'The floor is not going away. OK?'

By: Ray Pellecchia

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At NYSE Euronext's Analyst Day earlier this month, the press focused mostly on talk of mergers. Overlooked were Duncan Niederauer's comments about market quality, specialist participation, future of the trading floor, etc. His remarks didn't constitute news per se, but I don't think I've ever heard anyone talk so candidly and authoritatively about the real value and utility of the trading floor.

Call that kiss-up if you will, but I just love the way this guy talks, and more than that, the way he acts on what he says. This stuff has needed to be said -- and done -- for a long time. In Duncan, our market has an advocate with the expertise and wherewithal to make things happen, and that's why I'm devoting some this time and space today to his comments, without apology.

Been meaning to transcribe his presentation for some time, and when I finally I turned my attention to it, I discovered that the whole transcript of the entire day was already posted in the IR section of nyse.com. Bless you, NYX IR. Guess I should have checked sooner!

But better late than never on this. It really digs into the issues, and I can't think of a better, first substantive post under our new Exchanges blog banner.

Here's the link to the full transcript. Duncan's is the second presentation; I recommend scanning the whole transcript, because the other speakers also presented a lot of terrific information for those of you focusing on our competitive issues, globalization, reg issues, the various products and services, the whole gamut. In addition, here's the link to the slides to which he refers in his presentation; Duncan's are pages 25-30.

Following are some big excerpts from Duncan's comments and the Q&A:

A lot of you ask us from time to time, how are we doing with hybrid? How is it going? What's happening with hybrid? It is now completely rolled out as of the end of February. So I think now these statistics are somewhat telling. We have this notion in the markets today of are you fast or are you slow?. Are you fast or are you in auction mode? So you can see from the top right here, we are in fast mode almost 100% of the time.

This may surprise all of you, I don't think that's a good thing. If I'm hearing the customers properly, they do not want us to be NASDAQ. They do not want another super-fast video game with no price improvement and high volatility. What they want is a market that's fast when they need it to be fast, but also can discover prices for blocks when that's called for. So I would actually hope, as strange as it may sound, that 99.8% comes down. I'm not trying to get it to 100%.

We have gotten a lot faster. We've reduced latency just in the time that I've been here for incoming orders from 300 milliseconds to under 100 milliseconds. I think, by the end of the year, you'll see us get it down to under 10 milliseconds. Having said that, the biggest comment I'm getting from the sell side when I go out and meet with them is please help us figure out a way to efficiently price and print blocks on the floor of the New York Stock Exchange. Our customers are asking us more and more for that facility and I think we all agree that it's a bad outcome if every block is just going to print in the third market. That's certainly easier. That's where we've ended up in NASDAQ right? 70% of the volume trades in the montage to 30% that doesn't all prints in the TRF. It's not what I'm aspiring here and it's clearly not what the key clients are aspiring for so we're going to spend some time working on that.

Now, as we've gotten faster, you can see the percentage of volume that's auto executed has gone up dramatically. The percentage of trade that's auto executed has gone up dramatically. Spreads, both quoted and effective have come down a little.

The only thing that I think goes against the grain of market quality is volatility has picked up slightly. A surprise to no one in this room, I'm sure. As you go faster, a couple of things happen. As it becomes more of a video game, you're just lifting an offer, you're hitting a bid, you're lifting an offer, you're hitting a bid. Price improvement diminishes and volatility picks up a little bit because the way you dampen volatility is by having rules in place that encourage more liquidity at the NBBO and that encourage quote competition inside the NBBO.

In a fully electronic game, those two things just don't happen. So I'm not surprised volatility has ticked up a little bit. It's only marginally above pre hybrid levels, but I would hope to see that come down if some of the things I'm working on come out as they should and you can see the fill rates are quite good.

A little bit on innovation because a big part of what I'm trying to work on here as well is impacting the culture of the organization. You're going to find me, I think, fairly obsessive about making sure that we have a customer-focused organization that is equally focused on innovative practices. As a customer of this facility for a long time I didn't feel that either one of those two things was necessarily true until very recently and I'm going to make sure that it becomes something that everybody associates with this company. Those will not be words, I promise you, those will be actions.

