08/10/98 THE 21st CENTURY STOCK MARKET

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THE 21st CENTURY STOCK MARKET
Ready or not, floorless trading systems are here
Amid the clutter of multicolored paper slips and the din of traders, tens of billions of dollars' worth of shares noisily change hands in a typical day at the New York Stock Exchange. A veritable army of 6,000 floor brokers, specialists, computer technicians, and miscellaneous clerks is required to keep the vast trading floor running smoothly.
Away from the exchange floor, however, a revolution in trading securities is under way that directly challenges the Big Board and other exchanges. A flurry of new trading mechanisms is about to transform today's largely antiquated exchanges into 21st century cybermarkets--floorless, global, and highly automated. The process is taking shape with a burst of activity that is surprising even the most jaded experts. Says Robert M. Greber, chairman of the Pacific Exchange: ''The changes of the past few months are so dramatic as to be unbelievable.''
Perhaps most notable is OptiMark, devised by market veteran William A. Lupien and defense industry consultant John T. Rickard. It's backed by several well-heeled investors, including Goldman, Sachs & Co., other major investment banks, and Dow Jones & Co. (DJ), which owns 15%. The system features a supercomputer that conducts highly sophisticated courtships between buyers and sellers in cyberspace, arranging matches in nanoseconds, without layers of floor middlemen. It will begin trading NYSE stocks in October on the Pacific Exchange and next year on the screen-based NASDAQ stock market, which predominantly trades high-tech issues.
OptiMark's imminent unveiling is only a small part of the whirlwind of activity. The last few months have seen a spate of mergers and alliances, with many exchanges either shutting down floors in favor of faster and cheaper screen-based systems or considering such a move. A sampler:
-- NASDAQ is planning to put its network on the Internet.
-- Chicago's futures exchanges are debating when, not if, to close their venerable trading pits.
-- MATIF, the Paris futures exchange, shuttered its pits eight weeks after introducing screen-based trading.
-- London's futures exchange agreed to put some contracts online after losing one of its biggest to Germany's electronic exchange.
-- Cantor Fitzgerald & Co. is seeking approval to trade U.S. Treasury bond futures online.
-- The American Stock Exchange's acquisition in June by the National Association of Securities Dealers set off other combinations, including the merger of the Pacific Exchange and the Chicago Board Options Exchange, which are now exploring screen-based options trading.
-- The NYSE is considering linking with exchanges in Canada and Latin America and has opened talks with the Paris Bourse. NASDAQ's parent is having similar talks with Frankfurt and London.
-- The Securities & Exchange Commission, in a reversal, has proposed to let alternative trading systems operate with minimal oversight. ''Now, our basic philosophy is to get out of the way, while still providing investor protection,'' says Chairman Arthur Levitt Jr.
As cybermarkets emerge, they could have profound effects on every American with assets in the stock market, every publicly traded company, every securities industry employee, and countless investors. Electronic trading will also transform overseas markets. The changes they bring will be both disruptive and liberating.
Although the future is far from clear and tricky questions of global regulation and investor protection remain to be solved, the outlines of the 21st century's securities markets are becoming evident. Exchange floors will be little more than showy frontispieces. Exchanges won't be run for the benefit of a membership cartel because there will be no seats. Instead, they will be run like a business and may even be publicly traded. With the advent of electronic trading systems, there will be more choice among trading methods. Exchanges will be integrated globally through high-speed data lines and satellite uplinks. Many markets will simply migrate to the Internet. ''One has to question whether we need exchanges in their current form,'' says former SEC commissioner Steven M.H. Wallman. ''Why maintain a floor for what is essentially an electronic business?''
Most large companies will list their shares globally and trade round the clock. The cost of raising capital could decline as the Internet makes it easier to distribute shares of initial public offerings and as more investors pile into the market. For investors, the risk of default will be reduced by instantaneous settlement of trades instead of the current three days. In a few years, it will be as easy and cheap to buy IBM from Budapest as it is from New York.
Already, the NASD is looking to move NASDAQ into cyberspace despite inadequate security and huge problems with the Internet's limits on capacity. ''I have no doubt that investors will trade NASDAQ stocks over the Internet in a few years,'' declares NASD President Richard G. Ketchum.
