By Bob Ivry, Whitney Kisling and Max Abelson – Jul 6, 2011 3:46 AM GMT Wed Jul 06 02:46:11 GMT 2011
The 219-year-old symbol of American
capitalism, now called NYSE Euronext, is about to complete a $9.42 billion
merger with Deutsche Boerse AG (DB1) that will give the Frankfurt-based
firm 60 percent of what would be the biggest exchange company in the world. The
deal is the culmination of a decade of scandal, regulatory mandates and a
technology arms race that opened the industry to electronic upstarts and forced
the old Wall Street boys’ club to become an international company that makes
most of its money from businesses other than stock trading.
“When I started in the business, Deutsche Boerse was open for two hours a day and
the New York Stock Exchange was THE NEW YORK STOCK EXCHANGE,” said Thomas Caldwell, chief executive officer of
Caldwell Securities Ltd., a money-management firm in Toronto, who has worked in
the industry since 1965. “You just have to stop and say, ‘Wait a minute here —
Deutsche Boerse, New York, equal partners? How did that happen?’”
Over the years, trading has gotten
cheaper and faster, benefiting investors. Buying 1,000 shares of AT&T
before 1975 would have cost $800 in commissions, Charles Schwab, who founded
discount brokerage Charles Schwab Corp., told the U.S. Senate in February 2000.
That’s about 100 times more than the fees paid by some retail stock-pickers
Even so, many of those same
investors abandoned equities after the Standard & Poor’s 500 Index, the
benchmark measure of U.S. stocks, plummeted 6.2 percent in 20 minutes on May 6,
2010. Though the NYSE was the only exchange that didn’t have to cancel
transactions after the so-called flash crash, the plunge created the perception
that markets in general weren’t safe because high-frequency traders, who buy
and sell in milliseconds, are beyond the reach of regulators and enjoy trading
advantages on exchanges, said Joe Saluzzi, co-head of equities trading at
Themis Trading LLC in Chatham, New Jersey.
“We have a two-tiered market,”
Saluzzi said. “Some traders have information and speed, and the exchange caters
to them because that’s where it makes its money.” The merger won’t change that
formulation, he said.
The NYSE is required to allow all
customers access to all services, said Richard C. Adamonis, a NYSE Euronext (NYX) spokesman. Other markets don’t have
that requirement, he said.
The deal with Deutsche Boerse needs
the approval of half the NYSE Euronext shareholders, who are scheduled to vote
tomorrow, and three-fourths of the German firm’s stockholders, who will decide
by July 13. The companies have wooed shareholders by agreeing to pay about 620
million euros ($895 million) in dividends.
“There’s this sentiment out there
that we’re not what we were, and that’s right, we’re not,” NYSE Euronext CEO
Duncan L. Niederauer, 51, a former co-head of equities trading for Goldman
Sachs Group Inc., said in an interview. “The NYSE doesn’t want to be what it
was. The game changed. We’re obliged to get into new services, new products,
new asset classes, new regions. If we do that successfully, that’s a great
story, not a sad story.”
Niederauer is slated to be CEO of
the combined NYSE Euronext and Deutsche Boerse. Reto Francioni, the head of the
German company, will be chairman.
New products, namely derivatives
such as options and interest-rate swaps, are what Niederauer is counting on to
revive a company whose stock has lost almost half its value since it started
trading in March 2006. NYSE Liffe, Europe’s
second-biggest derivatives market, will join Eurex, the biggest, owned by
After doubling each year from 2005
to 2007, NYSE Euronext’s operating income has since slowed, falling 32 percent
in 2009 and growing 3.7 percent last year.
Combined, Liffe and Eurex may earn
$1.18 billion in three years, according to data compiled by Bloomberg, Credit
Suisse Group AG and Macquarie Group Ltd. Applying the average valuation of its
three closest derivatives-market competitors would result in a business worth
more than the combined companies before they agreed to merge — and that’s
leaving out their other operations.
The old NYSE ran with the help of a
group of stock traders called specialists. In 2002, seven NYSE-designated
firms, including LaBranche & Co., had the job of stepping in and trading stocks
when there were imbalances between buy and sell orders so that ups and downs
could be smoothed. Specialists were also required to hang back as long as NYSE
customers could trade with one another.
LaBranche, created in January 1924,
became the first independent specialist firm to sell shares to the public in
August 1999. With their central role in trading and their access to market
information, specialists were a closed and lucrative club.
