If you can't beat 'em, join 'em

Apr 25th 2005
From The Economist Global Agenda

The New York Stock Exchange's proposed merger with Archipelago, an all-electronic market, could transform the venerable floor-based exchange beyond all recognition. But not everyone is happy with the deal

IF JOHN THAIN, the chief executive of the New York Stock Exchange (NYSE), learned anything in his many years at Goldman Sachs, it was: if in doubt, cut a deal. The one he unveiled on Wednesday April 20th—the purchase of the all-electronic Archipelago exchange—may transform his 212-year-old, floor-based, not-for-profit mutual company into the world’s most modern financial market.

The deal, which is subject to approval by shareholders and regulators, would give the NYSE’s 1,366 seat-holders (and owners) 70% of the new company and $400m in cash. Archipelago shareholders would get the other 30%.

This continues the wave of consolidation that has seen the number of electronic exchanges dwindle from a dozen in the 1990s to about five. More matches may follow: NASDAQ, the world’s largest electronic stockmarket, is expected soon to announce a takeover of Instinet, a brokerage firm and electronic trading network controlled by Reuters, for about $1.8 billion. Because trades gravitate to the most active exchanges which offer the most liquidity, peripheral markets, notably regional exchanges, have withered away.

This changed a bit over the past decade as the NYSE began to lose some market share to new, faster, cheaper all-electronic rivals exemplified by Archipelago. Meanwhile, its reputation was tarnished by successful prosecutions of Big Board traders who put their own interests ahead of their customers’, and by weaknesses in its self-regulatory function. Seat prices slid—although they have risen strongly in recent weeks.

Now Mr Thain has made strides on all fronts. The NYSE is to spin off its regulatory arm into a separate, not-for-profit entity, removing potential conflicts of interest. And it will become a listed, for-profit company without following the lengthy route, via de-mutualisation and a public offering, that has taken other exchanges years. (It took the Pacific Stock Exchange five years to de-mutualise and it has yet to list its shares, according to Dale Carson, the exchange’s spokesperson.) The merger also gives the NYSE a way into NASDAQ-listed stocks, in which Archipelago has a 25% market share, and the growth business of derivatives trading.

Many hurdles still lie ahead. In becoming a for-profit company, for instance, the NYSE will have to manage a difficult change in its relationship with other Wall Street firms, which were part of the mutual structure but are now competitors as well as customers.

Also, for now at least, the Archipelago merger only brings the two firms under the same roof; it does not knit them together. There are no plans yet to integrate the two exchanges’ technical platforms or businesses, calling into question the synergies behind the deal. So NYSE and Archipelago shareholders will continue to have competing interests. In particular, NYSE owners, many of whom are traders with an interest in the continued existence of a trading floor, are likely to resist moves towards an all-electronic format, and may even stymie the deal. “The merger won’t go down quietly,” says Benn Steil, a financial expert at the Council of Foreign Relations.

Already there is disquiet. Some of the exchange's biggest brokers, fearing that the deal will leave them short-changed, are angry that Goldman Sachs was allowed to act as adviser to both companies—especially since the investment bank owns both a share of the NYSE (as one of its seatholders) and a 15% stake in Archipelago. This, the critics assert, constitutes a gross conflict of interest. Hoping to capitalise on this frustration, Kenneth Langone, a former NYSE director, is trying to assemble a rival bid for the exchange. However, he has an awkward relationship with some of the regulators who have a say in approving any deal, including Eliot Spitzer, New York's attorney-general.

Assuming the NYSE's merger with Archipelago does go ahead, the ultimate test of its success will be whether it lowers the cost of trading. Richard Grasso, Mr Thain’s predecessor, who was booted out after a scandal over the size of his pay packet, did not manage this in his long tenure. If Mr Thain can meld the two businesses and pull this off, the deal will be a brilliant coup. If he fails, the NYSE will continue to have a struggle on its hands.

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