NEW YORK (Reuters) - A once cozy relationship between exchanges and broker-dealers has cooled as investment firms develop new trading platforms and square off against the markets they relied on for decades.
Tensions have risen as a number of leading exchanges transform from private organizations accountable to seatholders to public companies with investors to please.
“Broker-dealers were accustomed to viewing exchanges as utilities and now we’re seeing some growing pains,” said Keefe, Bruyette & Woods analyst Richard Herr. “There is a new profit motive at the exchanges and for the next couple of years there will be this pushing and pulling.”
Public exchanges had a busy 2006, with blockbuster deals such as the $14 billion merger between NYSE Group NYX.N and Paris-based Euronext ENXT.PA, an options platform planned by the Nasdaq Stock Market (NDAQ.O), and price changes such as the New York Stock Exchange’s elimination of a monthly fee cap for member firms.
“NYSE’s fee change significantly increased trading costs for the largest six to eight brokers,” Herr said. “The fee cap was a vestige of the exchanges being a utility.”
Broker-dealers have also been active, investing in regional exchanges and alternative trading systems, or ATSs, that may circumvent public exchanges.
One high-profile ATS is Block Interest Discovery Service (BIDS), which is backed by investment banks Citigroup (C.N), Goldman Sachs (GS.N), Lehman Brothers LEH.N, Merrill Lynch MER.N, Morgan Stanley (MS.N) and UBS UBSN.VX.
“Broker-dealers are involved in my business because the exchanges changed their form and became for-profit, multi-asset class and multinational organizations,” said Timothy Mahoney, Chief Executive of BIDS.
Exacerbating the emerging tension is pressure on commissions received by broker-dealers, who can be squeezed by growing competition, client scrutiny and increasing costs.
“(W)hat is clear from overall industry numbers is that the core business of institutional equities - executing trades, providing research and advisory services and restructuring portfolios - is not beating its cost of equity capital,” wrote Sanford Bernstein analyst Brad Hintz in a note last May.
BATS Trading, another broker-dealer backed ATS, could ease things for some brokerages. It has been pitching an aggressive fee schedule and says it recently handled about 10 percent of Nasdaq-listed volume.
As a private dealer-owned company, BATS follows a model abandoned by NYSE and Nasdaq when they transformed into institution-owned, shareholder-driven public companies, BATS Chief Executive Dave Cummings said.
“The big question is whether publicly held exchanges are in the dealers’ interests,” he added. “It’s pretty clear the broker-dealers weren’t too happy with the market structure they saw 18 months ago. I think they are a lot happier with what they’re seeing now.”
Regional exchanges, typically small and private, have also benefited from broker-dealers like Citigroup, an investor in the Philadelphia and Boston Stock Exchange.
These investments on their own made sense for Citigroup, said C. Thomas Richardson, who spent 12 years at the investment bank before becoming president of BSE’s Boston Equities Exchange.
But the transactions also give Citigroup alternative markets to work with, keeping the NYSE and the Nasdaq duopoly in check, Richardson said.
Broker-dealers have also built capabilities through a process called internalization, which saves on fees by matching trades through internal inventories but that could raise conflicts if brokers are pressured to execute those trades in-house.
“Internalization by the brokers effectively removes (exchanges) from the process,” TowerGroup managing director Robert Hegarty wrote in a note. “Use of these systems represents just one more nail in the coffin of the traditional exchange floor.”
The threat from broker-dealers remains to be seen, but if the situation overseas is any indication, more clashes may be in store between firms and exchanges.
Investment banks Citigroup, Morgan Stanley, Goldman Sachs, Merrill Lynch, UBS, Credit Suisse CSGN.VX and Deutsche Bank (DBKGn.DE) announced plans in November to create a new pan-European trading platform to compete directly with European exchanges like the London Stock Exchange (LSE.L).