Recent steps we've taken, just in the last few months, were to create our own trade reporting facility. To fold in a small company called TransactTools that will help us commercialize and be much more focused on our client connectivity and similar and related technologies and MatchPoint trading, which I think is part of the answer to the block issue, but not the entire answer. MatchPoint trading is a Posit like, what I would call temporal cross, we will start by launching an after-hours cross. You'll probably see us launch hourly crosses. It does beg the question of whether we should have a continuous block trading mechanism, but I'll touch on that in a minute. MatchPoint will not be that. MatchPoint at most will just be a portfolio level cross that happens 4 or 5 times a day as we gradually roll it out.

Last slide, you could also call this slide what are some of the things I'm working on right now, when I talk about near term priorities.

We've touched on the first bullet point. This has to be about market quality. Sure, am I focused on market share, I have to be. My general view is if I get market quality right, market share will follow. So a lot of the things you're going to see us trying to change are about improving market quality and I'll get to them later in the slide.

Block price discovery, we've already talked about. There's three different ways I can attack the block business here to bring blocks under the umbrella. One is to just simply accept that it's going to be like NASDAQ and encourage everyone to print them in our trade reporting facility. As I said earlier, I don't think that's the outcome everybody wants.

Second alternative you can take is to create a facility that would look like some of the existing crossing networks, dark pools, reserve pools, whatever you'd like to call them, where people could put in their interest and it would be a facility of the New York Stock Exchange, it would be side by side with the book we have running now and we may explore some options there.

But the third way to do it, which is what we're really focused on now and seems to be what the clients want, is doing it inside the book. We have had some success lately, frankly just on the back of client meetings I've been having, saying if you guys really want it then bring them to the facility now. Let's see how we do it, let's see how fast or slow we are at getting them to the tape and then let's discuss what the experience was like so I can make sure the experience gets better and better.

For example, just Monday, following up on a couple of sell side meetings I had had, we did 2 blocks totaling 30 million shares of Selectron. I promise you two months ago those would have gone to the third market. So we're trying, we're going to get better at it, and we're very focused on block price discovery because I think it's a critical component of market quality.

You will also see us working very closely with the SEC, trying to amend rules. As I've said to a number of you already who I've met in my stay here, and I continue to say, that there is no big bang on this stuff. We didn't get here in a moment, we're not going to get to some other place in a moment. You're going to see us do a lot of, what I would call, incremental changes.

I would be the first to say that 5 years ago, if you looked at the balance of opportunities our primary market maker/specialist had, versus the obligations that same person had, it's fair to say the opportunities outweighed the obligations. I actually now believe the reverse is true. I think the regulatory pendulum has swung so far that I want to have a model that has a primary market maker with obligations. So I am telling the SEC that is what I am endeavoring to have. Let me have that market model. To do that I need to tweak a few of the rules that I think have -- in places where I think the pendulum has swung too far. At the same time, since I'm focused on market quality, I'm going to make sure that the way I measure the specialists or primary market maker for their performance is going to be very much tied to market quality.

You will recall, for those of you who listened to the last earnings call, we talked about the incentive payment pot we have now and frankly it gets distributed, not entirely, but almost entirely based on market share. That's not good enough. It's going to be tied to a number of different metrics and I think we'll commit, in front of all of you here today, that potentially by August 1st and certainly no later than September 1st, we will be having the metric I talked about on the last earnings call in place. It will include things you'd expect me to include. It will include level of price improvement, level of size improvement, management of volatility, tightness of spread, liquidity offered at the NBBO, percent of time you're on the NBBO. It may not be all of those things, but that gives you a flavor for the direction in which I'm heading.

The specialists are aware of this, they know that the recipe is still not quite finalized but we're going to give them full transparency into it. And I think if I align their interests with the interests of market quality, I'll take my chances on that. So you can hold us accountable for getting that done in the August/September time frame.

If you also saw my CNN media introduction, where I look like I weighed 240 pounds, you will know that I talked about the floor and where the floor is going. The floor is not going away. OK? The floor is undoubtedly going to get smaller. It is probably in my interest to have it get a little more consolidated, it's easier to manage, it's easier to run it more efficiently. And I'm sure there are many people downstairs who will feel that they cannot reinvent themselves in the new world and will continue to hand in their badges.

