NYSE Moves Toward Electronic Trading
August 9, 2004
Facing increasing pressure to overhaul its antiquated trading system, the New York Stock Exchange has proposed reforms that could encourage more electronic trading in listed stocks.
John Thain, chief executive of the NYSE, announced last Monday that new trading rules would create a hybrid market, one that blends the strengths of the open outcry system with the speed and efficiency of an electronic marketplace. Building on its Direct Plus order execution service originally launched in 2001, the NYSE hopes to ramp up the speed of transactions while maintaining accuracy and anonymity.
"In our hybrid market, we will provide for immediate, automatic execution against the best bid and the best offer to the extent of the displayed liquidity, without any restrictions on the frequency or on the size of orders submitted," Thain told reporters at a press conference.
In a regulatory filing with the Securities and Exchange Commission, the NYSE requested the elimination of the 1,099-share restriction on Direct Plus orders and the 30-second lockout period between orders executed from the same account. Currently, Direct Plus caters to the retail market by not allowing the large block trades institutions such as mutual funds often make. If approved, it would take the NYSE anywhere from six to 12 months to get the new electronic trading system up and running, Thain said.
The measures include the capability to "sweep" the order book 5 cents above or below the displayed price. If the sweep moves that price to its limit, automatic execution would cease and the specialist would intervene. Once new best bid and offer prices are established, the ability to revert to automatic execution would kick in again. Another amendment would create an "auction limit" order, which would provide customers the opportunity for price improvement with automatic execution.
"It's nice to see them moving in the right direction, but the devil is probably in the details," said Michael Plunkett, executive vice president and head of domestic brokerage at Instinet, regarding the new initiative. "Once institutional customers get a bit of a taste of electronic trading, I don't think they'll stop pushing the envelope."
An easing of these restrictions would enable large institutional investors like mutual funds to execute their orders automatically. With new developments in technology driving costs downward, big mutual fund houses such as Fidelity have threatened to take business away from the exchange. At present, the Big Board controls 80% of the market share for publicly traded companies. Fidelity declined comment until it has time to review the proposal thoroughly.
Aside from the cost, critics also argue that floor brokers slow down transactions and can't keep up with the fast pace that modern markets have come to demand. Fidelity and other big shops are concerned that they're not getting best execution on the floor and that orders often sit in a specialist's book unfilled. Given these conditions, institutional investors are less likely to place big orders because specialists inevitably step in front of the trade and lowball the order by a penny. In order to prevent this from happening, institutions will spread their trades around in smaller blocks across a number of different exchanges.
"The fact is people are getting a grip on what it means to their order, and it has real impact on performance," Plunkett said. "If every time you're down there you're losing a few cents to some other intermediary, at the end of the year, that's coming out of the investor's pocket. So I think they're becoming more concerned for the right reasons."
Under Thain's hybrid structure, specialists will continue to provide liquidity and make markets, interacting both on the floor and electronically. However, the specialists will be mostly relied upon to assume control over trading at the open and close of the session, when there is a burst in volatility. During the first and last hours of trading, volume is high, particularly when there is breaking news such as earnings surprises or economic or geopolitical events that disrupt the market. "Fully electronic markets cannot respond well to these types of events, and so prices whipsaw, and investors get hurt," Thain said.
Plunkett strongly disagrees with Thain on that point. "If stocks are, in fact, somewhat illiquid [to the point] where a large investor may have somewhat of a larger impact on a particular stock, then that's the nature of the beast," he said. "Capital markets should be allowed to flow where supply and demand takes them. It's a little naive to think that when stocks are whipsawing all over the place, that the specialist or any other market maker is going to take the other side of those trades."
The use of floor traders worldwide has greatly diminished in the last 20 years, with London abandoning the practice in 1986 and Australia clearing its exchange floor in 1990. The debate over which system is more efficient is a hotly contested one. The specialists argue they get the best price for the customer, whereas electronic trading platforms boast best execution, enabling its traders to move more nimbly.
The shift toward a hybrid market comes on the heels of the tumultuous last 12 months for the 212-year old exchange, one that included two high-profile scandals--one involving former NYSE head Dick Grasso's excessive pay package and the other inappropriate trading practices at five specialist firms.
"They've removed some of the limits, but [for the most part], they're still keeping them in place," Plunkett said. "It's hard to argue that those limits are not in place for any other reason than to protect the brokers on the floor."