The fierce competition among North America's stock exchanges
Never before have American listed companies had so many choices. With exchanges pounding the highways, luring new listings business with promises of greater liquidity, better IR services and improved products, it's not surprising that many companies, domestic and foreign, are confused. Meanwhile, US regulators and stock market administrators have their work cut out to maintain America's standing as the world's leading capital market.
The SEC, and the securities industry in general, are proud of the role the US market has played as a global driver for capital formation. The SEC would defy anyone to point to a more efficient market structure. But all is not perfect in Shangri-la. The market must evolve to meet new challenges and new technologies. And everyone agrees that North America's exchanges will change dramatically in response to the SEC's Market 2000 initiative.'The US capital market provides the greatest degree of liquidity in the world,' says Robert Greber, president of the Pacific Stock Exchange (PSE). 'But technology makes it easy for capital to shift. We could be blindsided by new systems and concepts that allow pockets of deeper liquidity to occur elsewhere, hurting our markets. We have to adapt to the demands of global markets.'
Besides, sceptics may take the SEC up on its dare to find a better market, or at least a less controversial one. The traditional US exchanges accuse alternative markets, including proprietary trading systems, of poaching on their turf; the regionals are clamouring for more trading privileges on NYSE and Amex stocks, as well as new products; and there is even a Justice Department probe into alleged price-fixing on Nasdaq.
Nevertheless, even the most doubting observers would be hard pressed to find a superior market. Take the NYSE, the world's largest, where in May total capitalisation hit a record $5 trillion, topping Tokyo by $300 bn and up from $4 trillion three years ago - when Tokyo held top spot.
'After 200 years of equity market history, the number of companies listed in the US has doubled in the last decade,' says Edmund Lukas, vice president, international business development, at the NYSE. 'The appetite for capital of American investors is unmatched anywhere, and their thirst for non-US stock is growing as well. This is the largest capital pool in the world - it needs a home, and it's finding that home worldwide.'
'Despite far fewer IPOs this year, down around 40 per cent from 1994, this is a very robust capital market,' says John Wall, executive vice president of market and market services at Nasdaq. 'America still offers a market that is unparalleled in providing capital. While IPOs are down, we will continue to see a tremendous number of secondary offerings for established companies, and the strength of the US market will continue.'
With fewer listings, the battle to attract companies is heating up. Last year, 119 IPOs listed on the NYSE, with another 52 foreign companies joining the ranks. But the NYSE faces a critical test as many more IPO companies choose Nasdaq. Having taken the world's top spot for trading volume for the first time in 1994, Nasdaq's capitalisation is now $886 bn, while Amex continues to lose ground, currently with $129 bn.
Heightened competition among stock markets is raising the quality of the market for both issuers and investors. The primary exchanges are dogged at every step by the regionals, who have unlisted trading privileges for NYSE, Amex and Nasdaq stocks under the auspices of revamped technology and the national market system.
More than any other, the PSE has maintained the flavour of a regional exchange, capitalising on the Golden State's numerous emerging companies and savvy investors. 'Our exclusively listed companies look very different from our dual listings,' says Greber. 'They tend to be smaller and in industries that are familiar to investors on the West Coast, like microbrewers or ecology-oriented companies.'
In May, the PSE won SEC approval for a programme giving smaller companies greater access to capital by allowing them to list two classes of small business security: Small Corporate Offering Registration (Scor) and Regulation A (Reg A). With a streamlined application process and reduced filing fee, Scor opens the door to small businesses which cannot meet requirements for large company IPOs. They can raise up to $1 mn a year with Scor, saving up to $100,000 in legal and underwriting fees.
The PSE also has a 'regional loyalty' marketing programme which targets Californian and western institutional and retail traders and brokers, as well as pension funds. At one time, institutional order flow accounted for only 5 per cent of PSE trading volume; it's now nearer 20 per cent.
But the biggest challenge for exchanges may not come from each other but from the brokerage firms on their own trading floors. With shrinking commission rates and falling profits, many large firms are filling the traditional role of specialists, matching buyers and sellers of listed stocks. That's fine for the IROs or investors interested in trading an issue, when liquidity is welcome in any form. For a primary exchange, though, the word fragmentation comes to mind.