The NYSE is also investing in new technologies, but they will be grafted onto a process that involves lots of real people. ''Our customers want a broker and not a mailbox to receive their order and see that it gets executed,'' says NYSE Chairman Richard A. Grasso. Still, he warns his members that ''the real challenge is to define their relevance in a world of technology.''
CONTROL FREAKS. Why the rapid-fire changes, and why now? A big factor is the Internet, which has attracted droves of novice investors and created an entirely new industry of online brokers. In 1996, there were only 1.5 million online brokerage accounts. That number is expected to explode to 5.3 million by the end of 1998. Such accounts are now responsible for 25% of all retail trades. By 2002, there will be 14.4 million online accounts, with $688 billion in assets, reckons Forrester Research Inc. analyst Michael Gazala.
Already, 74 Internet brokers offer quick trades, real-time quotes, access to research, and even portions of IPOs--at rock-bottom prices. But investors are clamoring for access to markets beyond national borders and more control over their orders. They don't just want to place their orders through an electronic broker, they want to access markets online. ''It gives me more confidence when I can place an order and see it reflected immediately in NASDAQ's [buy and sell] quotes,'' says Timothy E. Brog, a New York-based small-business consultant.
The NASD recently gave its blessing to market makers who want to provide pension and mutual funds with direct access to NASDAQ. Market makers are professional traders who put their own capital behind their buy and sell quotes on the NASDAQ system. Retail investors can already do the same through Datek Online, whose Island trading system lets investors place orders directly into the NASDAQ system. ''Millions of people will be negotiating the price of securities, and not just a few powerful NASDAQ market-makers or New York specialists,'' says Jeffrey A. Citron, the 27-year-old chairman of Datek Online Holdings Corp. (Datek Online has disassociated itself from Datek Securities, some of whose founders are under SEC investigation.)
As cybermarkets evolve, Wall Street firms will have to make big adjustments. Some jobs will be lost, especially among floor brokers. Full-service brokers who work out of branch offices will have to shift their revenue base from transactions to advice. ''Brokers must learn to add value by giving their customers more personalized advice and relying less on transaction fees,'' says SEC Chairman Levitt. ''The firms that don't recognize that are going to be out of business.''
HARD TRUTH. Some investment banks will distribute underwriting deals such as IPOs through online auctions, which will make distribution faster and cheaper--but may also entice new rivals to offer lower fees to issuing companies. ''The changes that will hit us over the next 10 years will be profound,'' says John W. Bachmann, managing partner of St. Louis-based Edward Jones, whose 4,200 investment advisers cater to the retail market. ''The Internet will reveal that lots of what we think are value-added services are really commodities.''
Cybermarkets also could have implications for major financial centers, since their economies could be at risk if securities firms stop concentrating in big cities where current markets are located. ''With the globalization of markets and the trend toward electronic trading, traders and investors can move their trades anyplace in the world,'' says Brooksley Born, chairwoman of the Commodity Futures Trading Commission. ''Their location in a financial center becomes less significant.'' NASDAQ's data center operates out of an unprepossessing building in a Trumbull (Conn.) business park.
The online onslaught already is driving down the value of exchange seats. Seat prices in New York have plummeted 32%, from a record high $2 million in February to $1.35 million, while a CBOT seat's value has plunged 52% from a year ago. Online brokers' commissions also have been cut to shreds, averaging under $16 a trade, down from almost $53 in 1996.
Large securities firms aren't yet fully embracing the Internet. Instead, they are gingerly testing the waters. ''They're being conservative out of fear they'll cannibalize their existing brokers,'' says Piper Jaffray Inc. analyst Stephen Franco.
With more than 14,000 brokers working out of 701 branch offices, Merrill Lynch & Co. (RUM) isn't shy about moving its services online, but only clients who invest at least $100,000 can get access to it. This fall, they will be able to send trading orders directly to the NYSE floor or the NASDAQ network, commission-free. But Merrill will not compete with discount brokers, insists Vice-Chairman John L. ''Launny'' Steffens. ''Executions may be commoditized, but advice will never be,'' he says.
HUMAN TOUCH. The market renaissance puts the NYSE's Grasso in a delicate position. Although the NYSE is the biggest exchange, it's in danger of becoming the most costly. Neither Grasso nor his members are technophobes: They've spent $1 billion since 1994 to speed up delivery of orders to the floor. But they insist that only humans can perform the complex alchemy involved in matching buyers and sellers.