In papers prepared for its initial
public offering, LaBranche disclosed that it regularly turned about 71 percent
of sales into profit before paying its managing directors. Earnings before that
expense climbed at least 25 percent every year from 1995 through 1999, almost
doubling in 1998. That year, 34 managing directors split a compensation pool
that gave each of them an average of about $1.7 million, according to
Technology and the government would
undermine the specialists’ profitability.
In 2004, the U.S. Securities and Exchange Commission charged all seven specialists,
including LaBranche, with making $158 million from trading when they didn’t
need to step in and filling orders at levels that were inferior to the best
prices. Specialist firms settled with the regulator for $247 million.
The U.S. government’s pursuit of
criminal charges against 15 individual specialists for securities fraud went
nowhere. Some were acquitted while others saw their charges dismissed. One jury
conviction of a Fleet Specialist Inc. employee was overturned by a federal
judge, who said prosecutors hadn’t proved fraud. The guilty pleas of two others
were set aside.
After the scandal, the specialists’
role at the NYSE declined as trading became more automated and rules changed.
LaBranche never posted annual net income after 2006, and it sold its NYSE
market-maker business to London-based Barclays Plc (BCS) in 2010 and the rest of the company
to Cowen Group Inc. (COWN), a New York investment bank, in
The specialists have been replaced
by “designated market makers,” who no longer see all the orders coming into the
exchange and don’t have to wait until others trade, though they must continue
to smooth order imbalances and maintain what the NYSE describes as fair and
Grasso, who became CEO in 1995,
defended the specialists, running interference for them with the media and the
government at the expense of investing in new technology to make its market
faster, said Alfred R. Berkeley, president from 1996 to 2000 of Nasdaq Stock Market Inc., the NYSE’s biggest rival for corporate
The decline of the traditional NYSE
reflected “regulatory policy, nothing the exchange management did,” Grasso
The NYSE was a men’s-only club until
1967, a place where brokers could leave their dress shoes on the stairs leading
to the trading floor after they changed into sneakers for the work day. It was
a place where paper orders, crumpled and discarded, would pile so high that
cleanup workers looked like they were shoveling snow.
Traders kept containers of talcum
powder in their desks, said James Maguire Jr., 49, who first worked on the NYSE
floor in 1979 as a college freshman on Christmas break. When famous visitors
arrived, one trader would distract the celebrity or CEO and another would shake
the talcum on their shoes. When New York Jets quarterback Richard Todd showed up in white
shoes, they used cocoa, he said.
“It was good-natured fun,” said
Maguire, who worked as a clerk, a broker and a specialist until 2004. “The idea
was that you may be a big shot in the board room or in politics, but you’re on
our turf. You’re one of the guys.”
The back-slapping extended to NYSE
governance, according to a 2003 letter by William H. Donaldson, 80, chairman
and CEO of the Big Board from 1990 to 1995, and chairman of the SEC, the
exchange’s chief regulator, from 2003 to 2005.
Until 2003, the CEOs of 10
brokerages regulated by the NYSE sat on the exchange’s board, and half the
NYSE’s 12 public directors, designated to protect investors’ interests, were
presidents, CEOs or former CEOs of firms that traded on the exchange, such as
JPMorgan Chase & Co. Chief Executive Officer William B. Harrison Jr.
The board allowed Grasso to pick the
directors who set his compensation. One Grasso choice was Kenneth G. Langone,
the co- founder of Home Depot Inc., who became chairman of the compensation
committee. Grasso, in turn, sat on the board and compensation committee of Home
Grasso was hailed as a savior of
Wall Street for his work to restore the NYSE following the terrorist attacks of
Sept. 11, 2001, which halted U.S. equities trading for four days, the longest
shutdown since 1933. When terrorists flew two hijacked jetliners into the World
Trade Center’s twin towers, just blocks away, Grasso used the public-address
system to urge staff and traders to remain calm.
“I saw their reaction to his voice,
and I was impressed,” Bill Silver, a floor trader, said in an interview six
days later. “He’s a respected authority there and they trusted his judgment.”
Grasso was “spectacular” in working
to reopen the exchange, said Harvey L. Pitt, who at the time was chairman of
“He called me the first thing every
morning and the last thing every night, to check in with me, find out what I
wanted, to offer suggestions,” Pitt said.
The attacks highlighted the
vulnerabilities of concentrating so much of the U.S. equities market in one
The aftermath of the restoration
also provided an early glimpse into the compensation issue that would result in
Grasso’s ouster. He received a $5 million bonus in 2001, in part for his work
in reopening the exchange.
Kurt Viermetz, a JPMorgan vice
chairman at the time, praised Grasso at a dinner in June 2003 for his role in
restoring the capital markets — with one catch.
“For some, our American hero was a
little overpaid,” Viermetz added.