Take Charles Schwab & Co, the biggest US discount broker, which has snapped up nine specialist firms on the PSE since October. This allows Schwab to make markets in Big Board stocks away from New York - in AT&T, General Electric, DuPont, and 420 others; and over half of its electronically generated order flow in these stocks is routed to the PSE.
An anomaly among regionals, the PSE has a strong retail base and does more trades in a day than any exchange except NYSE. To cater to the little guy's tastes, the PSE has eagerly cosied up to discount brokerages like Schwab, and followed Cincinnati's lead in allowing more than one market maker in a stock to compete for order flow.
To NYSE and Amex, this means lost business. The Big Board may go on setting records, but its trading share in its own stocks has started to slip. In April, only 68.2 per cent of the volume in NYSE stocks traded in New York, down from 70.9 per cent in January, and from an all-time high of 98 per cent. Most of that erosion is in small orders.
This trend to specialist trading has helped some regional exchanges, as well as the pilot Cincinnati Stock Exchange, which is actually in Chicago and not a regulated exchange. Cincinnati lets dealers trade against their retail order flow - a contentious issue - and has seen volume climb from 1.2 bn in 1993 to 1.5 bn last year.
Other regionals are setting up similar systems. Chicago Stock Exchange (CHX) applied to the SEC to start an electronic marketplace called the US Stock Exchange; and last year the Boston Stock Exchange launched its Competing Specialists Program. Boston says this is nothing like Cincinnati's, but member firms routinely compare the two.
Why the Big Board exodus? The short answer is broker profit. SEC Rule 19c-3 permits brokerage firms to trade Big Board stocks listed after 1979 out of the firms' inventory - known as upstairs trading. On the other hand, a customer order to buy stock on the Big Board is sent to the floor to meet other customers and match with a sell order by a specialist. By avoiding the Big Board, brokers get commissions from both the buyer and seller. Perhaps more important is the profit scored from wider spreads.
Good news for the broker, but what about the investor? Fidelity, one of the largest US fund managers, sees no problem, noting that customers get a better execution even when orders are filled outside New York. And if Fidelity isn't complaining, it's unlikely that many other investors will.
'Regionals are liquidity providers,' says William Lee, the senior vice president of customer service and communications at the Boston Stock Exchange (BSE). 'Without the regional exchanges, the NYSE would have retained its monopoly of trades, and spreads would have stayed too wide for the degree of institutional penetration the US now has. The NYSE has been forced to follow our lead: regionals created electronic order delivery, price improvements, and stimulated the invention of new systems and trading methods.'
Competition among the regionals for coveted NYSE order flow is rife, and the contenders are eager to show the cost benefits of their respective trading floors. Since 1994, the BSE has issued 'report cards' showing price improvement over time on electronic orders from large institutions. In February, BSE's largest brokerage happily opened up its report card - indicating $1 mn savings over the year to date - then showed it around its buyside customers.
Other exchanges have since followed Boston's lead in issuing report cards. The NYSE, for instance, is providing reports on net savings made by coming to New York, but Lee says it lacks the statistics to back these up. 'Boston can do it because we have everything integrated into one system: quote disemmination, information vending, order routing, execution and clearing. We have all the data in one place.'
'The exchange is a schizophrenic animal,' says Lee. 'We provide a forum for our brokers to conduct their business, but we also have a responsibility to the investors that provide the orders. So, ultimately, we have to protect the customers of our customers - a major contradiction. In fact, floor specialists aren't guaranteed to profit - some do, some don't. That's the reality of the market?'
With the bulk of trading at regional exchanges now being in NYSE and Amex-listed issues, it's hard to see how they can compete long-term. Philadelphia Stock Exchange's equity floor traded 1.34 bn shares in 1994, up just 3 per cent from 1993, whereas New York's total, at 73.42 bn, was up 9 per cent. The Pacific, meanwhile, traded 2.1 bn shares in 1994, actually down 9 per cent from the year before. Chicago had 1994 volume of 3.3 bn shares, Boston 1.24 bn.
