NYSE-Euronext: An Efficient Market Structure - Finally!

Until recently, NYSE listed stocks traded in an arcane and fragmented manner. The execution platform for NYSE listed stocks had been hopelessly stuck in a specialist centric model that left execution inequitable and uncertain. Naturally, change was resisted among the entrenched entities within this execution framework. But at long last the painful transition to an electronic, automatic execution platform seems complete. The floor traders, specialists, and traders who took advantage of the formerly inefficient and obsolete system will no longer be able to capture profits derived from the fragmentation.

The new market structure will allow volume on NYSE listed stocks to burgeon.

In the past, a NYSE specialist could control 75% or more of the order flow and the remaining percentage would trade on the third market, on regional exchanges, or Electronic Communication Networks (ECNs) such as Instinet. These other execution platforms would often trade at levels well above or below the proceeding trade on the floor of the NYSE. The discrepancies frustrated buyers and sellers and consistently led to short-term arbitrage trading opportunities between the NYSE execution and other platforms. This arbitrage demonstrated market inefficiency and traders took great advantage of the NYSE system.

Information regarding large working orders held by a specialist or an order clerk was routinely available to other market players. Traders often utilized this information to front-run large orders. This widespread disclosure of large working buyers or sellers was also problematic for market efficiency.

As markets evolved, the NYSE platform lagged behind the Nasdaq platform by three to five years. For years the Nasdaq platform was besieged by problems, including information sharing among competitors regarding large orders, pervasive arbitrage opportunities between market-makers and ECNs, and payment for order flow that kept spreads wide. In 1996, on the trading desk that I managed, I fought against receiving payments for the order flow on Nasdaq stocks because the execution performance was superior for non-rebated orders.

However, the Nasdaq market has steadily evolved to a highly efficient structure. These improvements have caused painful restructuring of trading-desk operations and personnel obsolescence. The net result of the superior structure is a vast increase in volume, liquidity, and execution quality on the Nasdaq.

The most recent improvements to the execution platform on the NYSE finally allow listed stocks similar benefits to Nasdaq traded stocks. While the NYSE will never be as efficient or scalable as the Nasdaq market, the NYSE is just breaking ground in its ability to capitalize on the scale-up of volumes that ought to follow. For example, traders, if they so choose, can now put on and take off a short position five times over in the same time frame that it often took to execute a single short-and-cover through a specialist.

There is a myth forming that the elimination of the downtick rule has led to an increase in volatility. I must refute this assertion. Exchange Traded Funds (ETFs) have been shortable without downticks since their inception, and ETFs and futures move the markets far more than individual stocks. A comprehensive list of stocks has been shortable without downticks for over a year, including Home Depot and Pfizer, with no change in volatility in these “test” stocks. In addition, for a significant period of time, Nasdaq stocks have been shorted on downticks through the Archipelago Exchange without altering their volatility profile.

Pundits are too concerned about shorting but never mentioned the fragmented trading on the NYSE that created poor execution for funds and great trading opportunities for traders. Where was the outcry when specialists would regularly gap down a stock to print a block when that entire volume would trade higher on ECNs?

Market share for the floor of the NYSE will likely continue to erode. This may cause the need for an overhaul of their fee structure. However, NYSE Arca ought to pick up much of the lost floor business and the Nasdaq stock market could also benefit through its ability to capture NYSE listed stock market share through their proprietary ECNs. Most significantly, as market players adjust to the new trading paradigm of NYSE listed securities, overall volume and liquidity increases will benefit both NYSE Euronext and Nasdaq.