Later in 2003, the NYSE board went
further, awarding Grasso $140 million — enough for almost 8,000 years of
tuition at New York-based Pace University, where Grasso was given an honorary
degree. As Grasso’s predecessor as CEO of the NYSE, Donaldson had received
annual pay of about $2 million.
After he found out about Grasso’s
compensation, which followed the specialist scandal, Donaldson, Pitt’s
successor as SEC chairman, demanded an explanation. “Grasso’s pay package
raises serious questions regarding the effectiveness of the NYSE’s current
governance structure,” Donaldson wrote in a letter to the NYSE board.
“In my opinion, nobody did anything
wrong except there were judgments made about compensation that people can
debate,” Harrison, the former JPMorgan CEO, said in an interview. “A lot of
people thought it was too much. Some people didn’t.” Harrison wouldn’t say
which side he came down on.
Institutional investors trading on
the NYSE, however, had few qualms about questioning the board for paying Grasso
so much, and some called for Grasso to quit, which he did.
Grasso had previously lobbied the
NYSE board to oust Donaldson, according to Charles Gasparino’s book, “King of
the Club,” and “Donaldson had a long memory,” Pitt said. “This was his chance
to get even.”
In an interview, Donaldson said
there was nothing personal about his battle with Grasso over the pay package.
“It was a tough thing to do,”
Donaldson said. “I felt this was a really bad situation, a self-regulatory
agency was writing rules for corporate America and not having any guidelines
for its own governance.”
Grasso’s compensation didn’t
constitute a scandal, Langone said in an interview.
“There was nothing illegal or
criminal about it, or unethical, which is even better,” he said. “It was the
members deciding how much Mr. Grasso was worth, and he was paid that amount of
money. It was the members’ money. It wasn’t some charity.”
“Grasso was the one person who
personified the institution, who knew everyone and knew where every body was
buried,” said John C. Coffee, a securities professor at Columbia University’s
law school in New York. “Dick Grasso was the last emperor.”
The Grasso compensation and
specialists scandals reduced the NYSE’s political power and gave the
Donaldson-led SEC more leverage to push through new rules that reshaped the
U.S. stock markets, according to James Angel, a finance professor at the
McDonough School of Business at Georgetown University in Washington.
“You can’t have your monopoly and
eat it, too,” Angel said. “In 2001 they were operating a horse-and-buggy market
where humans screamed at humans. When you add the scandals, that led to a
regulatory environment that made it easier for competitors to compete.”
In 2005, the SEC approved Regulation NMS, for national market system. The
new rules were designed to drive down trading costs for investors and increase
competition among exchanges, eroding the dominance of NYSE and Nasdaq’s
exchanges by moving trading onto as many as 50 markets.
Reg NMS was the final nail in the
coffin for the old New York Stock Exchange.
It altered and expanded the
trade-through rule, which gave exchanges 30 seconds to fill orders sent by a
rival. Critics said the rule led to delayed executions, cherry-picked orders
and sometimes less-than-best prices for investors. Reg NMS gave a boost to
faster electronic markets and increased competition for the NYSE. Prices on
exchanges that weren’t fully electronic, like the NYSE at the time, could be
ignored, the SEC said.
Nasdaq, which had faced competition
from electronic trading systems since at least the late 1990s, acquired the
Inet electronic equity market in 2005 and consolidated U.S. equity trading onto
the company’s platform within a year. The company had bought Brut, an early
electronic communications network, or ECN, in 2004.
Since 2000, Bats Global Markets,
based in Lenexa, Kansas, and Jersey City,
New Jersey-based Direct Edge Holdings LLC, each of which now runs two stock
exchanges, have grabbed 18 percent of a marketplace that used to be dominated
by the NYSE.
The owner of the Big Board increased
its commitment to electronic trading in 2005 when it announced it would buy
Archipelago Holdings Inc., a Chicago-based electronic exchange operator.
Bloomberg LP, the parent company of
Bloomberg News, operates Bloomberg Tradebook, an electronic trading system.
While all this market fragmentation
drove trading costs down, it also has been blamed for the May 6, 2010, market
free- fall. Between 2:40 p.m. and 3 p.m. New York time that day, a plunge in
stock prices erased $862 billion of market value. Accenture Plc (ACN), a Dublin-based technology
consulting firm, fell as low as a penny from about $41.
