small ones, which then find
multiple bidders. Traditional electronic trading systems have
not had the flexibility to break large orders into multiple
small ones. Nor have they had the ability to conceal the size
of the initial offer. When other traders know a large offerer
is in the market, they raise their prices. Floor specialists
may not have adequate capital to provide liquidity for large
institutional orders. These problems have tended to limit the
appeal of alternative trading systems to institutional
investors.
However, a new supercomputer-based ATS
called OptiMark takes significant steps to overcome these problems.
The OptiMark system allows an offerer to break up a large offer
into blocks that can trade at different prices. The identity
of the offerer is concealed. OptiMark Technologies, based in
Durango, Colorado, functions as a service bureau and charges
per trade fees. It does not act as a dealer and take
positions in trades. This fact should give it significant
appeal to institutional investors. Dow Jones & Co.,
Goldman Sachs, major investment banks and a host of
institutional investors have financed the development of
OptiMark.
The attractiveness of alternative trading
systems has already triggered major changes in the existing
markets. These changes include the following:
-
Decreases in the prices of exchange
seats by August 1998 on the New York Stock Exchange
(from $2 million in February to $1.35 million), the
Chicago Board of Trade (from $857,000 in 1997 to
$410,000), and the Chicago Mercantile Exchange (from
$925,000 in 1994 to $330,000).18
-
The National Association of Securities
Dealers' acquisition of the American Stock Exchange
and the Philadelphia Stock Exchange. The NASD
operates NASDAQ. NASDAQ deals in 6,010 stocks. The
American Stock Exchange trades more than 800 stock
and index options and warrants; the Philadelphia
Exchange trades 2,700 stocks and options.
-
The merger of the Pacific Exchange and
the Chicago Board of Options Exchange. The Pacific
Exchange trades options on small stocks. The Chicago
Board of Options Exchange trades 1,100 stocks,
indexes and other financial instruments.
-
The request of Cantor Fitzgerald, a
broker, for permission to start an alternative
trading system for U.S. Treasury bond futures.
-
The establishment of back office links
between the Chicago Board of Trade (CBOT) and the
Chicago Mercantile Exchange. The CBOT trades
commodity, interest-rate, and bond futures plus
financial-index, commodity, and Treasury futures. The
Chicago Mercantile Exchange trades
livestock-and-dairy-product, currency,
financial-instrument, index, and bond futures and
options.
-
The Chicago Board of Trade's
announcement that it will allow electronic trading in
addition to its traditional open-outcry trading in
September 1998.19
-
An agreement in principle between
NASDAQ and OptiMark that NASDAQ
will incorporate OptiMark Technology
into its equity trading system.
-
An agreement between the Pacific
Exchange and OptiMark for the
Pacific Exchange to begin using OptiMark to
trade stock listed on the New York Stock Exchange.
-
NASDAQ's announcement that it will
soon begin allowing investors to transmit trading
orders directly to NASDAQ via the Internet.20
-
Instinet's consideration of allowing
retail investors access to its alternative trading
system via the Internet.21
The Move to a Single European Currency
One reason that U.S. markets are
consolidating and reaching accommodations with alternative
trading systems is because they face increased international
competition. It is likely that single capital market of equal
size will emerge in Europe in conjunction with the move to a
single currency. Although equity markets have appeared or
expanded in a number of European countries, the division of
the continent into multiple currency areas prevented the
development of a single large market. One reason is that
investors in one country who invest in a stock denominated in
the currency of another country face foreign exchange risk as
well as market risk. For most investors, that is one risk too
many.
Over the past decade, the governments of
many European countries have taken a number of steps to
foster the growth of local equity markets. Aware that
government programs cannot meet the social insurance
requirements of aging populations, they have fostered the
growth of private pension plans. These pension plans need
somewhere to invest funds. Local stock markets in London,
Frankfurt, Paris, Amsterdam, Milan, Madrid, Stockholm, and
Zurich have provided that place.
As a result of this trend, share ownership
by individuals in many European countries has risen. It still
remains below U.S. levels. In the U.S., 43 percent of adults
invest in the stock market directly or through mutual funds.
Percentages in Europe are significantly lower: 25 percent of
British, 16 percent of French, and six percent of Germans.22
Trading volume is Europe is fragmented
among multiple exchanges. At a time when the New York Stock
Exchange ($4,100 billion) and NASDAQ ($2,200 billion)
generated a total of $6,300 billion in trading volume, the
exchanges in London ($2,265.7 billion), Frankfurt ($1,043.2
billion), Paris ($685 billion), Madrid ($333 billion), and
Lisbon ($77 billion) generated a total of $4,403.9 billion.
