The recent history of the New York Stock Exchange (NYSE) is interesting in part because it’s an illustration of how disruptive new technology can be. Twenty years ago the NYSE and it’s relatively young rival NASDAQ accounted for 97% of the total U.S. stock trading volume. Then the rapid development of computer technology, combined with a handful of regulatory changes, enabled dozens of alternative trading venues to sprout up over the past two decades, increasing competition for volume and driving down the exchanges’ profits, ultimately pushing the NYSE — one of the most enduring symbols of American capitalism — towards increasing irrelevancy.
So yesterday’s announcement that a young, Atlanta-based commodity and derivatives exchange called IntercontinentalExchange (ICE) has agreed to purchase NYSE Euronext for $8.2 billion is just another sign of traditional exchanges’ waning importance on Wall Street. What’s more, analysts believe that the primary appeal of NYSE to ICE was not even its historic trading floor or equity exchange business, but rather for a London-based derivatives exchange it owns, called Liffe.
It’s not the first time that ICE tried to aquire Liffe. When NYSE Euornext and the German stock exchange operator Deutsche Borsche tried (unsuccessfully) to merge earlier this year, NASDAQ and ICE hatched a plan to swoop in, purchase, and split up NYSE Euronext, with ICE taking the Liffe and NASDAQ taking the rest of the company. As Diego Perfumo, an analyst at Equity Research Desk told Bloomberg News:
“When Deutsche Boerse and NYSE Euronext tried to merge, ICE immediately partnered with Nasdaq and tried to poach NYSE away . . . ICE was going to keep Liffe and Nasdaq was going to keep the rest of NYSE . . . What [ICE CEO] Sprecher is after is Liffe.”
Why is a derivatives exchange so attractive to ICE while the stock exchanges NYSE Euronext operate an afterthought? Derivatives exchanges are much more profitable than equity exchanges. Felix Salmon of Reuters explains:
“There are lots of stock exchanges, and none of them make much money. By contrast, there are relatively few derivatives exchanges, they tend not to compete directly with each other, they tend not to compete on price, and they’re wildly profitable.”
The story of how the equity exchange business became so unprofitable starts in the 1990s. In 1998, the SEC announced “Reg. ATS,” which authorized electronic communication networks to be used between traders to make deals outside exchanges. In 2001, the SEC made another big move, requiring stock prices to be quoted in decimals rather than fractions. This changed the minimum difference between stock prices from 1/16th of a dollar to 1/100th, preventing exchanges from making extra money on the spread between the price at which they sell a stock and the price at which they buy stocks. Then in 2005, the regulator implemented a set of rules collectively known as “Reg. NMS,” which, among other things, required brokers to route trades to the venue that offers the very best price — further squeezing the margins that the exchanges could eke out as they competed with a bevy of new rivals for volume.
Along with these rule changes, the rapid development of computer technology allowed upstart firms to easily set up their own trading platforms, and to court a new generation of so-called high-frequency traders, who use powerful computers and software to move in and out of positions thousands of times per second.
So while high profile mergers like ICE’s purchase of NYSE Euronext, or NASDAQ’s purchase of the Philadelphia, Boston, and OMX stock exchanges may make it seem like the industry is consolidating, this is actually not the case. While traditional exchanges around the globe have been combining their strength in recent years, this is just in response to the competitive pressure they’ve been feeling from new alternative trading systems like Knight Capital or BATS Global Markets.
This new world of stock trading, in which volume is fragmented among dozens of electronic trading networks instead of concentrated on the floor of the New York Stock Exchange, has both benefits and drawbacks. The main benefit is reduced trading costs for investors. Increased competition and market efficiency means that traders can often execute trades for a nominal amount of money. At the same time, some critics of this new system argue that the fragmented nature of American equity markets poses systemic risks for the economy. And there are also questions of whether this increasingly complex and fragmented market makes it easier for high-frequency traders to use their sophisticated algorithms and powerful computers to take advantage of average investors.
These sorts of questions will continue to be debated by investors as regulators work to improve market structure. But however the story unfolds, it’s unlikely that the New York Stock Exchange will ever again dominate American capital markets the way it did for its first 200 years of its existence.