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Euromoney Electronic trading

Euromoney Electronic trading

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Published by Wayne H Wagner
Electronic Trading: Rival Or Replacement For
Traditional Floor-Based Exchanges?
Electronic Trading: Rival Or Replacement For
Traditional Floor-Based Exchanges?

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Published by: Wayne H Wagner on May 01, 2008
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Electronic Trading: Rival Or Replacement For Traditional Floor-Based Exchanges?Wayne H. Wagner Senior Advisor, ITG Solutions NetworkChairman, OM/NI, llc.4/30/2008 19:26:32 a4/p4
More so than for most human endeavors, speed, information, and reliability are valued inthe exchange of securities. Thus advances in automation and communication of vital dataclearly add liquidity value to investors, and exchanges have usually been among the first toembrace technological enhancements.Exchange automation began with the stringing of the first Atlantic telegraph cable in 1886,which reduced order-to-completion time cycles from six weeks to a matter of hours.Transaction latency reduced by a ratio of roughly 500:1. In recent years, we’ve seenincreases in speed of the same five-hundred-to-one order of magnitude by switching frommanual order submission to DOT, and similar speed enhancements as we move to fullyelectronic trading.Each of these innovations has reduced time delay (latency), decreased implementationcosts, and, by allowing investors to react to ever smaller nuggets of information, enhancedliquidity.The catchwords today are efficiency and effectiveness. The buyside is trying to better coordinate strategy and execution to make the process more effective and efficient. Thusboth buyside and sellside are driven to continual search for higher productivity and lower cost alternatives. Monitoring effectiveness before, during and after the trade is becominguniversal.The current debate rages over there remains any need for physical interaction at thecenter of the exchange process such as that which occurs on the NYSE, the only one of the big stock exchanges that still operates a floor.At year end 2006, news sources are filled with indications that the exchange and the floor community are hedging their bets: “Floor Brokers Look for Lifeboats;” “Big BoardSpecialists Join Forces to Deal Stocks on CBOE;” and, most impressively “Big BoardPlans to Close 20% of Trading Floor.” Barron’s features “Death of the Floor” as the cover story in its November 20, 2006 issue.Many believe that floors are obsolete, a premise the NYSE hotly disputes. They believethat the NYSE hybrid model represents the best of two worlds, and can do a better jobthan NASDAQ in trading less liquid stocks.
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Davis, Paul L., Michael S. Pagano, CFA and Robert A Schwartz, Life After the Big Board Goes ElectronicFinancial Analysts Journal, Volume 62 Number 5, 2006
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It seems too early to predict the demise of the physical trading floor, although the tide isclearly running against it. As Martin Sexton points out:The changes at NYSE and elsewhere show the way forward for all exchanges.Whether or not it follows the route of demutualising and listing, an exchange mustbe run as a business, not a club. Sentiment must be replaced by well thoughtthrough business plans that give customers – investors and traders – what theywant. Technology must be used to enable buyers and sellers to come together in aregulatory environment that ensures honest dealing but doesn't get in the way of growth. Exchanges that refuse to accept change must recognise that they have noright to exist and at best will end up as museums living off state subsidies – until thesubsidies are removed.
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 As Sexton suggests, demutualization plays a key role in changing the adaptability of anexchange. The original exchanges were mutual societies dedicated to the interests of thelimited number of participants. Naturally, voting power was retained by the memberswhose livelihood -- even their own sense of self worth – was tied to The Way Things HaveAlways Been Done. Seatholders would not chose to open the door that would lead to their own disintermediation and destroys their accumulated human capital. Thus the exchangewas run by the inmates; and attempt to innovate invariably led to tedious arguments,compromised decisions and vicious power plays.A good term for the activity that used to predominate on the floor is
information central 
:When there was interest in a stock, floor brokers would gather around the specialist towork things out. The floor brokers were representing institutional orders, although theywere usually bound to “best efforts” rather than specific instructions. The institutions hadvery little direct control; they relied on the relationship to and clout over the brokerage firm.They may not even know the name of the person representing their order in the crowd.The old NYSE design granted the specialist an enormous advantage of seeing more thananyone else could see about order flow. But the specialist’s role was conflicted –representing public orders while allowed to trade for his own account. This conflict wastightly constrained by Exchange rules, but history teaches us that the temptation to exploitloopholes never goes away. While actual cases of specialist malfeasance have beenremarkably few, each has left a bad taste in the mouths of institutional traders andregulators.The operative phrase describing the floor negotiations was “nobody looks bad.In other words, the price movements were controlled by the specialist so that everyone got a goodenough deal, presentable to the investors. The floor brokers placed a lot of faith in thissystem, but to the investors it looked mighty suspicious.
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The Handbook of World Stock, Derivative and Commodity Exchanges 2005 Edition.
 
The floor was quaint, it was fun, the relationships were rich and rewarding, the sense of being part of “the greatest market in the world” was intoxicating, and if you were any goodyou could make a handsome profit year after year. But to the customers it was opaque,slow, uncontrollable and prone to mischief. In a casino, the house always wins, and thenagging thought of institutional traders was that they were the suckers in this game.It is easy to understand the members’ desire to see the floor live on, in the same way it iseasy to understand nostalgia for steam trains. Walking onto the floor is a magicalexperience that thrills all who experience it. The pulse of action, the camaraderie, thesense that something immensely important is being conducted in a very clever manner cannot fail to impress. The problem of the exchange floor may be that of the steam train:while peculiarly both quaint and impressive, they were too noisy, too dirty, too slow, and,most importantly, technologically outdated.John Thain’s clever solution to this problem was to buy off the seatholders by buying themout. In a situation where seat prices had declined from $2.6 million to under one million,seatholders were attracted to a premium that recognized the value of corporate control.Substituting a corporate culture for the mutual benefit society gave the exchange theflexibility to innovate. The quid pro quo to the former members was an attempt to retain arelevant functionality for the floor in the hybrid market.Many observers conclude that the floor-based exchanges are outmoded: aren’t all marketplaces going to be electronic in the near future? Or not?Assuredly, the floor was a vital institution for centuries, evolving with the changing needs of its customers. The pace of change is quickening, calling into question the floor’s verysurvival. This raises some important questions: Does the floor still add value? Will itsurvive? Is the vaulted eye-to-eye interaction truly necessary? Or will the floor populationfind it more to convenient to operate the same functions in a computer-filled floor booth, inan upstairs office or at home in their pajamas?To answer these questions, we need to consider the value-added functions of anyexchange, and discuss how they have been allocated to the floor. We will explore thesteps that got us to where we are, then discuss what an ideal market might look like, andconclude with how close to ideal we are likely to come. In the process we will discusswhether a fully automated exchange is likely or desirable. By “fully automated exchange”we mean one in which the computer performs, among other automated functions, thedrawing of liquidity and price discovery.
Competition on Commissions, then on Spreads
Some might date the beginning of the demise of the floor (if that’s what it turns out to be) tothe regulatory changes that instituted fully directed commissions on May 1
st
. 1975.Everyone knew deep down that commission schedules based on retail-sized orders couldnot survive the rapidly growing domination of institutional trading, yet no one knew whatthe post May Day world would bring.3

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