To survive, the regionals are searching out niches, and focusing on better services and lower costs. The SEC broadened the market for regionals in 1975 with the national market system, but it also opened up the markets to competition from entities like Nasdaq. The regionals' original raison d'tre was to provide a market and liquidity for small regional companies. That reason still exists, but barely. Instead, the likes of Chicago and Philadelphia are carving their market out of new products and technology, often challenging the Big Board to keep up.
A curious dichotomy is nestled in America's heartland: CHX is both a deep-rooted regional exchange and a global, technology dynamo. While relying on the personal touch to attract midwestern listings, its technological reach extends worldwide.
Robert Forney, chief operating officer, says the CHX approach to listings is personalised: he cites a June visit by Bethlehem Steel's CFO, when the exchange rolled out the red carpet and invited Chicago's investment elite to meet their guest. Forney is also planning to visit South Africa, where he hopes to market CHX trading software to the Johannesburg Stock Exchange.
Fee-based technology sales are one of the keys to Chicago's business. While other exchanges have shopped around for trading floor technology, CHX has developed its own. With in-house trust and clearing operations, it can create new products, customise software, and provide high-level support for order sending, floor brokers and specialists.
CHX has taken its expertise to extremes that some believe undermine the foundation of stock markets with 'third market' or off-exchange trading capabilities. Chicago Match, a matching system unveiled in January, introduces floor brokers into the institutional crossing network equation - a dynamic seen by some as direct competition to exchanges. Meanwhile, the US Stock Exchange, with competing market makers, is up for SEC approval this autumn. This, too, can be seen as amounting to a competing exchange within an exchange.
The CHX is in a leading technological position, should regulatory reins loosen, from which to expand its listings. When it makes a deal overseas, technology not only forges links between the exchange and the brokerage community, but creates a lifeline of transaction activity into the US, providing exciting opportunities for investors. To date, Chicago has exported technology to Panama, Ecuador, the Netherlands, Thailand and the Philippines, while Columbia, Mexico and South Africa are all prospects.
Joseph Rizzello insists that the term 'regional exchange' is an inaccurate description of the Philadelphia Stock Exchange (Phlx). As vice president of marketing and product development, he claims that Philly offers more. 'Only one segment of our market speaks of the fact that we are a regional exchange: the equity trading floor where we list primary NYSE and Amex listings,' says Rizzello. 'Beyond that, we are a national and international market with our equity index and currency options trading floors.'
Philly boasts a string of firsts. It was the first exchange in the US in 1790; one of the first to pioneer equity options in the 1970s; first to list currency options in 1982; first to open an overseas office in London in 1984; first to offer stock clearance; and it was almost the first on the Internet in June. After two centuries of leading the pack, Philly has earned its moniker as 'the innovative exchange'.
Today, it is a primary market for over 250 equity and nine sector options. Phlx's per product average for sector options rivals the volume of all other markets combined, and this initiative is led by four of the most active US sector options - bank, utility, gold/silver and semiconductors. Phlx also lists options on 72 currency pairs, and a link with the Hong Kong Futures Exchange will allow Philly to trade currency options internationally for 20 hours a day by January 1996.
'We offer more products and services under one roof than any exchange in the world,' boasts Rizzello. 'We are able to take risks. We're like a speedboat compared to an ocean liner - we can change course much faster than other exchanges.'
But options have not been an easy sell. US corporates take a parochial view of these instruments, although Rizello argues that they are a key risk management tool. They are also, he says, a religion, although he doesn't expect US companies to accept them on faith. 'Phlx carved its niche listing options,' Rizzello says. 'If IROs and CFOs aren't paying attention to options, they had better start. If a CFO has a portfolio of semiconductor companies, and he sees a market decline coming but doesn't want to sell those stocks, he can use our instruments to hedge. The cornerstone of Phlx, beyond new products, is education. One problem is the press about derivatives is negative, and the stories where they save billions are never told.'
As for the NYSE, it does not plan to sit idly by as the market shifts. Rumour has it that if the SEC approves the Cincinnati pilot later this year, the Big Board will try to set up its own system to let member firms internalise order flow.