As I said last week, for all the people who are handing in their badges, I've got just as many people coming into my office saying they're going to hire more people. They want to make a go of it. So my commitment to them has been to give them more reasons to come in and make their living as an agency broker here everyday. It is a long standing rule of the New York Stock Exchange and the SEC that if you are an agency broker on this floor, all you could do was trade IBM, Wal-Mart and Home Depot and our stocks from the -- from your booth on the floor.

It was challenging to access away markets in our stocks as liquidity has migrated somewhat out of the building and it was not possible for you to trade all the other products we saw in slide 1 that are now part of NYSE Euronext. This never made any sense to me, it continues not to make sense to me and I think any day now we will have a notice from the SEC saying we're approved to have our floor brokers booths be viewed like any other agency branch office would be, with the proper compliance bells and whistles in place, and they will be able to trade any and all NYSE Euronext products from the floor, subject to them having the right charter, having the right memberships, et cetera, et cetera. My job is to make it fairly easy for them to do that.

What does that do for us? It keeps them in the building. It keeps the floor operating in a vibrant way. And if any of these other rules that I'm changing which will take a little longer than the filing I just mentioned to get done, impact the market in a positive way where we have more information at the post, most price discovery at the post, then I've got a well run efficient floor already in place, which I can easily mobilize to participate in that market.

. . .

Q: You mentioned you have a lot of people come into your office who are looking to expand their floor presence. How many trading licenses are actually in use right now, and do you actually expect that number to stabilize and maybe rise over the next year?

A: I would still have to believe it's going down a little bit further, right, so I think the number right now, and someone will correct me, it's 840, 850. I'm within 10, I may not get it exactly right. I do think that there's still some people that are just going to decide they can't leave -- they have to leave the floor because they just can't figure out how to make it in the new world.

The people that are coming into my office are people that have had good buy side relationships and have always had a business and view the changes I'm making as a possibility to have an even bigger business. And, they're willing to roll up independents who might be sole proprietors as long as they've got good buy side relationships too.

The people who I think end up still leaving are people who never really had great buy side relationships and sort of benefited from the time and place advantages that the old rule set offered them. It is hard for them to reinvent themselves so I think some of them will still leave. And, I also think on the house side, we have seen most people go.

I was up at UBS on Monday. They have gone from 30 to 7. I don't see them going from seven to zero. Bernstein is the only firm of note that completely vacated the floor and they were already outsourcing three quarters of their business to other brokers on the floor. So, it was a little bit of a misnomer that they abandoned the floor. They were at 75/25 outsourcing/insourcing already and I teased my friends at Lehman on Friday because when I went up to see them for lunch on Friday, the Post had already come out saying Lehman evacuates their people from the floor. They let three or four clerks go, they still have seven or eight brokers, one of whom did a huge block in Selectron on Monday.

So, I think the house brokers' population will still get smaller because the sell side firms feel they can do a lot of it upstairs. But, the sell-side firms I have talked to, none of them really want to take it to zero because they think we might change the rules, they do want to print the blocks here, and even just around IPOs and stuff, you want one of your own guys in the crowd doing that. So, I think it goes down a little bit from here but not much smaller from here.

Q: Hey, Duncan, can you just follow up a little bit more on the conversations you have been having with the sell-side. They seem to be telling you they want a vibrant floor model for crossing blocks, at the same time they are investing in BIDS and looking to internalize more. How do you interpret the two discussions?

A: I will tell you how I interpret them, because seven weeks ago I was one of the guys investing in BIDS. Okay, so I probably have somewhat of a schizophrenic approach to this one because I kind of know what both sides are thinking on this one.

You are the sell side and the exchange doesn't look like it is doing anything to help you get -- price is discovered for blocks. Liquidnet seems to be going directly to your clients as is Pipeline and other people that look like Liquidnet and Pipeline, basically saying you are not invited to this party. This is for clients only. Brokers are not welcome. So, if you are a broker you feel like, well, I do not see the exchange helping me, and I see the other guys working against me. I had better get something in place where I can wrest control of this back to my own place.

