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The Tremors From Two Trading Titans


When the heads of the New York Stock Exchange and NASDAQ announced plans to buy the electronic upstarts that have been eating their lunch lately, there was much talk of how the deals would benefit investors. "We will be more innovative and more efficient," NYSE head John A. Thain promised. "We will offer our customers more choice." And NASDAQ Stock Market Inc. Chief Executive Officer Robert Greifeld said: "Investors will be better served."

They may well be. If the optimists are right, the drive by computer-savvy mavericks at Archipelago Holdings Inc. and Instinet Group Inc. (INGP) to lower costs and speed up trading may even get ratcheted up a notch. Certainly, the battle between the two juggernauts, strengthened by the electronic insurgents, will heat up. As the NYSE goes public, it will be accountable to a broad group of shareholders rather than just the members who now run it. What's more, concentrating buyers and sellers in two places, instead of letting them scatter in several trading sites, should make for deeper and more robust markets.

Just how the deals will play out isn't yet clear. The NYSE's plans to merge with Archipelago could even be thwarted by rival bids, perhaps by Wall Street firms annoyed by the prominence of Goldman, Sachs & Co. (GS) as a big stockholder in Archipelago and adviser to both sides in the deal. The regulators, too, must still have their say, and the conditions they impose could impede progress or accelerate it. The fate of the NYSE's much-criticized floor also is up in the air, even as executives of both the exchange and Archipelago vow to stick by it.

But there are reasons to believe that the changes they have helped drive can't be stopped, even as the upstarts become part of the Establishment. For one, institutional investors such as mutual and pension funds will resist any backsliding. And they're in a position to get what they want. If spreads, the difference between the buy and sell prices of stocks, begin to widen from the mere pennies they often are now, the institutions could move their business elsewhere. Thriving, albeit smaller, alternative electronic systems, such as the Liquidnet Inc. and POSIT block-trading operations, would gladly take more of their trades. So, too, would brokerages that could match buy and sell orders internally among clients -- though the Securities & Exchange Commission will require them to match the best prices offered. "Our own institutional customers have been very clear about the desire for more control of the trading process and more innovation," says Ian Domowitz, head of research for Investment Technology Group Inc. (ITG), the brokerage that runs POSIT. "I don't believe the consolidation will interfere with the customer demand."

GIANT SINGLE MARKET?

Certainly, the behemoths that emerge from these deals have every reason to compete more vigorously. They will now play in each other's backyards, with both Archipelago's ArcaEx exchange and Instinet providing electronic venues where investors can trade both NASDAQ- and NYSE-listed stocks. Arca plans to operate separately from the NYSE floor, so investors can choose which venue they prefer -- opting for quicker electronic execution, for instance, if speed is their biggest concern. NASDAQ plans to mesh its operations with Instinet over the coming year to form a single market. Both deals will "allow people to come together to get better prices and liquidity," says Terrence Hendershott, an assistant professor at the University of California at Berkeley's Haas School of Business.

Some boosters of the deals contend securities markets are natural monopolies. Unlike other industries, they can work better for their clients -- investors -- when they consolidate. That brings more buyers and sellers together, theoretically making for better prices. "Would we be better off if we had 10 equally sized auction sites or better off because buying and selling is concentrated on eBay (EBAY)?" asks Hendershott. "As long as eBay's [fees] don't get too high, we are better off that way."

Looking beyond the proposed mergers, some market players say they expect a single giant exchange to emerge eventually -- though there would be plenty of debate over whether that would best serve investors. Advocates particularly like the NYSE-Archipelago deal because it will give investors a single place to trade options and exchange-traded funds, as well as stocks. Archipelago is closing on its purchase of the Pacific Exchange, which will help it move into options. Harold S. Bradley, a senior vice-president at Kansas City (Mo.)-based American Century Investments, a big mutual-fund house, predicts "national convergence, where options, futures, equities, and derivatives are traded on the same platform."

So long as outside innovators are allowed to thrive, concentration may not be a worry. Recently, most innovation has come from outside NASDAQ and the NYSE. Regulators will likely be pressed to make sure that the mergers and the rules they establish around them don't inhibit outsiders' creativity, which so far the SEC has encouraged. "The SEC has removed most of the barriers to entry and competitiveness in this business," says University of Southern California finance professor Lawrence E. Harris, recently the SEC's chief economist.

No doubt, the deals will drive change at the NYSE. The Big Board hopes that its planned hybrid market -- bringing faster electronic execution of trades to the hallowed floor -- will preserve its open-outcry auction and the specialists who handle transactions rather than just letting buyers and sellers square off. But if the hybrid can't match the performance of Arca, the floor could give way to a fully computerized future. "The floor has to fail at this point," says economist Harris.

EVOLVING SPECIALISTS' ROLE

And yet, thanks to the merger, the specialists may find their role evolving. In an Apr. 24 SEC filing, Archipelago said it plans to upgrade its electronic system to allow market makers to offer prices that improve on posted buy and sell prices, as specialists now do. Archipelago President Mike Cormack says the change would be a selling point for Arca.

Even though executives at Archipelago have been fierce critics of specialists, they and NYSE leaders have said they'll keep the floor operating. The specialists help the market by being ready to buy or sell stocks when other market players aren't. Eventually, they could wind up handling mostly lesser-known stocks. "Where the floor is going to add most value will be in small, less liquid issues and in large block trades," says William F. Cline, a managing partner at the Accenture Ltd. (ACN) consulting firm. "Will enough critical mass remain on the floor? I don't know. It'll be fun to watch."

For investors and regulators alike, there will be plenty to look for in coming weeks. Will investors be better served by the mergers in the end? Probably. But they should watch closely to be sure. By Joseph Weber in Chicago, with Mara Der Hovanesian in New York, and Amy Borrus and Mike McNamee in Washington


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