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The 'Neanderfloor'

Author: Benn Steil, Senior Fellow and Director of International Economics
October 31, 2003
Wall Street Journal


The board restructuring plan soon to be unveiled by the New York Stock Exchange’s interim chairman, John Reed, will, for the first time in the exchange’s history, isolate its poachers and gamekeepers in separate power centers. With conflicts of interests so deeply woven into the NYSE’s fabric, this step would have been unthinkable before the revelations of former chairman Richard Grasso’s gargantuan pay package.

Given how much wider and deeper the investigation into specialist trading abuses has become since then, however, the key question to ask is whether investors will see benefits from this new two-headed board. The answer: almost surely no.

In creating an oversight structure in which the NYSE’s member-owners will direct strategy and operations while outsiders control policing, Mr. Reed has opted for a governance fix to an ownership problem. Despite the fact that computerized trading has made obsolete the traditional brokerage role -- bringing an investor order to an exchange for execution -- the NYSE continues to be owned exclusively by broker intermediaries. The owners choose to perpetuate the Neanderfloor not out of sentimental attachment, but because it is vastly more profitable than allowing investor orders to meet in cyberspace. And they are able to continue doing so without effective competition thanks to the Securities and Exchange Commission’s decades-old “trade-through rule,” which precludes electronic competitors from building up critical mass. Where the rule is not operative, in exchange traded funds (ETFs), electronic venues own the space.

To the extent that Mr. Grasso was “worth” $188 million to the exchange, it was clearly not based on product or infrastructure innovation. Mr. Grasso left the NYSE’s business model precisely as he found it. The exchange still has no significant business outside its traditional stable of large-cap equities, despite the fact that new futures, options, warrants and ETF products are powering profits at Europe’s publicly listed exchanges. The trading system is a living museum, automated just enough to speed order flow down to the floor, after which automation deliberately stops. This allows the army of seatholders to pick the live carcasses of public limit orders, trading ahead of them for the price of a mere penny per share (if they’re obeying the rules), safe in the knowledge that there are public buyers behind their buying and sellers behind their selling.

The former chairman’s worth to the NYSE was in shielding its owners from excessive scrutiny. Consider the current investigation into systematic specialist trading violations. In 1999, the SEC ordered the NYSE to rectify its surveillance failures as part of a decade-long series of prosecutions and congressional inquiries following the 1992 Oakford front-running scandal -- in which evidence was uncovered by The Wall Street Journal that NYSE management (under Bill Donaldson’s chairmanship) took steps to keep suspect practices hidden from the SEC. Yet here we are again, with a slow-motion investigation focused on one specialist firm suddenly and dramatically widened and accelerated, and with far more stringent criteria imposed on the audit trail, only after SEC intervention in the wake of Mr. Grasso’s departure.

The exchange’s traditional marketing pitch for the specialists -- that they are there to buy when there are no buyers -- is transparent nonsense. It doesn’t take a George Soros to tell you that this is a bonehead trading strategy. Yet specialist franchises are commercial businesses, and have been remarkably profitable ones at that, which suggests that the actual strategy must be to buy before the buyers and sell before the sellers. The current investigations are sure to conclude -- shock of shocks! -- that this is what they do.

Does Mr. Reed honestly believe that an independent regulatory board is going to snuff out the very foundation of floor-trading profits and seat prices without triggering a civil war at the heart of the exchange? If he does not, he should do his successor a favor and come clean. He should explain that the NYSE’s regulatory problems indeed derive from its governance, but that its governance problems derive from its ownership. There is no sustainable governance fix without an ownership fix.

He should then give the exchange a chance at civilized reform by calling for a demutualization, capitalization of the seats, and a public listing. The new owners of a for-profit NYSE will have an entirely different incentive structure. They will no longer look to maximize the profits of the guys in funny jackets, but the profits of the exchange enterprise itself. They will quickly conclude that policing floor shenanigans is a huge cost that can be avoided with an electronic trading platform on which who-trades-when is determined entirely by algorithm. And all this can be done, as in Europe, with a unitary board.

There may be no substitute for good governance, but Mr. Reed is much more likely to get it if the owners can profit by it.

Mr. Steil is a senior fellow at the Council on Foreign Relations.