The NYSE has no desire, however, to make radical alterations to its market structure. Despite the widespread changes wrought by technology, neither the NYSE nor the Amex has any plans to abandon the trading floor. This may be flying in the face of the trends but the NYSE insists that nothing can replace the feel of the floor, where brokers meet to gauge market sentiment.
Spreads are indisputably narrower on the NYSE and the Amex than on Nasdaq and the NYSE is marketing this strength in the global market. Besieged by competitors on all fronts, it has decided to set its sights on bigger game: international listing and order flows. If this succeeds, the rewards will be handsome: by capturing the top third of the 2,300 or so foreign companies eligible for listing, the exchange could increase its capitalisation by $4 trillion. If, on the other hand, it were to capture the 575 US-based NYSE-eligible companies that trade elsewhere, its capitalisation would increase only $440 bn. The Big Board has about 2,400 US companies, but the important foreign minority (230 companies) does account for 12 per cent of trading volume.
This June, not yet two weeks on the job, chairman Richard Grasso was already on the streets of London and Rome, drumming up business. He anticipates a doubling of the foreign firms currently listed on the NYSE over the next two to three years - a move in line with the increased appetite for foreign stocks from US investors. The Big Board showcase has two gems which it trots out on its international marketing drives: Glaxo, the UK pharmaceutical company which recently became Glaxo Wellcome, was the second most actively traded stock on the NYSE in 1992 and '93. And in 1994, Telmex was the most active. An extra feather in the Big Board cap is that both these mammoth stocks were migrants from Nasdaq.
Nasdaq: Still Smelling Sweet
A Nasdaq advertisement of a few years ago showed a deserted room full of cobwebs, dust and overturned furniture. A voice-over described the overhaul of the London Stock Exchange in the late 1980s, when it switched from floor-based to electronic trading. As the camera focused on two huge doors slamming shut, viewers were told that the LSE got its novel automated system from the NASD, and that NASD had been using it for more than 20 years. The message? That floor-trading has had its day.
The Nasdaq marketing team likes to talk the numbers. In 1984, Nasdaq had 38.1 per cent of US trading volume; by 1994, it had topped the NYSE with 48.8 per cent. A decade ago, Nasdaq's reputation was of a seedy OTC market; now it's the second largest market in the world, in dollar volume. And, according to Fortune magazine, 82 of the 100 fastest growing US companies in 1995 are listed on Nasdaq, including nine of the top ten.
Nasdaq's growth has certainly been phenomenal. Established by the National Association of Securities Dealers in 1971 as the world's first electronic stock market, it now has 4,900 listed companies. During 1984-1994, the value of its trades rose 844 per cent to $1.4 trillion, second only to the NYSE's $2.5 trillion. Share volume grew by 390 per cent, to over 74 bn. Over the same period, NYSE value grew 220 per cent and share volume 218 per cent. As for new listings, more than 80 per cent of US IPOs were listed on Nasdaq in 1994, and the market has 326 foreign company listings, more than the NYSE and the Amex combined.
Nasdaq's current crop of commercials boast success stories like Microsoft and Intel. 'As a securities market, it's healthy for us to stand up and let the investing public know there are wonderful companies to invest in - and many of them just happen to be on our market,' says John Wall, executive VP of market and market services at Nasdaq.
Wall's outlook may seem sunny given the pall over Nasdaq. Amex levelled complaints in 1993 of $3 bn of 'excess' trading costs paid yearly by Nasdaq customers. Then, last year, Nasdaq market makers faced over a dozen class action suits charging collusion, price fixing and anti-trust violations. The suits were triggered by an academic study revealing a suspicious lack of 'odd-eighth' quotes for many of the largest stocks, perhaps indicating collusion. Those suits have been consolidated into a large case getting underway in New York.
Since the launch by the Justice Department of its anti-trust probe into Nasdaq last year, every Wall Street market maker has been hit by demands for truckloads of records and wide-ranging information about dealings with Nasdaq. The investigation is expected to continue at least through this year, while the SEC is conducting its own separate scrutiny. Nasdaq members have consistently denied the charges; and neither issuers nor investors seem to have cold feet. Indeed, the Nasdaq composite index soared 8.7 per cent in first quarter 1995 to a record high, while share volume, dollar volume, foreign listings, and market capitalisation also achieved all-time highs.