What I said to the sell side firms is -- it is hard for me to say that was not the right thing to do since I was one of the engineers of that idea. But at the same time, the block price discovery thing is something, I think you and I talked about this last week, where our interests are aligned with the big sell side firms. It is not good for me and it is not good for the big sell side firms if block price discovery gets done in dark pools where neither we nor they have any stake or skin in the game. So, I think our interests are fairly aligned on that and so I do not blame them for doing what they are doing. I would like to think I can give them a reason where they do not have to do that. So, that is kind of the goal.

Q: Just to follow up on that, since we did not talk about that last week, and given the changes that you are contemplating with regard to the specialist model. Do you think there is a possibility that we may see a change in the cast of characters and does it actually make sense for this sell side to become more involved as specialists sort of combine the efforts with respect to block price discovery?

A: Yes, that is a great question. There's a few different ways I could answer that one, because there's a lot more threads there than you probably think. Clearly, the model right now is contingent on having a primary market maker with obligations. We have seven firms already playing that role. A number of other firms have approached me saying, with a couple of caveats they would like to play that role. It remains to be seen how that all shakes out. What I keep saying to the SEC is, I am not there to defend the seven firms that do it now, I am there to defend the role because it's a big part of my market model.

If you go back 10 to 15 years ago, there were what, 70 or 80 specialist firms. So, stocks have changed hands before and I am sure there will be more of that coming later. It is incumbent on these seven individuals to do it now. They've got their own decisions to make. They either figure out a way to make it work with the rule set, or I am sure not going to stand in their way if they chose to make a different decision. That is their decision, it is not my decision. But, I have had a number of other firms approach me saying, not that excited about being a market maker with constraints and not many opportunities, but I do think I have good risk management systems or I'd love a shot of that if one ever comes available.

So, I think you'll see us talking about that more in the coming months. I'd rather stop there today, if I could, because I've got more work to do on how that's going to play out.

Q: Duncan, you were the head of electronic trading at Goldman Sachs. It is interesting because the transformation that we see seems like the Jerry Putnam transformation here. No, I am teasing here. In regards to--

A: Sorry, Mr. NASDAQ, I didn't hear you.

Q: Touche.

A: If you're going to bring it, bring your A game, people, okay?

Q: I'm hitting too close here. Fair point. The point is -- that was a joke.

A: I know it was.

Q: But, you did say you want -- the floor is important, it is important to be here, it is important to the New York Stock Exchange. I imagine there's a lot of people out here -- a lot of people that own the stock probably with the idea that the floor was going to go away. And, I guess the question is, I know you're never going to get hard numbers, but has the economic -- I don't think it would be that hard -- but has the economic analysis been done to say what does market share have to be, what does volume have to go up to to offset the economic benefits of closing the floor. From a pure economic standpoint, do you win in the long run by keeping the floor open?

A: A couple of things. Number one, a big part of my job at Goldman was the electronic business but I also ran the sales trading business at Goldman's too. So, I ran both. I think a lot of people know me mainly after a 22-year career as someone who was involved in the electronic business, but I was just as involved in the high touch business. I am sure, I think a lot of people did speculate when I came here that that is the last straw for the floor. Now they are just going to become a giant ECN. If your customers are telling you that is not what they want, if to me becoming an ECN ultimately reduces an important barrier to entry then -- and you have to be in position to want to compete that way and be that way, to me that is a multi-step process.

Now I have also learned...that if I did do the economic analysis and was able to save a bunch of money by reducing or closing the floor, Nelson would just take credit for it anyway. So, if you know that then you know that probably factors into my thinking also.

But, I think the next step you'd rather take is, it is going to get smaller, with the other gentleman's question. You try to have enough technology you can run it efficiently and consolidate it. And look, I am not going to swim upstream. If the market a year from now -- if I'm asking those same big customers a year from now and I can see how the demographics of trading look, and the market is saying to us, okay, just flip the switch and just be an ECN, you can't be -- you can't just say, oh I'm going to ignore all that input. It is not what we are being told right now.

