The New York Stock Exchange still uses specialists to physically match stock buyers and sellers. Europe's largest exchange, the London Stock Exchange, automated its specialists (called stockjobbers) 20 years ago. Fully electronic Nasdaq started in 1971. The specialist gene is part of the NYSE -- as long as it remains, the lessons (and benefits) of exchange evolution may be missed.
Those selfish genes. All they care about is making more of their own kind. Down at the NYSE trading posts, there are some fans of Richard Dawkins, author of The Selfish Gene. Be careful. Resisting the lessons of evolution too long can produce odd outcomes. Take the mantis -- the female combines love and lunch by eating the male after mating.
A quick history
The New York Stock Exchange began 213 years ago, when 24 brokers signed the Buttonwood Tree Agreement, creating a club for members to trade with each other. These memberships came to be known as seats (or trading posts). The recent launch of the NYSE Group (NYSE: NYX ) converted the seats into publicly traded stock. Specialist firms owned, or leased, many of these seats.
Specialists were born by accident, according to Peter Bennett, an exchange historian. Take James Boyd, a leading broker of his time, who broke his leg in 1875. Unwilling to walk, Boyd did business from a chair at the Western Union trading post. Noticing this, busy brokers asked Boyd to work their Western Union orders while they ran around to other posts. They rewarded Boyd with a commission -- making him the first specialist. As a reward for their obligation to maintain "fair and orderly" markets, the NYSE assigns specialists three stock-related jobs. As auctioneers, they collect and publish bids and offers. As brokers, they buy and sell for customers. And as trading principals, they use their own capital to buy and sell positions. Each specialist is assigned a specific stock, and all trading in the stock flows through its specialist.
Here's a puzzle. How does the London Stock Exchange, Europe's largest, trade giant stocks such as GlaxoSmithKline, Vodafone, and Shell without humans? How does Nasdaq (Nasdaq: NDAQ ) trade Microsoft, Google, and Dell electronically? And why does the Big Board (as the NYSE is known) need specialists to trade the likes of IBM (NYSE: IBM ) and Verizon? Anti-evolutionists swear that specialists provide liquidity to small stocks. Again, the LSE uses computers to trade its largest mid-cap and small-cap stocks.
Do the specialists add value? Not in Morningstar's recent icy opinion -- LaBranche (NYSE: LAB ) , the largest specialist, has a fair value of zero, and they wouldn't buy the stock at any price!
Applying Morningstar's logic and the Fool's arithmetic, I calculate that the specialists cost the U.S. stock system more than a billion every year. Here's the calculation. Take LaBranche's total 2005 revenues in its specialist and market-making segment (though it includes some AMEX operations) of $284 million. Note their 25% market share of NYSE volume. Next, multiply LaBranche's revenue by four, for the total cost to the U.S. stock system of the specialists. Calculating the cost of automating the specialist system is complicated, but it should not be more than 20% of this total.
Evolution's lessons for the NYSE
Lesson No. 1: Stop barking, and catch up with the London Stock Exchange (LSE). It's summer 1986. Lots of cheerful chaps are wearing funny jackets, running around and waving at each other . stockjobbers, the British version of specialists. Suddenly, in the autumn of that same year, the trading floor of the LSE goes OK Computer and the stockjobbers disappear. The building becomes a backdrop for financial shows.
Despite the prospect of a dog fight with the Nasdaq, the NYSE should buy the LSE. There's less risk of a merger migraine than with the Euronext (bid announced today) -- a loose combination of French, Belgian, Dutch, and Portuguese exchanges.
Lesson No. 2: Genes aren't destiny. Character can help you change. Exchanges are trading factories: Fixed costs are high, but once break-even is reached, extra volume is pure profit (assuming the exchange is electronic). Tom Caldwell, one of the world's leading investors in exchanges, views stock markets as a combination of eBay and Google. Leveraging the model means automation and lean production. For NYSE, the evolutionary gap is wide -- in 2005, electronic trading counted for only 11% of total share volume.
Lesson No. 3: Returns without risk mean you're an endangered species. Despite the obligation to provide liquidity, no matter how stormy the stock market, specialists seem to profit. Take LaBranche. It has average gains of $193 million in each of the last three years on principal (trading for its own account) transactions.
Lesson No. 4: Leave hybrids to Toyota. Instead of moving trading to the Archipelago system as fast as possible, the Big Board has come up with NYSE Hybrid Market -- a genetic confection of specialists and electronic trading. In its defense, the specialist gene cries, "Big volumes make us special." But last Friday, May 12 -- a busy trading day with gas price and interest rate fears -- Nasdaq volume was 90% of the NYSE.
Lesson No. 5: Encourage independent offspring. NYSE owns two-thirds of the Securities Industry Automation Corporation (SIAC). SIAC provides technology and communications services to the Big Board and AMEX. It functions as a service bureau -- providing services at-cost -- rather than as a for-profit business. SIAC should be made into an independent business. Cognizant (Nasdaq: CTSH ) , with a current market capitalization of $9 billion (NYSE is valued at $11 billion), started life as the software development arm of Dunn & Bradstreet. LSE has no captive IT supplier and outsources technology platforms and service management to Accenture (NYSE: ACN ) and Verizon.
The missing link
But evolution isn't just Darwinian doom. If you can evolve to better fit your environment, it's an opportunity to create a new, high-profit business model -- "The Blank Slate" -- with three major benefits.
1. Huge cost savings. You can do the LaBranche analysis above. Or you can estimate the savings from automating most of the 423 specialists, 787 floor brokers, and 2,227 clerks conducting business on the NYSE's trading floor as of March 31. There's also 46,000 square feet of iconic New York real estate waiting to become the next Trump Taj Mahal Hotel & Casino.
2. Operating leverage from ability to scale. Tom Caldwell, the exchange investor, expects NYSE trade volume to double in the next five years. This would add more than $300 million of transaction revenue (before considering similar increases in market data and processing fees). With a fully automated exchange, the marginal costs would be low -- computer servers are much cheaper, and less excitable, than traders.
3. Fully evolved operating margins. NYSE operating margins for the last fiscal year are 11%. In contrast, the LSE operates at 35%, and the Chicago Mercantile Exchange (NYSE: CME ) at 57%. Though, it lacks CME's clearinghouse franchise, the NYSE is the world's largest and most liquid cash equities exchange. Full leverage of its brand and liquidity pool with an all-electronic trading mechanism can bring operating margins closer to 50%.
The NYSE can fully realize the value of its trading factory by going fully electronic -- and leave its specialist gene behind with the Buttonwood Tree.
For more Foolishness on the NYSE:
- I Heart NYSE
- Riding Technology to a Triple
- Early, Wealthy, and Wiser
- Cranky Consultants at BearingPoint
GlaxoSmithKline is a Motley Fool Income Investor pick, while Vodafone, Microsoft, Dell, and Accenture are Motley Fool Inside Value selections. eBay is a Motley Fool Stock Advisor pick. Take the newsletter service of your choice for a30-day free trial.
Fool contributor John F. Finneran is a management consultant, investment analyst, and writer specializing in the financial value of technology. He does not own any of the shares mentioned. Feel free toemail him.