In May, Nasdaq responded with a study concluding the even eighths quotations are neither unusual nor evidence of collusion. Authors included Nobel Prize winning economist Merton Miller of the University of Chicago. The study concluded that Nasdaq's success resulted from providing 'services investors want at competitive prices.'
But the move most likely to silence the critics is Nasdaq's new trading system which was unveiled in March this year. It is claimed that Naqcess will not only improve efficiency in the handling of small investor orders, but will also revolutionise the market structure. 'Naqcess will be a terrific step forward in the natural evolution of markets,' says Wall. 'It's not just a technological development, but a change in the structure of our market. Naqcess will change how stocks are traded for small investors as well as for institutions. And it is only the beginning of structural changes to benefit Nasdaq companies and their shareholders.'
Naqcess is a limit order system, a new phenomenon in a market where prices have been based on dealers' quotes. Since its November 1994 attempt to improve prices for small investors, N-Prove, was killed by the SEC, Nasdaq has been in discussions with Wall Street brokers and market participants to come up with Naqcess. Under the proposed system, small investors would be able to enter limit orders and have a better chance of completing the trade quickly. Limit orders of up to 3,000 shares priced between the dealer spread would be broadcast to all Nasdaq terminals, then automatically matched and executed.
'We are borrowing the limit order feature of auction markets from traditional exchange structures and imposing it on a dealer market,' Wall says. 'Naqcess lets a limit order come in as a market price, just like on NYSE, and the enabling force is technology. The effect is tightened spreads, increased transparency and complete protection for customer limit orders.' Nasdaq hopes to have its system running before year end.
Wall says the real test will come when Naqcess goes before the SEC, (at time of writing, expected in July). But a good omen came in the form of a thumbs-up from one of Nasdaq's most vehement critics, William Christie, professor of finance at Vanderbilt University. Christie, who helped author the study that ignited the storm of lawsuits last year, said in the Wall Street Journal that the system was an improvement: 'It looks like they're moving in the right direction. Their heart's in the right place.'
Reinventing the Amex
This June, cyberspace welcomed a surprising new denizen. The American Stock Exchange became the newest node on the Internet, launching its latest image before an estimated 30 mn computer users. But the event was touched with the kind of irony that has plagued the exchange for years: Amex proclaimed itself the first US stock market to launch a home page on the World Wide Web just hours before the Philadelphia Stock Exchange. The NYSE will offer its own 'expansive' site this summer.
'We are taking a fresh look at the services we provide for listed companies, and there have been major shifts in the environment of equity listings in the last two decades,' says Ronald Corwin, senior vice president of marketing at Amex. 'The Internet is a whole new way for people to exchange information. Amex on the net is a gateway for the investing public to reach companies.'
Amex undoubtedly takes investor relations seriously, placing heavy emphasis on industry conferences and corporate forums. The Internet step reinforces this image, with the Amex page offering free information about the exchange and its listed companies traded, including daily summaries. Hypertext links allow investors to jump to other sites which charge for earnings estimates, analysts' reports and pricing.
Amex also announced an alliance with America Online to provide information to AOL's 2.5 mn subscribers. Corwin notes that the service is initially targeted at individual investors, leading many to question whether all the hoopla is worth it. Some commentators estimate the Internet and CD-Rom combined to have only a 2 per cent penetration among institutions.
Nevertheless, the Internet launch is the latest step in a bid to upgrade the reputation of Amex. The exchange is an archetypal auction exchange, specialising in smaller, newer issues as well as derivatives; but it runs a distant third to the NYSE and Nasdaq. In 1994 it celebrated its third best year ever with a new chairman, Richard Syron, former president of Boston Federal Reserve Bank. Since he came on board, Amex has spent heavily on technology and advertising. Its $3 mn campaign touts the advantages of auction exchanges over dealer markets like Nasdaq, promising 'narrower spreads, short sale protection and less volatility.'