I think it is important to the brand, I think it is important to the market model, until such time as it isn't. And, I just don't see that time when it isn't right now. So, that is what we are going to try. You are right, you probably could go through the math and try to figure it out, but what is the offset to market share if you don't have a floor. If it is just an ECN, if it is just a video game, it is hard to know. So, I haven't gotten that far yet.

Q: I think those are all great points, the only point I'd come back is that if you look at equities it is one of -- a very straight-forward product. It is not an auction. If you look at the exchanges that have gone electronic, I don't know whether all -- they got a hundred percent support at the beginning. I would say you are probably going 150% in the right direction in letting decide but there's also at least some evidence that is definitely worthy of looking at.

A: Absolutely, and frankly, Rich, that is the easier decision to make. You have a lot of historical precedence to say that's the easiest decision to make, and if the market structure we end up with is that 70% of the volume trades in an ECN-like structure, and the other 30% is printed with no price discovery then, I don't know if that's market structure to be proud of so I'm probably a little constrained by my philosophies of what I think market structure in the country should be.

And, I'd rather let this -- since I have these assets now, boy, they're hard to get back if I get that wrong and I'd rather just manage them in the way I'm managing them now; try to change some of the rules and let the market model run for a little bit and see how it works. I can't -- if all the signs point in another direction, you can't be blind to them either. So, you will see where we are going. We will keep everybody posted.

How much -- do I have time for any more? We have one more question.

Q: Duncan, you talked about three keys to improving the business. One is getting the SEC to tweak the rules; the second is to have the specialists rollout more algorithms of electronic trading; and third is the incentive piece, which you are working on. What inning are the specialists in in terms of rolling out their algorithms being fully able to interact with the market? And, what is kind of a reasonable timetable for pilot program for the SEC to change the rules?

A: I will try to answer them in that order.

Number one, they've all got their -- I think algorithm is such an over-used word today-- they've all got some kind of market making system attached to our API. Some of them appear to be working better than others, just like you would find if you went and looked at 15 NASDAQ market makers, risk management systems or order management systems. You would find some great ones, some good ones and some not so good ones. So, I think they are all trying to tweak their risk management and market making systems and try to figure out how to make a go of it. I guess a big part of the test for them is to find out under the current rule set how can they do.

What I have been -- I have been talking to the SEC on not quite a daily basis, but about a lot of different things because I have observed early is communication with them is going to be really important. I was somewhat emboldened by Mr. Sirri”s comments a few weeks ago saying that it may not be fair that the leading exchanges are subject to this laborious filing and comment period and approval process when, in today's landscape, almost no one with whom we compete is subjected to the same process. So, I have called him a few times saying, boy, that made me feel great, I guess I can count on much quicker turnaround now to all the things we are asking for.

And, I think what he and I have talked about the last few days is, I don't know that a pilot makes any sense so I started there seven or eight weeks ago. Now, what we are saying is let's just attack one rule at a time. Let's just do it and then I will measure it. So, pilot the time not the number of stocks. Because, for example, one of the things I really want to change is I want to eliminate the price improvement scale. Okay? The way it is written right now, no market maker in the stock that is $0.05 or $0.06 wide is going to improve by $0.03, just to provide price improvements. And, that has eliminated quote competition inside the quote.

For me to pilot that on 200 stocks when I want that to be a critical measure of how I am going to measure the specialists starting in August, it makes no sense. I've got to do it on all stocks and price improvement is only going to go in one direction, if it is pretty low right now. So, I am confident I will be able evidence and improve market quality to improve price improvement and tighter spreads. I think he is coming around to that notion that we should commit that if it looks completely wrong in four to six months we should do something about it. And, pilot the time but not go through this 200 stock process.

So, look, I'm cognizant of the fact that everything has to go through them, I'm cognizant of the fact that that's an important hurdle I have to clear every time I want to change a rule that other rule that other people don't have to, but I'm finding the relationship right now with them very positive. So, just keep watching this space and hopefully you will see us get some of these things gradually changed, as I said incrementally not all at once. Okay? Thanks a lot everyone.

Tags: New York Stock Exchange, Hybrid Market, NYSE, NYSE Euronext, NYX, trading, stock market, trading floor, specialists, brokers, Duncan Niederauer