The London Stock exchange generates more than half of
European volume.23
Any consolidation of European markets into
a single large market would have dramatic competitive
implications for U.S. markets. If this unified European
market automates trading and execute trades at lower cost
than the NYSE and NASDAQ, it is likely to attract both
issuers and investors who would otherwise have gone through
the US markets.
One obvious candidate for this role is the
Deutsche Borse, which runs the Frankfurter Wertpapierborse
(FWB) and the Deutsche Terminborse (DTB). The FWB is
Germany's leading securities exchange, which now operates
both floor trading like the NYSE and an electronic trading
system. When the FWB finishes introducing a new electronic
trading system, it may eliminate floor trading completely.
The DTB is Germany's first fully computerized exchange and
the leading German financial futures market.
The DTB has already made significant
inroads in the to business of the London International
Financial Futures Exchange (LIFFE). At the beginning of 1997,
70 percent of trades in German bonds were executed through
the LIFFE. By the end of 1997, 70 percent were executed
through the DTB.24
The success of the DTB has prompted the
less automated London Stock Exchange to enter a joint venture
with the Deutsche Borse. Only two years ago, the turnover of
the London Stock Exchange was more than that of all other
European exchanges combined.25 London has
traditionally been the leading European financial center. It
has had an important stock market for significantly longer
than most of its European competitors.
However, the London Stock Exchange has
encountered significant difficulties in boosting its
technological base. As a virtual corporation without its own
assets, it has not assumed the kind of control over its
technological development that Deutsche Borse has exercised.26
The UK's position in European finance is to some extent
threatened by its plan to remain outside the initial Euro
zone. Germany's position is enhanced because the European
central bank will be located there.
Prior to the announcement of the London
Stock Exchange's alliance with the London Stock Exchange, the
Deutsche Borse had been engaged in alliance talks with the
Paris bourse. The British-German alliance dramatically alters
the competitive environment of the other European exchanges.
The move to a unified European stock market
has triggered significant interest on the part of US markets
in both attracting European investors and issuers and in
entering alliances with European exchanges. Both the New York
Stock Exchange and NASDAQ give significant publicity to their
non-US issuers. Both have sections of their Web sites
targeted at foreign investors. The NYSE is investigating
possible ties to the Paris Bourse and exchanges in Latin
America and Canada. NASDAQ is doing with same with the
exchanges in London and Frankfurt.27 NASDAQ has
embarked on a European marketing campaign to generate
interest in it among European investors.
Conclusion
Changes of historic proportion are now
occurring in the world's securities markets. Two apparently
contradictory trends are evident: splintering and
consolidation. In the U.S., both splintering and
consolidation are evident. As technology advances and is
exploited, splintering occurs as new players introduce
alternative trading systems; consolidation is occurring as
traditional players attempt to respond.
In Europe, traditionally splintered markets
have exploited technology at different rates and with varying
levels of effectiveness; consolidation is beginning as
markets that have exploited technology most effectively
demonstrate their strength. One possible outcome is the
emergence of a single unified global securities market linked
to worldwide investors—both institutional and retail.
The legal structure to support such a market is not yet in
place.
Securities regulators in the leading
economies have begun to examine what such a structure would
require. Insurance companies as institutional investors have
a front-line view of these developments. As providers of
variable products to individuals, they have to deal with an
ever more sophisticated public with significant ability to
trade in securities markets directly. Their reliance on the
alternative trading systems for the execution of mutual fund
exchanges will continue to increase. Securitization of
insurance risk is likely to grow. The coming years should
prove very interesting ones.
Footnotes
1The SEC uses the term alternative trading
system to refer to automated systems that centralize,
display, match, cross, or otherwise execute trading interest,
but that are not currently registered with the SEC as
national securities exchanges operated by a registered
securities association. See the Exchange Act Concept Release,
May 23, 1997, Number 34-38672; International Series Release
Number IS-1085, File Number S7-16-97.
2 Paula Dwyer et al, "The
21st Century Stock Market," Business Week,
August 10, 1998, p. 67.
3 David Barboza, "On-Line
Trade Fees Falling Off the Screen, New York Times,
March 1, 1998, Section 3, p. 4.
