The winds of change are sweeping the floor of the New York Stock Exchange, as federal regulators look to overhaul the world's biggest marketplace.
In the wake of the scandal surrounding former Chairman Dick Grasso's forced resignation and allegations of illegal trading at specialist firms, the Securities and Exchange Commission is hard-pressed to reevaluate its corporate governance and trading practices.
Grasso was ousted following an uproar over his egregious $187.5 million compensation and retirement package. In a more recent development, Frank Ashen, head of human resources and top ethics officer at the Exchange announced that he would also be stepping down. His resignation makes him the first high-ranking official to leave the Exchange since Grasso was pushed out. Ashen, 59, was one of the key architects of Grasso's ill-famed pay deal.
But prior to the scandal being uncovered, the NYSE already had been scheduled to unveil a series of corporate governance reforms at its next board meeting on Oct. 2. The planned reforms came in response to seething criticism of the makeup of its boardroom and inherent conflicts of interest. But in light of the new developments, Exchange officials said the release of that report may be delayed to allow newly appointed interim chief John Reed more time to get up to speed on the proposals. Reed, the former Citigroup chairman who was named Grasso's replacement last Sunday, certainly will have a full plate given the breadth of issues plaguing the Exchange and its diverse group of constituencies.
"The most important thing on the agenda is the review of whether to divorce the regulatory function from the business side of the Exchange," said Eugene Goldman, former senior counsel in the SEC's enforcement division, now a partner with the law firm of McDermott, Will & Emery in Washington, D.C. "That would be the case even if there is no IPO."
The NYSE has always existed as a self-regulated organization based on the concept that one must have intimate knowledge of how it works, expertise that could only be found among the member firms. But times have changed and the SEC now has the expertise to oversee its operations. During the 90s, the Nasdaq went through a similar crisis when it was discovered member firms were fixing spreads between the bid and the ask on stocks, so that when prices fluctuated the spread stayed the same.
As a result of this blatantly illegal practice, the two functions of trading and regulation were split into separate entities, the Nasdaq and the National Association of Securities Dealers. In splitting the functions, it eliminated the conflict of interest of having member representation on the board of directors. Under the leadership of Mary Shapiro, the NASD doesn't have to go to the business leadership of Nasdaq, but rather she has her own enforcement staff that bring their own actions. So one of the biggest decisions for the NYSE directors will be whether they plan to become a public company and issue shares in itself.
Another governance issue is whether the chairman and chief executive positions should be kept separate. One of the major criticisms of NYSE leadership, not to mention many corporate entities, has been the conflict of interest that is built in to overseeing both the business and the directors responsible for protecting the interests of its members.
Ultimately, the Grasso pay scandal and the floor-trading probe give SEC Chairman William Donaldson further leverage in his quest to reshape U.S. markets. That could spell trouble for the open auction system that has been used on the floor of the Exchange for more than 200 years. And for those in favor of modernizing the technology used to execute trades, the timing couldn't be better. Under Grasso's leadership, the NYSE favored the open outcry system of trading, which relied on the use of specialists to match buy and sell orders for its customers. Despite the rise of electronic exchanges such as Instinet and Island, the Big Board managed to maintain its stranglehold on the marketplace, collecting 80% of all trading volume.
Since the news of Grasso's departure broke there has been little impact on the Exchange's volume, but some within the industry believe that if they do not restore public confidence soon there could be some adverse long-term effects. Specifically, competitors could see increasing volumes over the long haul."Individually [the scandals] might not be that bad, but aggregately, it's possibly taking its toll," said Steven Schonfeld, chief executive officer of Schonfeld Group of Jericho, N.Y. a proprietary securities firm that specializes in short-term trading. He believes that once the NYSE calms the waters and confidence is restored that technology will become more of a concern than anything else. "At some point, whether it's now or two or three years in the future, the public will realize that ECNs are a better way to execute New York stock."
"I lean toward demutualization of the Exchange, aligning the incentives of the new management and the new shareholders to structure an exchange that is more efficient," said Hans Stoll, a finance professor at Vanderbilt University's Owen School of Management "This would require a phasing out of the role of the traditional floor brokers and specialists." Stoll notes that this shift has already been in the works for some time with five big specialist firms now controlling the floor, including Goldman Sachs and Bear Stearns. "The days of the little specialist are gone," he said.
The use of floor traders has greatly diminished in the last 20 years, with London abandoning the practice in 1986 and Australia clearing its exchange floor in 1990. The debate over which system is more efficient is a hotly contested one. The specialists argue they get the best price for the customer, whereas electronic trading platforms boast best execution, enabling its traders to move more nimbly. Schonfeld suggests that if electronic trading gains enough participation, then it would top the open outcry system not only in execution but also in price and liquidity
"NYSE dominance in volume will continue, but they are going to have to adapt to the new technology," Goldman said. "If they are flexible in meeting the challenges I think the commissioner will impose, they can keep a good percentage of what they have."
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