The decline was triggered partly by
one firm’s trade in stock-index futures, according to a study released Oct. 1
by the SEC and the U.S. Commodity Futures Trading Commission. The trading
algorithm employed by the firm, identified by two people with knowledge of the
findings as Overland Park, Kansas-based Waddell & Reed Financial Inc. (WDR), sparked the rapid selling of stock
futures because it took into account volume but not price or time, the report
Volume increased as high-frequency
traders, who buy and sell based on split-second price movements, traded as
stock futures fell, prompting the mutual fund to increase its sell orders to the
market. Disparate rules across stock exchanges and delays in the dissemination
of trading data, especially for companies listed on the Big Board, led to
confusion in the equities market, the report said.
“What we learned is that there are
so many venues that trade the same product and don’t have the same rules,”
Grasso said. That created a “vacuum” on May 6, he said. “The institutional
difference is profound.”
The flash crash highlighted a
trade-off that continues. Buying and selling stocks is cheaper and faster, but
can also be riskier.
“People sometimes feel that the
computers are too much in control,” John A. Carey, a Boston-based money manager at Pioneer Investments, which oversees about $250 billion,
said of exchanges in general. “In the old days, at least you had specialists on
the floor who could get a sense of what was going on and could calm people
Since the May 6 crash, the SEC has
instituted so-called circuit breakers for some of the largest stocks and almost
350 exchange-traded funds. If a security drops 10 percent or more in five
minutes, trading in those shares stops for five minutes. The SEC is in the
process of altering the curbs to limit price moves instead of halting stocks.
That didn’t stop the acceleration of
investors fleeing equity markets that began with the collapse of confidence in
credit markets following the Sept. 15, 2008, bankruptcy of Lehman Brothers Holdings
Retail investors pulled $96.6 billion from U.S. stock funds between May and
December 2010, even as the S&P 500
rose 6 percent, according to data from Washington-based Investment Company
Institute and Bloomberg. That represented 2.3 percent of the 2010 year-end
assets in U.S. equity funds, ICI data show.
At the same time, bond funds were
gaining, with about $121 billion in inflows during the same period. It wasn’t
until the start of 2011 that investors returned to stocks, adding $11.4 billion
in January, the most in 20 months. They withdrew more than $5 billion in March
and have taken money out every week of May and June, ICI data show.
Under John A. Thain, who was
president of Goldman Sachs before he became NYSE CEO in January 2004, the
exchange went public by completing its merger with Archipelago in March 2006,
making multi-millionaires of the specialists and brokers who owned seats on the
NYSE. Thirteen months later the company paid 9 billion euros for Euronext NV,
which operated exchanges in Brussels, Lisbon, Paris and Amsterdam, where it was
based, and the Liffe derivatives exchange.
Derivatives offer NYSE Euronext’s
biggest operating margin and are an increasing share of the company’s profit.
As late as the first quarter of 2009, NYSE Euronext said stock trading and
listings made up 61 percent of net revenue. In the first quarter of 2011, that
unit contributed 48 percent, while 35 percent came from derivatives trading and
17 percent from its technology division, according to a regulatory filing.
After the merger with Deutsche
Boerse, the derivatives business would account for 37 percent of the combined
company’s revenue, while stock trading and listings would shrink to 29 percent,
the company said at an April shareholder meeting, citing 2010 pro forma data.
Changes have swept out the
industry’s clubby atmosphere, said Berkeley, formerly of Nasdaq and now
chairman of Pipeline Trading Systems LLC in New York.
“There were WASP cliques, Jewish
cliques and Irish cliques when I came into the business in the early 1970s,”
Berkeley said. “Technology blew that away. Technology doesn’t care what color
you are. It cares how much you know.”
Technology has also made the NYSE
floor “way quieter” than it used to be, said Maguire, who told the talcum-powder story.
“When I walk in now, there’s that
absence of the buzz,” he said. “The business is still out there, but it’s being
done by computers.”
Those computers are located in a
high-security building on a neatly landscaped 28-acre (113,300 square meters)
former quarry in Mahwah, a northern New Jersey crossroads just south of the New
York state border. Everything there is big. Pipes 20 inches (51 centimeters) in
diameter bring water to cool the computers. The 20 surge protectors that guard
against power outages are each as big as a Hummer H4. Generators on hand in
case the facility loses utility power can keep cranking electricity on their
Brokerages and high-speed trading
firms can pay a basic fee of $8,000 a month to have their
computer servers hooked up to the trading grid, where orders are executed,
according to the NYSE Web site.
The landscape is very different from
the one Dick Grasso left eight years ago.
“You know what? You never look
back,” Grasso said, wearing a black suit with a pink tie and a 9/11 lapel pin
depicting an American flag on a New York Police Department badge, during a
recent interview. “The tape goes in one direction.” He thrust out his hand and
moved it slowly, following an invisible stock ticker. “Remember that. It only
goes in one direction.”