And Grasso's open-mindedness only goes so far. He refuses to let OptiMark use an existing network, the Intermarket Trading System, to gain access to the NYSE's order flow. ITS is a data network created by Congress in 1975 to connect the NYSE to the seven other U.S. exchanges. If OptiMark's orders can't interact with the NYSE's, it may never attract enough investors to get its system up and running. As Grasso sees it, OptiMark shouldn't be able to piggyback off his exchange's business.
OptiMark's Lupien figures Grasso has to resist because of the makeup of the NYSE's membership: Of 1,428 members, 479 are floor specialists and 365 are independent floor brokers. ''Our system threatens more than half the voting membership,'' says Lupien. ''It's no wonder they're fighting.''
Unable to resolve their dispute, the warring parties have tossed the ball to the SEC, which is seeking industry comment on why it shouldn't let OptiMark get the access it wants. Most industry observers believe Grasso is less concerned about OptiMark than the precedent it would set. If OptiMark is allowed to use ITS, other alternative trading systems might pile through the door. Datek's Citron admits he would be among them. ''Dick Grasso has lined up his tanks against us,'' he says with a scornful laugh. ''And he should.''
The online revolution will create winners and losers, but most experts believe retail investors will be among the winners. Gregor S. Bailar, NASD's chief information officer, envisions a day--perhaps just a few years away--when retail investors will use personalized stock markets to help manage their portfolios. Using advanced software, investors will seek out the securities that they want for their portfolios as well as the exchange that offers the cheapest execution and the investor's preferred trading method, Bailar says. It might be an online auction for shareholders who want to trade directly with each other, or it might be NASDAQ's dealer market or a link to the Euromarket. NASDAQ plans to offer them all. ''We'll become an Internet portal site, offering a market of markets,'' says Bailar.
While retail investors will have more control over their orders, institutional investors will continue to drive the markets. And new trading systems such as OptiMark could make their jobs a lot easier, says Peter Jenkins, who most weeks handles 8 million shares as head of global trading for fund manager Scudder Kemper Investments Inc. OptiMark's supercomputer lets a portfolio manager who wishes to sell 500,000 shares of General Electric Co. (GE), for example, put in an order to sell at the market price of $150, but indicate a willingness to shave off a quarter-point, to $149 3/4, if the whole lot could be unloaded at once. Likewise, the system would find a buyer who wants GE shares, but not at the market price. Because of its ability to tease out trades that otherwise would remain hidden--and to do so anonymously--Jenkins expects volume to skyrocket.
Currently, large institutional traders play a cat-and-mouse game with orders. They can't afford to show a large order or the market will move against them. But nor can they afford to wait too long to pounce or they won't get the shares their portfolio managers need at the prices they want. If the cost of delays and missed trades can be reduced, says Jenkins, the cost of trading will drop and investor returns will improve. ''This is really very exciting,'' says Jenkins. ''There's nothing else like it out there.''
But some view the cyber-market revolution more with trepidation than excitement. At the Paris futures exchange, Marche a Terme Internationale de France (MATIF), officials began an experiment with screen-based trading last April with the thought that, after a year or so, the markets would decide whether screens or open outcry were superior. Within two weeks, the market picked electronic trading--and now some 100 MATIF employees and 600 floor brokers are out of a job. ''They want us to trade electronically, [but] it is not the same profession,'' says Eric Boutigny, one of MATIF's top traders. ''This way of life is finishing. I have to look for other work.'' All received generous severance packages for up to two years' salary and an additional 18 months' unemployment allowance. ''We did things the French way,'' says a MATIF official. ''When it happens to Chicago, there will be a massacre.''
''OMENS.'' That possibility was not lost on the Chicago futures markets, with their 10,000 traders and 140,000 additional workers. The Chicago Board of Trade, for example, is frantically preparing its electronic exchange in the face of new competition from broker Cantor Fitzgerald, which is seeking CFTC approval to trade U.S. Treasury bond futures online. ''We're not going to be like Julius Caesar and ignore the omens,'' declares CBOT head Patrick H. Arbor. ''We will defend our market share.'' Indeed, the CBOT's board on July 28 voted to allow electronic trading alongside open outcry, starting Sept. 28. First, though, the CBOT most convince its members, many of whom oppose letting screens in. The CFTC's Born declines to indicate whether she will grant permission to Cantor, but says there is nothing in her agency's mandate that allows her to stop new technologies to protect jobs.