4 Rebecca Buckman,
"Explosion of Internet Trading Accounts Makes Big
Brokerage Firms Go On-Line," Wall Street Journal,
February 9, 1998, p. B7 C.
5 Paula Dwyer et al, "The
21st Century Stock Market," Business Week,
August 10, 1998, p. 68.
6 John L. Steffens,
"Delivering Value in the New Economy: Merrill Lynch and
the Technology Future," speech to PC Expo, New York, New
York, June 17, 1998, accessed on Merrill Lynch's Web site.
7 Ibid., p. 72.
8 Securities Industry
Association Fact Book 67 as referenced in Securities
and Exchange Commission, the Exchange Act Concept Release,
May 23, 1997, Number 34-38672; International Series Release
Number IS-1085, File Number S7-16-97, footnote 213.
9 Securities and Exchange
Commission, the Exchange Act Concept Release, May 23, 1997,
Number 34-38672; International Series Release Number IS-1085,
File Number S7-16-97, p.8 and footnote 14. The concept
release is available on the SEC's Web site.
10 Both use electronic systems
for order delivery and execution, dissemination of
transaction and quotation information, specialists' limit
order books and the comparison of trades prior to settlement.
See the SEC's Report to the Congress: The Impact of Recent
Technological Advances on the Securities Markets, Section
IV B, available on the SEC's Web site.
11 The New York Stock Exchange
is introducing a new trading floor communications network
that enables specialists and brokers to use a single screen
to manage orders and monitor market data. Floor brokers can
communicate with their firms' booths on the floors'
perimeters via wireless voice communication devices. They
also carry wireless data devices to receive orders and send
reports from the floor. See the SEC's Report to the
Congress: The Impact of Recent Technological Advances on the
Securities Markets, Section IV C, available on the
SEC's Web site.
12 "SelectNet allows market
makers to negotiate and execute orders with one another
through NASDAQ terminals, rather than by telephone. Through
Select Net, a member can direct buy or sell orders in NASDAQ
securities to a single market maker (preferenced orders) or
broadcast orders to all market makers in the security. They
can negotiate the terms of orders through counter-offers by
sending messages through SelectNet. SOES is a comprehensive
automated order execution system that allows for the
electronic execution of small orders in NASDAQ securities.
SOES automatically executes unpreferenced orders in rotation
against those market makers who are at the best quoted bid or
offer on NASDAQ at the time the order is entered. With the
agreement of the market maker, SOES orders also may be routed
or "preferenced" to a particular market maker for
execution at the inside market, regardless of which price the
preferenced market maker is quoting." Footnote 260 to
the SEC's Report to the Congress: The Impact of Recent
Technological Advances on the Securities Markets, available
on the SEC's Web site.
13 The Securities and Exchange
Commission, the Exchange Act Concept Release, May 23, 1997,
Number 34-38672; International Series Release Number IS-1085,
File Number S7-16-97, p. 25.
14 Footnote 11 to SEC's concept
release soliciting public comments on various approaches to
regulated automated trading systems, national securities
exchanges, and foreign market activities in the US, Release
No. 34-672, posted on the SEC's Web site.
15 Ibid., Footnote 12.
16 Ibid., Footnote 13.
17 Marcel N. Massimb and Bruce
D. Phelps, Electronic Trading, Market Structure and
Liquidity, Financial Analysts Journal,
January-February 1994, p. 39.
18 Paula Dwyer et al, "The
21st Century Stock Market," Business Week,
August 10, 1998, p. 66.
19 David Barboza, "An
Expert in Trades," The New York Times, July 24,
1998, p. C1.
20 Tim Wilson, "NASDAQ Puts
Stock in Web --Merging exchanges set sights on direct
trading," InternetWeek, July 6, 1998, Issue 722,
accessed via TechWeb on the Internet.
21 Sean Davis, "Instinet
Mulls Move into Retail Market via Internet, The Wall
Street Journal Interactive Edition, August 3, 1998,
accessed via the Internet.
22 John Tagliabue, "Selling
Europe on the Stock Market," The New York Times,
March 1, 1998, Section 3, p. 1.
23 Melanie Bien, "Traders
force the rate of exchange," The European, July
13-19, 1998, p. 10. NASDAQ supplied the figures.
24 Melanie Bien, "Traders
force the rate of exchange," The European, July
13-19, 1998, p. 8.
25 Ibid., p. 9.
26 Ibid., p. 8.
27 Ibid., Footnote 18.
