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August 10, 1999

Are the Public Markets Going Public?
Part 2

by Louis Corrigan (TMF Seymor)

All of this talk is surely quite puzzling to most individual investors, who tend to think of our public stock markets as pretty much faceless, disinterested mechanisms that allow stock transactions to take place between various market participants. Since the markets are ultimately overseen by the SEC, they may almost seem like quasi-government structures. Yet, in fact, our major public stock markets are private, mutualized institutions controlled by their members. For example, the Nasdaq and American Stock Exchange are both owned by the National Association of Securities Dealers (NASD), which is owned by its member firms. So stock markets are not just vehicles for making capitalism run smoothly, but institutions driven by the imperatives of hundreds of capitalists who have banded together in mutual self-interest.

These markets strive to generate revenues and profits, partly by attracting new public companies willing to pay to "list" their shares, and partly by keeping trading in those companies' shares "in house," among the members of the market. The NYSE, for example, reported 1998 revenues of $728 million (mostly from fees collected from the 3,000 companies whose stocks are listed on the exchange) and net profits of $101 million. As business enterprises, markets try to attract new customers, create new products, spruce up their systems, and market themselves to maintain their competitive position.

They're pretty much akin to what your local mall would be like if it were owned by the merchants that sell goods there. Though the merchants may compete with one another for business, they tend to benefit if the mall itself remains a popular destination for shoppers. In general, then, the value of these merchants' businesses will rise or fall with the mall's ability to continue to attract customers. Just as that mall needs to respond to a rival mall that opens across the street, America's major stock markets are scurrying to reorganize so they can address the new challengers.

Hurdles remain for both the NYSE and the Nasdaq. The NYSE, for example, has asked the Internal Revenue Service to rule on whether members who convert their exchange seats into an equity stake in the planned public company (and a license to trade on the Big Board) will incur taxable capital gains. That's important given that the price of seats on the exchange has soared from around $100,000 some 20 years ago to $2.5 million today.

Exactly how the markets will be regulated in the future remains a pressing concern, particularly with SEC chairman Arthur Levitt, who noted July 26 that any changes must assure protection for investors and a fair market. NYSE chairman Grasso seems to think the Big Board could still police itself, but regulators need financial support to do their jobs, and a publicly traded NYSE would have to justify that expense to its owners. Such an arrangement just seems likely to create too many conflicts of interest between NYSE stockowners and the owners of the stocks that trade on the exchange.

For its part, the NASD is preparing for a private placement followed by an IPO that would leave it with minority control of Nasdaq but total control of NASD Regulation (NASDR), the market's regulatory unit. Funds raised in any private placement (perhaps hundreds of millions of dollars) would help finance the NASDR. Some commentators have argued that the NASDR ought to be merged with the NYSE's regulatory office, or that their market surveillance responsibilities should at least be divvied up. The SEC is likely to influence the outcome here, but the current divisions probably will no longer make sense in the near future, as the barriers between markets become increasingly blurred.

Most individual investors are not likely to notice any obvious changes if and when the NYSE and Nasdaq go public. However, coordination between the various markets will probably become even more challenging as legacy systems require substantial upgrades to embrace digital technology and keep up with increased electronic trading. Also, traders will probably find that one ECN offers measurably better trades than another because it's gathered the heaviest trading volume.

Over time, however, the various costs associated with trading should continue to decline as the markets for stocks become more competitive and more efficient. Indeed, increased competition between exchanges may channel trading to the best system for a given issue, perhaps allowing ECNs to rule when it comes to high-volume, large-cap stocks while channeling less liquid names to systems managed by specialists and market-makers, whose mediation will add value.

There's certainly some "brand" cachet to the NYSE and Nasdaq that should give these players an edge. Liquidity gives them an even more tangible advantage today. Still, it's not clear that either currently has the systems or organizational structures in place to really outperform the upstart ECNs over the long term on the key areas of execution and price.

Indeed, in the parlance of e-commerce, the major stock markets are being "Amazoned" by new players that are building their businesses from the ground up to serve pure electronic trading needs. The digital revolution is now reshaping Wall Street itself, setting off a new round of innovation and price competition that's transforming the most fundamental structure of free market capitalism -- the capital markets themselves.

Back to Part 1


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