Jan 17, 2007

ding ding ding

Ever since I started working on Wall Street there is one thing I have always wanted to do. And that is see the trading floor of the New York Stock Exchange. Taking a tour of the floor used to be a straight forward thing. But post-9/11, security become naturally more secure. The whole area around the exchange is blocked to traffic and entry to the floor has been limited to employees and invited guests.

I have a huge fascination with the NYSE because of three things: the history (long by U.S. standards), the symbolism it stands for (capitalism), and the fact that it is an anachronism. The history starting in 1792 can be found here. As a symbol of capitalism it is probably unrivaled. It's probably not as well known that the floor is hideously outdated as a venue for trading. This is probably the most interesting aspect of the NYSE for me.

When you watch CNBC and see Maria Baritoromo down on the floor talking with traders, what you are seeing isn't entirely the NYSE. The traders who are placing orders and completing trades all work for someone other than the NYSE; companies like A.G. Edwards or Bear Stearns. These traders have clients such as pension funds or hedge funds. They get an order from their client and take it to the floor to be executed. Also down on the floor are Specialists. These again are not NYSE employees but employees of independent firms like Labranche. Each Specialist controls the trading dynamic of 1 to 30 stocks that he's in charge of. He takes orders from the traders and sometimes gets involved with trades himself. So what does the NYSE do?

For all practical purposes they provide a building. On the face of it, this does not sound very glamorous. They are merely providing a meeting venue for people who want to buy and sell stocks. Over time they've introduced other services such as some of the electronic hardware and software needed to simplify the trading process. They've had to expand the space of the venue (there are actually 4 trading floors). But otherwise they make more as more shares are traded and their costs shouldn't go up as much. They also provide a listings business. Companies like General Electric pay the NYSE to be listed on their exchange. They pay them a lot! This again largely goes to the bottom line. And they also provide data. Information on what happened to what stock at what time can be purchased by companies interested in that data. Again some overhead is needed for them to do this but it's a good business. So why don't a lot of exchanges start up?

The NYSE used to be private and owned largely by the traders and specialists who are on the floor. Why start another venue when you own the venue? But recently the SEC has tried to promote competition in this space with a number of regulations. One was to open up the possibility of alternative trading systems. Archipelago (now owned by the NYSE) or INET (owned by Nasdaq) are examples. These proliferated in the 1990s. More recently the SEC has instituted Regulation NMS which effectively makes a trade fungible across all the existing trading venues. The main ones are NYSE, American Exchange, and the Nasdaq. But there are many others that cater to different types or trades like LiquidNet or BATS. Sometime this year the competition rules will all be in place and trades placed at one venue must be routed to another venue if a better price can be found there. This effectively breaks the monopoly that the NYSE has had. Just because a stock is listed on the NYSE does not mean that the stock must be traded there. Over time NYSE's share has slowly eroded away. In some ways the NYSE has been caught with its pants down.

There is no really good reason to have people at a station in the middle of the trading floor manually trading stocks. Ever seen the floor of the Nasdaq? No. Because it doesn't exist. The Nasdaq is completely electronic. Whereas a trade might take 2 minutes to be completed on the old NYSE it can take 1 millisecond to do it on the Nasdaq. For some traders such as statistical arbitragers (stat arbs) this is insanely important. Much more important than price.

Also a trade on the old NYSE was totally transparent. It was largely clear to the Specialist who was making the trade, how large it was, and how desperate the trader was. They could use this to their advantage to make money. Lots of money. When you are trading large blocks of a stock you don't want anyone to see your hand. If I have 500,000 shares of IBM to sell the Specialist has a pretty good idea that the price of IBM will go down and he can get 'ahead of the trade'. Electronic venues are basically anonymous. So called 'dark pools of liquidity' are really anonymous. Companies doing trading really like this. This again can be more important than the price of the sale or purchase to within reason.

One thing is clear - electronic exchanges are how trades will be done going forward. So unless the NYSE can become electronic it's dead in the water. It naturally is becoming electronic. So what happens to the traders and specialists on the floor? I'll get to that.

While I largely cover technology stocks for our hedge fund, my boss tends to throw other industries my way when it gets a little complicated. He knows I like stuff like this. The current state of affairs with the exchanges is complicated. So I have spent a fair amount of time understanding how this industry works. For all the talk of electronic trading however there is something to be said for the NYSE's brand. It has cache. Why do companies list on the NYSE and pay ten times as much as if they listed on another exchange? Cache. They want to ring the bell, they want to see Maria, and they want to tell their buddies on the golf course they are listed on the premiere exchange in the world. Who cares? It's not their money.

So when I recently got an invite to the floor how could I turn it down? I was dying to see this antique in action. As luck would have it, out of the 30 people invited, I was one of 8 chosen to be a part of the opening bell ceremony. KICK ASS! I didn't quite get lucky enough to actually push the button though. Yes the bell is electronic and works via a button.

It's a pretty amazing thing to stand up on the balcony and see the entire main room trading floor before it opens. The traders and specialists are busy getting their orders and order books in shape. I was lucky enough to spot Thain, the CEO, showing the mayor of New Orleans, Ray Nagin, around the floor. There's a clock right in front of the balcony counting down the time to the open. The market opens at 9:30 AM. At 9:29:30 tradition has it that the balcony guests and whoever is interested on the floor start clapping. Presumably to get everyone's attention. At 9:29:50 the bell button is pressed for 10 seconds. And then the trading begins. It was good fun.

After that we had a few presentations and then walked around the floor. No cameras were allowed unfortunately. The building itself is clearly old. Off the main floor it almost had the feel of being in the White House. 30 feet ceilings and ornate cornice work. Paintings of past heads of the NYSE adorned the walls. The floor was a little different. I talked with some of the specialists and traders. There was a palpable tension when talking to them. Some were defensive about their jobs and the value they add. Some were more resigned to the fact that they may not be here next year. If the NYSE becomes fully electronic there is no reason to be there and not much for them to do. The floor itself is a bit of a mess. The main room is pretty decent but it was reminiscent of the movie Brazil. Lots of retrofitting has occurred over the years. Some of the other rooms were more like Beirut as one trader put it. As the exchange goes electronic the efficiency of each person goes up. Lots of people have already been laid off. Some stations were devoid of terminals and people and wires were left hanging out.

While it was a bit of a mess there was still a feeling of history and awesome power down on the floor. Some serious money trades hands down there. Even the people were big. Many of the employees seemed like your stereotypical ex-high school football players. The two men I met initially (they were almost all men) were huge meaty good old boys who looked like they played hard. A good group of people. Most got their jobs through good old nepotism. There is no real major you can get in floor trading so it helps to know someone.

Overall the energy level on the floor is less than I would have expected. A lot of the work now is done electronically. People don't need to get involved so much. They can actually take a break to eat. And there's a sense of sadness about that. Things are changing around them. Everyone knows everyone and when people are laid off everyone knows about it. The future for them is uncertain. And it's not a skill that can easily be transferred to another profession.

I think the main floor will always exist. The listed companies like to see people doing stuff. They want to see Maria. And they want to step up on that balcony and ring that bell. But 5 years from now much of what I saw will probably be gone. The old ways of doing things will be gone. The IT guys will probably be more important than any specialist. But all is fair in capitalism.

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