John Thain, CEO of NYSE Group
The early stages of the strategy are progressing well. Last week's results revealed net income of $68 million for the NYSE's third quarter, a year-on-year increase of 209%, with pre-tax operating margins doubling to 26%. But there are many moving parts to the strategy. Pulling it all off as planned will require lots of things to go right -- especially technologically -- and there will be political risks as well. Let's look at the individual parts.
Hybrid hits the Street
In the U.S., the most recent initiative is the NYSE Hybrid Market, the new trading system that came about in response to the SEC's Regulation National Market System (Reg NMS), which levels the playing field for investors by providing equal access to prices and mandating trade execution at the best price. It got its name for combining automated trading with intervention from human specialists, when a matching best price can't be located electronically.
The Hybrid is currently being tested on 91 listed securities, with plans to have it completed by December. Given that the NYSE has more than 2,700 listed issuers, there's still plenty of work ahead.
As the NYSE commented on its results call, the Hybrid is slower than Nasdaq's Instinet system and even the NYSE's own Archipelago platform. That raises the question of why the Archipelago platform wasn't used, and the likely answer is that Archipelago was designed for full automation, which would preclude specialist participation in a trade. Those genes again!
Yet even a successful technology implementation of the Hybrid is likely to diminish the specialist role. The most probable outcome is fully automated trading of large, liquid stocks, with specialist participation in small, illiquid stocks. And this is the optimistic scenario. The pessimistic one involves the NYSE losing market share because its compromise Hybrid system loses out to faster trading systems at the Nasdaq (Nasdaq: NDAQ) and other competitors.
Securities across the U.S.A.
In addition to working on the Hybrid, the NYSE's technologists are laboring on finishing the integration with Archipelago. Plus there's the new NYSE Arca Options platform that got rolled out earlier this month. Incredibly, the technologists have also been working on moving the NYSE's Automated Bond System (ABS) to a new fixed-income platform. The NYSE has applied to the SEC for permission to trade most of the corporate bonds issued by companies listing on the Big Board. Doing so would take the NYSE into the competitive territory of electronic debt-trading venues such as MarketAxess
Preserving Paris
The grandest part of the strategy takes us to Paris, where the NYSE wants to merge with Euronext. Shareholders from both companies are scheduled to vote in December, with the deal targeted to close in the first quarter of 2007. Regulatory risk on the deal has dropped with the SEC confirming that after the merger, Euronext will continue to be a company that is not an issuer under the Sarbanes-Oxley Act. As such, SEC rules will not apply to Euronext.
Political risk remains, especially with the publication of a report sponsored by Paris Europlace -- an organization charged with promoting Paris as a financial center. This report, led by Henri Lachmann, a prominent French industrialist, makes the extraordinary recommendation that Euronext acquire the cash-equity businesses of Deutsche Borse and Borsa Italiana before any merger with NYSE. Ominously, the report observed, "consolidation of stock markets raises issues that go beyond the admittedly legitimate interests of their shareholders." French Finance Minister Thierry Breton liked the report, and he is part of the approval process for the deal. So the risk of patriotic and political pressures smothering the merger is very much alive.
Assuming the Euronext deal gets done, substantial execution details -- especially technological risks -- will dominate. Of the projected annual savings of $275 million from the merger, $250 million is slated to come from technology. Forecasted revenue synergies are less than half, at $100 million. Technology drives this deal and the future of NYSE.
Distracted in New York
The difficulty of achieving the technology savings is being underestimated. An investor presentation on the Euronext website, billed "Creating the First Global Exchange," smoothly proclaims that Euronext and the NYSE will combine their IT organizations and leverage the outsourced, joint venture model used by Euronext. This approach would be consistent with the ongoing restructuring of the NYSE's subsidiary, the Securities Industry Automation Corporation (SIAC). Yet it is inconsistent with comments from the NYSE's chief technology officer, Steve Rubinow. When asked in an Oct. 6 Computerworld article what had been determined so far on how the merger between the NYSE and Euronext will affect IT operations, he responded: "Not very much. Hybrid is still very much front and center."
This creates two risks. First, the Hybrid -- along with all of the other technology initiatives -- is dominating the attention of NYSE's technologists, to the detriment of planning how to realize savings from the Euronext merger. And, second, the clash of technology philosophies -- Euronext uses a completely outsourced model, whereas the NYSE uses its in-house company, SIAC -- will complicate post-merger integration.
Tokyo is too far
As every strategist knows, no modern strategy is really grand unless it has an Asian component. So last Friday, the Tokyo Stock Exchange revealed that it had recent discussions with the NYSE about an alliance or possible business combination. Some kind of link-up is possible, as early as next year.
Explained in 730 pages
To support the Euronext merger, the NYSE filed the longest SEC prospectus this Fool has ever seen -- 730 pages. It's a fine piece of work, and it's also a sign of how complicated the NYSE Group and its strategy have become. The risk section makes the stunning understatement that the combined group "may have to integrate the businesses of the NYSE, Archipelago, SIAC, and Euronext simultaneously, which may be difficult."Difficult . and this does not even count the Hybrid system, bond and option expansion, and links with the Tokyo Stock Exchange!
In sum, the NYSE is, so far, transforming itself effectively, but investors need to watch for hard evidence of down-to-earth execution, especially on the technology front. Investors in trading infrastructure companies who have less taste for grand strategy might look at the International Stock Exchange
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NYSE became a Motley Fool Rule Breakers pick when it merged with Archipelago Holdings. Since its recommendation, it has beaten the market by 240%. Learn more about investing in disruptive technologies by trying out Rule Breakers free for 30 days.
Fool contributor John Finneran writes and advises on the financial value of technology for managers and investors. He does not own any of the shares mentioned. The Motley Fool has a disclosure policy .
