Are we headed for a Big Crunch or eternal expansion?
Leave it to Stephen Hawking and the Hubble telescope to scope out cosmic cataclysms. With the turn of the millennium the US market will also celebrate 25 years since its own Big Bang, and capital markets scientists are tracking the fallout like astronomers scouring the skies for new heavenly bodies to appear.
IROs may not be kept awake at night by looming asteroids, but they should not ignore market changes that are striking with the force of Ellie in Deep Impact. Nor should they be lulled by the way these changes take eons to traverse the vast dark matter of government.
Nearly two decades in the making, landmark banking reform squeaked past Congress by one vote in May and passed into the Senate's orbit. 'HR 10' allows banks, securities firms and insurance companies to merge into global giants with far fewer regulatory restrictions than they now face. Then there's the SEC's 'aircraft carrier'. Sluggishly setting sail laden with every kind of regulatory weapon available, the set of proposals will dramatically alter capital raising and investor relations, possibly cutting underwriters out of the loop for some large company offerings.
Meanwhile, at the market's molecular level, stock trading mechanisms are transmogrifying as Nasdaq and the Amex merge and electronic trading systems greet new rules and regulations. 'Whenever you improve market structure, who is the beneficiary?' demands J Patrick Campbell, Nasdaq's new chief operating officer. 'It's the investor; the shareholder of the issuer. And every time something is in the best interests of the investor, the cost of capital ultimately has to come down.'
Economists and astrophysicists alike debate whether we're headed for a Big Crunch or eternal expansion. With the concept of a Citigroup unthinkable a generation ago, consolidation now rules the financial universe. 'Given the growth of the financial sector, the number of intermediaries has not kept pace at all,' says Jeffrey Schaefer, consultant to the Securities Industry Association and for 20 years its director of research and chief economist.
In the last decade, the number of banks insured by the FDIC has shrunk by about one-third in the US, while the securities industry has diminished by up to 20 percent since the peak in 1987. There are two drivers, explains Schaefer: technology and globalization. 'Technology spending needs to be spread over a larger volume of business. Meanwhile, as corporate clients have expanded overseas, they've demanded their bankers offer services in any market they're operating in. Financial intermediaries have had to follow their clients and become more and more global institutions themselves - witness Travelers Group's new stake in Japan's Nikko Securities.'
Walls come tumbling
Modernizing a Depression-era regulatory scheme with HR 10 ratifies the financial industry's evolution over the last decade. 'We're creating a cogent system instead of a patchwork quilt of exceptions, a coherent set of laws rather than a mish-mash,' says Stuart Kaswell, general counsel at the SIA in Washington. 'The trend is already well underway, with major banks merging and interstate banking now a reality. With HR 10, I think we will see even sharper competitive forces: more securities houses being able to have traditional commercial banking operations and a broader range of services. We already see insurance becoming much more a world of financial services rather than specific product lines.'
Breaking down the walls between banking, insurance, securities trading and corporate finance nonetheless worries many market players. 'The whole process has eroded,' remarks Los Angeles investment banker Fredric Roberts, a former NASD chairman who's leaving the business in disgust. 'Today companies face more problems being public than they ever did; they're less informed and less advised. Nasdaq companies find it harder and harder to find market makers - real market makers who actually take positions. On the broker side, research has become a gatekeeper for corporate finance. It's virtually impossible to get an analyst to cover your stock unless you promise corporate finance business. That's a disastrous trend, and the question is, is the investor getting real research?'
Responding to concerns like these, the SEC has lately teamed up with the Justice Department for what may be a major crackdown on the securities industry. Front-running Big Board floor brokers are getting their comeuppance, while SEC chairman Arthur Levitt has alluded ominously to insider trading and pay practices among sell-side analysts. But the process is marred by a lack of solid rules fleshing out securities laws, with one appeals court recently describing an SEC rule interpretation as 'at times almost deliberately obscurantist.'
Kaswell disputes growth in fraud relative to overall growth of the market, and says the SIA's surveys on investor confidence and faith in brokers shows the industry's reputation is going up, not down. Schaefer tells the tale of finding a broker he trusted as a young man. After a year he began to have doubts about the broker's interests, so he just took his account elsewhere. 'Maybe not everybody has the common sense to do that. But most people, when it comes to their money, are looking out for it, and they'll act on their concerns.'
If the issuer is the nucleus and the investor the electron, then financial intermediaries feed off the quirks and quarks in between. At no time have the forces governing this atom been in such flux. 'The market structure is evolving rapidly,' says Scott Mason, CEO of Investment Technology Group Inc and a former finance department chairman at the Harvard Business School where he was a professor for 18 years. 'Technology is changing the way the buy-side does business, in particular its use of alternative trading systems.'
As heralded in the title of extensive new research from Greenwich Associates, Technology takes over the catbird seat. One striking result of the report is the penetration of non-traditional trading systems, for example ITG's Posit or Reuters' Instinet, among the largest US institutional investors: no fewer than 96 percent now turn to these systems for Nasdaq business. The reasons are quality of execution, confidentiality, lower spreads or commissions and, perhaps most important, the 'quest for liquidity.'
'As mutual funds get bigger, finding liquidity is an enormous risk,' explains spokesman Steve McMenamin of Los Angeles-based broker Jefferies Group, which owns 80 percent of ITG and plans to spin off the rest this year. 'It used to be political risk, volatility risk, ratings risk. Now, the hunt for liquidity is more intense.'
