Market Restructuring: What's in It for Investors? (Fool on the Hill) March 6, 2000

An Investment Opinion

Market Restructuring: What's in It for Investors?

By Yi-Hsin Chang (TMF Puck)
March 6, 2000

One of the hot topics on Wall Street these days is the issue of restructuring the stock markets by creating a central order book -- a "big screen," if you will, that would reveal orders from all sectors, including the numerous online brokerages and electronic communication networks, also known as ECNs. The idea is that this would prevent "fragmentation" of markets and increase efficiency and liquidity.

Sounds good, right? Who's against improved market efficiency and liquidity? Well, the issue is a bit complicated, and opponents of market restructuring dispute whether it would, in fact, improve efficiency and liquidity. You might be surprised at who's championing for change and who's resisting it.

Last week, the heads of four major investment banks testified before five members of the Senate Banking Committee in a government hearing room near the World Trade Center. The CEOs of Goldman Sachs (NYSE: GS), Morgan Stanley Dean Witter (NYSE: MWD), Merrill Lynch (NYSE: MER), and Credit Suisse First Boston spoke for the creation of a central order book linking the plethora of electronic trading networks.

The strongest voices against the proposal, believe it or not, were an unlikely tandem comprising discount brokerage Charles Schwab (NYSE: SCH), the New York Stock Exchange (NYSE), and the Nasdaq Stock Market. Why is Schwab on the same side as the NYSE and Nasdaq? Why is Schwab opposed to defragmentation, which seemingly would benefit investors?

The answers lie in a humorous remark by Nasdaq Chairman Frank Zarb, who joked that if the securities industry had a flag, it would carry the Latin translation for "What's in It for Me?"

What's in it for Schwab? Well, a central book order would basically disrupt Schwab's business model. Schwab has successfully attracted millions of customers by being one of the first to move its business online and by lowering commissions to $29.95 a trade ($14.95 for really active traders). Schwab has profited from the inefficiencies of the markets and traditional brokerages. The company benefits from fragmentation because it executes most trades internally, a profitable tactic that it says helps to offset lower commissions.

What's in it for the NYSE and Nasdaq? Saving the hides of specialists and broker-dealers, whose jobs would become obsolete with the establishment of an electronic central order book. No wonder the Independent Broker-Dealer Association, which represents more than 200 small broker-dealers, is threatening to disrupt the sale of Nasdaq unless the sale is delayed to allow for more time to debate market restructuring issues.

Of course, the major investment banks aren't being driven by altruistic intentions. Their securities businesses have been threatened by the onslaught of Internet brokerages. Not only are individual investors going online to trade, the fragmentation of the stock market makes it harder for the large banks to serve their big clients, the large institutional investors. In short, a central order book would help the large players compete against their now scattered competitors.

What's in it for the individual investor? Certainly, improved efficiency and liquidity are good things. A central order book would add transparency to the system and would mean narrower spreads for investors. While internal execution of trades is good for Schwab, investors sometimes lose out because they aren't getting the best price available. Still, if it weren't for online brokerages, we'd probably still be paying outlandish commissions on trades.

Nonetheless, I lean toward the creation of a central order book, the creation of more efficient, transparent, and liquid markets. What might hurt firms like Schwab in the short term are indeed short-term problems. The truly innovative firms will seek new ways of doing business to continue to better serve customers while improving the bottom line.

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