August 10, 1999

Are the Public Markets Going Public?

by Louis Corrigan (TMF Seymor)

People today may talk about "going long" the Nasdaq by buying an index fund that tracks the Nasdaq 100, a collection of largely high-tech companies that includes bellwethers Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT). Or for that matter, an investor might go long the New York Stock Exchange (NYSE) by buying a basket of the 30 major industrial stocks that make up "the Dow."

Soon, though, you may really be able to go long the Nasdaq or the NYSE. Or heck, even short them!

That's because each market is talking about issuing stock to the public, becoming shareholder-owned, for-profit companies. Such a move would simplify the now complicated control issues facing each market. It would also raise investment capital and create an equity currency that each could use to scoop up electronic communications networks (ECNs), those fast-growing competitors that have been grabbing market share. Member firms of both the NYSE and the Nasdaq would also be issued an equity stake, something that might further encourage these firms to keep their trading activities within the current markets.

Some commentators have wondered whether talk of the NYSE and Nasdaq going public signals the ultimate stock market top. You know, is Wall Street itself looking to cash out when times are good? Nothing could be further from the truth.

Both the NYSE and the Nasdaq are considering initial public offerings because they're struggling to reinvent themselves now before competitors overrun them completely. ECNs like Reuters Group PLC's (Nasdaq: RTRSY) Instinet, Datek's Island, and even newer upstarts like Archipelago -- which is backed by E*Trade (Nasdaq: EGRP), Goldman Sachs (NYSE: GS,) and now Reuters -- now conduct 30% of Nasdaq volume and 5% of NYSE volume. And Archipelago and other ECNs hope to become full-fledged exchanges capable of listing companies just like the NYSE does today.

The ECNs are leading the way with new initiatives, such as extended trading hours for individual investors. While the NYSE and the Nasdaq debate the issue, Datek is now using its Island ECN subsidiary to offer its brokerage customers the chance to trade until 5:15 p.m. Eastern Time. Other ECNs are expected to launch after-hours trading later this year.

These "third markets" essentially combine strengths of the Nasdaq and NYSE markets by allowing buyers and sellers to match orders automatically through an electronic system that amounts to an open "book" of limit orders. The ECN gets a flat rate fee on each trade. Such systems can work well for the most heavily traded stocks on both the NYSE and the Nasdaq because liquidity tends to assure that investors get the best prices when they buy or sell stock.

The largest of Nasdaq's 5,530 broker-dealers have long resisted an order book. Market makers profit by acting as middlemen between buyers and selling, pocketing the spread between the bid and the ask price. A centralized limit order book lets buyers and sellers bypass the middleman while also eliminating the market makers' competitive advantage of seeing the buy and sell orders that most individual investors can't see. (In late July, the National Association of Securities Dealer [NASD], which runs the Nasdaq, adopted an "optional" central order book, a watered-down measure that must still be approved by the Securities and Exchange Commission.)

However, some large Nasdaq member firms have already started supporting ECNs, essentially competing with the Nasdaq itself. Virtually every major Wall Street firm has now taken an equity stake in some ECN. The latest move came July 21 when Schwab (NYSE: SCH), Fidelity Investments parent company FMR, and Donaldson, Lufkin & Jenrette (NYSE: DLJ) teamed up with NYSE specialist firm Spear, Leeds & Kellogg to form a jointly owned ECN which will basically be a revamped version of Spear's Redibook ECN. Schwab's Mayer & Schweitzer unit is one of Nasdaq's largest market makers, but Schwab was reportedly frustrated by Nasdaq's hesitancy in adopting extended hours. Schwab will soon be able to profit by offering extended trading via its own network.

Though the Nasdaq was first to broach the possibility of selling shares to the public, NYSE chairman Richard Grasso is now saying that the 207-year-old Big Board could go public first, perhaps as early as November. One major reason for the NYSE's haste is that it wants to use ECNs to siphon business away from Nasdaq while protecting its own traditional turf. The NYSE has been trying to buy or partner with various electronic networks, but it has run into roadblocks due to its current organizational structure. Getting the 1,366 NYSE seat holders to sign off on the deal would effectively spur the reorganization that would make nimble leadership possible.

On to Part 2