One full-page Amex ad in the Wall Street Journal last year trumpeted that 301 companies had switched from Nasdaq to Amex since 1987. It failed to mention that some 113 of those no longer trade on Amex. 34 moved to the NYSE; and some 30 delisted after falling into bankruptcy or other financial problems. Still only 17 have moved back to Nasdaq over the eight years. Since January 1994, 40 have left Nasdaq for Amex; 18 have gone the other way.
One of Amex's major strengths is in derivatives. Last year it boasted a 30 per cent market share in equity options, and an options pricing system was installed floor-wide, providing all specialists with touchscreen technology to price quotes automatically. Twelve equity derivative products are listed, including three launched in 1994: options trading on the Mexico Index, the Hong Kong Option Index and the Amex/Oscar Gruss Israel Index. Options also began trading on two new sector indices, the Natural Gas Index and the Securities Broker/Dealer Index. Several more options products are planned for 1995, including an enhanced facility for trading odd-lot government bonds.
Back in 1992 Amex's management sought out a new niche in the Emerging Companies Market, which ran into trouble early on when it was found officers in two of the original 23 companies had problems with the SEC. The market was open to companies with a public float as small as 250,000 shares, trading for as little as $1 a share. Critics claimed it was nothing more than an exchange-sanctioned penny-stock market, and after the micro-company market traded nearly 1 mn shares on its first day, controversy sent trading tumbling.
In the first quarter of 1995, some 262,000 shares traded on the average day. Of the 65 companies that were listed on ECM, fewer than half graduated to the major leagues and 10 per cent were taken off the list. Altogether, 32 of the companies were still listed, pending SEC ruling, when ECM was discontinued in May of this year.
'Amex had an extended period when its strategic response to the changing market environment was inadequate,' adds Corwin. 'But in the last year we have cleaned up our act and shifted direction, orientation and thrust. It's got to do with being first in tomorrow's marketplace in attracting companies and investors.'
Canadian Competition: Within & Without
The battle between regionals and major stock markets is well understood within the Canadian context. With the Toronto Stock Exchange as the dominant market in Canadian equities, the Montreal Exchange and the Vancouver Stock Exchange have worked to carve out a niche in the regional capital formation process. Ironically, all three exchanges are faced with a greater danger, the movement of Canadian stock trading to the US market. Like the US regionals, their fight is now with Nasdaq and the NYSE.
Over the last two decades, volumes on Canadian exchanges have continued to grow. With total volume of 25.5 bn shares traded, amounting to some C$223 bn, 1994 was another record year. Yet, despite this comfortable level of activity, Canadian exchanges' dominance in the Canadian capital market is challenged. According to the Montreal Exchange, some 50 per cent of trading in Canadian interlisted stocks is being transacted on a US market. And, in some cases, Canadian IPOs have bypassed the Canadian market to list on the Nasdaq stock market.
One reason for this exodus may be the market mechanics of Canadian exchanges. 'We cannot expect this business to come to Canada, and in some cases come back to Canada, unless we put our own house in order,' says Gerald Lacoste, president and CEO of the Montreal Exchange. 'We must make sure we offer a visible market with the deepest liquidity. That is the way to stop this erosion of business to the US.'
In recent months, Lacoste has come out in favour of pooling expertise and experience in the face of the increasingly strong challenge from the US. 'A National Market System similar to the US may well be the missing link in the reform of Canadian financial services,' says Lacoste. 'Our exchanges must work with goodwill and a sense of innovation to attain these common goals.'
Both Toronto and Montreal agree their major competition is from US exchanges. For its part, the TSE is the continent's second largest exchange measured by trading value. The TSE trades on average 55 million shares a day worth some C$750 million. In recent months, the TSE has marketed its wares in the US to attract more attention to the Canadian capital market.
'This poses a severe test for national exchanges like the TSE,' said Rowland Fleming, president and CEO of the Toronto Stock Exchange. 'We are going to have to fight hard to keep the majority of trading in Canadian stocks here in Canada. The TSE's closest rival in trading Canadian stocks is not any other Canadian exchange.