No wonder business is booming for Jefferies, which promises to find the best pool of liquidity whether it gathers it together itself, goes to an exchange, or to a crossing network. Affiliate W&D Securities, which clears for Jefferies and ITG, is now number eight on the NYSE floor.
Chicken and egg
The SEC backroom staff are scrambling to serve up new rules covering electronic stock trading systems (ETSs) like Posit. The US already has over 50 - Reuters' Instinet, Bloomberg's Trade-book, Terra Nova Trading and Island - accounting for over 20 percent of all of Nasdaq's trading. But up until now they have all been treated as just simple broker-dealers - much to the dismay of the more highly regulated stock exchanges.
Now the SEC wants to give ETSs the choice of being regulated as exchanges or 'enhanced broker-dealers'. But the NYSE and Nasdaq may both have new freedom in competing with the electronic players. Now they can experiment with their own alternative systems, which until now had to undergo lengthy SEC review. The commission proposes instead that the exchanges could conduct two-year pilot programs of alternative systems before giving its full approval.
Automatic execution
As Amex members vote in June, they contemplate adding their auction market floor to Nasdaq's screen-based system. And the Amex has already outlined a new way for investors to 'automatically execute' stock trades, electronically bypassing the 'crowd' of brokers and specialists, and its bidding for the Philadelphia exchange. Meanwhile, Nasdaq and the Pacific Stock Exchange are both putting their sponsorship weight behind a much-touted 'black box' crossing network from Optimark.
'The NYSE has to now try and position itself against everyone else,' says Mark Edwards of Plexus Group, a Los Angeles-based institutional investment consultant. 'And as for everyone else, the barriers between what is a regional exchange and what is an electronic exchange are falling - a worldwide phenomenon.'
'The pressure is on trading floors, where the speed of trade executions is not as rapid as electronic exchanges,' says Bruce Weber, professor at New York University's Stern School of Business. 'However, the New York Stock Exchange has been able to constantly improve what its floor has to offer. Some 88 percent of its orders now come in electronically.'
As seen by Steve Wunsch, chief executive officer of the electronic Arizona Stock Exchange (AZX), 'There's been a movement to 'dealerize' the auction market and 'auctionize' the dealer market, all because of the SEC forcing it to happen. Carry that out very far and you wind up with a market that essentially looks the same all over, and probably is unsatisfactory as either an auction or a dealer market, and in any case devoid of choice.'
Wunsch says the obstacle faced by ETSs is having to thread their way through the regulatory maze, which is becoming a 'wet blanket' over innovation and competition. 'You wind up in the end with a government monopoly on liquidity facilities and price discovery, with the stock market essentially becoming a government designed and managed utility.'
Virtual market
In 20 years, says Plexus's Edwards, there won't be a best 'place' to trade stock. 'It's all going to be one virtual market, probably an electronic one where there's the least amount of friction. For now it's a fragmented market based on the wants and needs of investors. But according to a recent survey of our clients, the number one concern institutional investors have is that they want electronic integration. That way, when they want liquidity, it's there.'
In the search for candidates to lead the 'virtual market' of the future, many observers look no further than the two largest stock markets in the world: the NYSE, with around $12 trillion in market capitalization, and Nasdaq, which this year overtook the London and Tokyo exchanges with $2.13 trillion market cap.
'Different capital markets offer more choices than ever before,' says Nasdaq COO Patrick Campbell. 'A screen-based, multi-dealer market is the business model for the future, and the one that's working today. But it's an 'inclusive' model. With one of the finest private communications systems in the world, we have the greatest ability to connect different kinds of market to ours.'
ITG's Mason warns of the notion that in the end, like in Highlander, there can only be one. 'A buy-side trader needs access to a multitude of market structures: auction, upstairs principal, call, price discovery and so on. Sometimes he'll have to go to the upstairs market because of his sense of urgency and demand for liquidity. If he's more passive, he may find it efficient to use a call market like Posit, then later working more continuously in an order-driven market like Instinet.'
Black box
What scares the beans out of financial intermediaries is the prospect of the trading universe imploding into a computerized 'black box' without brokers and dealers, like planets sucked into a black hole. After all, in the quest for liquidity, no-one can supply more of it than the massive and growing nexus of institutional capital, dealing without intermediation. Some forward-lookers theorize that the internet will make the securities industry obsolete - issuers won't need an underwriter, market maker or investment advisor anymore. 'Are you done for?' wonders Registered Representative's June cover.
'It reminds me of the talk 25 years ago,' muses the SIA's Kaswell. 'Everybody said the computer was going to make the NYSE obsolete. They said fixed commissions were going to kill the securities business as we know it; it's now many times larger. The industry is extremely nimble and constantly adapting itself to the service demanded by issuers and investors. It's just as silly to think there will be no more securities industry in 2005 as predicting its demise was in 1975.'
'Broker-dealers are responding to alternative trading systems, realizing they have to add value in new and different ways,' says NYU's Weber. 'Are we going to cut out Wall Street? I don't think so.'
Technology and the future of the stock market, like subatomic particles, are inherently unpredictable. As Kaswell concludes, 'I have a feeling we ain't seen nothing yet.'