What Arbor and other LaSalle Street mavens fear most is that while they are concentrating on beating their local competitors, Europe's exchanges are plotting an invasion. Germany's Deutsche Borse now has 17 member firms with terminals on U.S. traders' desks. Deutsche Borse and others are doing limited trading in German government bond futures and are seeking regulatory permission to expand the program. That could siphon away significant market share. Europe's equity exchanges are also a threat to American ones. They have leapfrogged the NYSE and NASDAQ, according to Douglas M. Atkin, chief executive of Instinet International, because they began closing floors and automating 10 years ago.
Take the highly advanced Stockholm Stock Exchange, the first to go public and to give member firms remote access. Stockholm-based OM Gruppen, which owns the exchange, also owns Sweden's derivatives and commodities markets and has joined forces with Denmark's bourse. ''This is just the first step in our ambitions to create a Nordic trading platform,'' says CEO Lars Bredin. The Swedish exchange is discussing an alliance with Finland and Norway and has begun selling its off-the-shelf trading technology to exchanges in Australia and elsewhere. If the SEC allowed it, the exchange would have its system installed on U.S. brokers' terminals tomorrow.
INVESTOR POWER. The SEC isn't quite ready to let that happen, but clearly it's in the mood to experiment. For years, the regulatory agency was a bulwark against market restructuring. Levitt is giving the green light to new systems as long as they comply with the investor-protection and antifraud rules. Even more far-reaching, the SEC last year required NASDAQ market makers and electronic systems to display customer orders in the main NASDAQ network.
Almost overnight, NASDAQ became more open and understandable. Liquidity, or the measure of how easy or difficult it is to trade a stock, increased. And the gap between buy and sell orders shrank, transferring $25 billion from NASDAQ dealers to investors. ''The single most fundamental change to the equity markets in the last 20 years has been the SEC's order-handling rules,'' declares Datek's Citron.
However, regulators can't rest yet. For global markets to become a reality, they must coordinate investor-protection and antifraud regimes, which vary greatly by country. The SEC, for example, insists that only foreign securities registered with the agency may be sold in the U.S. And to register, foreign companies must comply with American accounting standards, which are stricter than most countries' and have the effect of lowering profits. Grasso and others are lobbying Levitt to accept less strict international rules, but so far those efforts are in vain. Says Levitt: ''I'm absolutely dead set against diminishing the quality of any of our accounting standards.''
Even the SEC's best and brightest aren't sure where the revolution in cybermarkets is headed, and the hidden dangers worry them. OptiMark, for one, has its disadvantages. Orders sent to the supercomputer aren't displayed anywhere, and that could deprive the markets of crucial information. If cybermarkets cause the disappearance of intermediaries--the NYSE floor brokers who interact with the specialists who match the trades, or the NASDAQ market makers who commit their own capital--markets could be hurt.
MISSING BUFFER ZONE. This is especially true if the bull market suddenly turns bearish. In a down cycle, ''the need for intermediaries to provide liquidity becomes paramount,'' says John N. Tognino, chief executive of the Security Traders Assn. ''You can hide a multitude of sins in a bull market.'' And online traders, many of them new to the stock market, could be left holding shares that have lost most of their value and can't be unloaded. Even now, studies show that online traders are getting below-market rates of return. This may be happening because they're trading too much. ''It's cheap and easy. Press a button, and off it goes,'' says Merrill Lynch's Steffens. ''The ability to trade for the sake of trading doesn't produce good results.''
And there are more than a few naysayers. While many exchanges are shutting down their floors, the NYSE is looking for a new building so it can almost triple floor size, to 100,000 square feet. Even the NASD is hedging its bets. ''I don't think floors will disappear,'' says Amex President Thomas F. Ryan Jr. Next year, Amex will have an electronic order delivery system, but the exchange won't be closing down the floor or getting rid of its floor specialists, Ryan insists.
Still, technology has opened up abundant new opportunities for companies that sell securities and investors who buy them. Just exactly where this wave of remarkable change sweeping the financial markets is going is unclear, but few doubt the momentum is unstoppable.
By Paula Dwyer in Washington, with Andrew Osterland in Chicago, Kerry Capell in London, and Sharon Reier in Paris

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