Direct Edge CEO William O'Brien (photo: Direct Edge)
A painting of the New York Stock Exchange in its heyday, depicting men buzzing around trading posts, hangs in the Jersey City office of William O’Brien. An inheritance from his father, it represents a way of life the Direct Edge Holdings LLC chief executive officer has spent a career helping to dismantle.
Now that Direct Edge has completed its merger with Bats Global Markets Inc., the combined company will vie with NYSE to be the biggest operator of U.S. stock exchanges, with both using computer servers instead of all those floor traders. Responding to a Twitter post last month that recalled an 1829 NYSE session that ended with no trading, the 43-year-old O’Brien wrote, “Trying to make this happen again real soon!”
Meant as a joke, the tweet still underscores the ferocity of competition between companies that operate in a space dominated by the Big Board for two centuries where yesterday 9.6 billion shares worth more than $429 billion traded. Buyers and sellers of U.S. stocks are now matched on more than 50 electronic venues, lowering costs and boosting speed for investors while increasing the need for exchanges to adapt to ever-changing demands from computerized traders.
“There’s certainly a psychological boost” that comes with having the biggest market share, O’Brien said in an interview Jan. 16, wearing his wedding band on his left hand and his University of Notre Dame class ring on the right. “Does it inherently change the value proposition? I’m not sure. We can’t rest on that.”
The portrait of the market in which O’Brien operates is harder to paint than it was in the era of his dad, who was born in 1936 and a Big Board member in the 1960s and 1970s. Instead of a landmark building on Wall Street with its own raw bar and barber, stock trades are matched in data centers with few windows tucked away in places like Secaucus, New Jersey, where palm-print scanners and other security measures await the few humans who enter.
Instead of people crowding around open-outcry pits, trading firms bunch computer servers around exchange machines in a process known as co-location. While clerks and pneumatic tubes once ferried order slips to floor traders, today fiber-optic networks and microwave transmissions connect the data centers of various exchanges in the suburbs of New York and Chicago. It’s all in an effort to shave microseconds from the time it takes to move information and be the first to trade on it.
The emergence of a challenger to the NYSE shows how much high-frequency trading has done to reshape the industry. Rule changes over the last 15 years opened the business to competition and spread trading across more than 50 electronic venues. Even as the regulations cut costs, they alarm some investors, who say the market has become too complicated, ripe for abuse and prone to malfunctions such as the “flash crash” of 2010, when the Dow Jones Industrial Average fell 998 points.
While the merger of Bats and Direct Edge reduces exchange owners, it won’t reduce the number of exchanges. They plan to keep operating all four of theirs, missing an opportunity to reduce fragmentation in the market, according to Dave Lauer, who helped develop rival market IEX Group Inc. IEX is owned by a group of mutual funds and other investors and makes efforts to mitigate the effect of HFT firms capable of pumping out thousands of orders per second.
“Almost everyone wants some reduction in complexity and fragmentation,” said Lauer. “And when you have two pairs of venues with identical business models and very similar pricing structures, why wouldn’t you merge?”
Academics have scoured market data to determine if the proliferation of venues and automated, high-speed trading has improved markets. Most conclude it has, according to Charles M. Jones, professor at Columbia University.
“Every time there has been a market structure change that results in more HFT, liquidity and overall market quality have improved,” Jones wrote in a paper supported by a grant from hedge-fund manager Citadel LLC. “Based on the vast majority of the empirical work to date, HFT and automated, competing markets improve market liquidity, reduce trading costs, and make stock prices more efficient.’
Direct Edge is combining with Bats at a time when the HFT firms that helped spur their growth are making less money. Profits in the industry fell to as little as $810 million in 2012 from $4.9 billion in 2009, according to estimates from Rosenblatt Securities Inc. HFT was involved in about half of trade volume in 2012, the most recent data available, compared with 66 percent in 2009, according to the firm.
Exchanges, which profit when buyers are matched with sellers, are carving up a shrinking pie. Bloomberg LP, the parent of Bloomberg News, operates a venue called Tradebook. U.S. stock trading has declined 28 percent, from an average of 9.8 billion shares a day in 2009 to 7 billion this year, according to data compiled by Bloomberg.
As with many questions he’s asked, O’Brien had an analogy to explain what happened.
‘‘The way to build a business or wealth in the United States from 1650 to 1900 was a lot different than from 1900 on,” O’Brien said. “You just keep going west, and you can’t do that anymore. The land grab era is over.”
Technology also has pushed the debate about market fairness off the exchange floor and onto the Internet for all to see, said O’Brien, who relinquished the CEO title to Bats’s Joe Ratterman after the merger closed yesterday as the Direct Edge brand is slowly phased out. O’Brien’s advocacy for the markets “lines up with our DNA and is why this merger is a natural fit,” Ratterman said in a Jan. 24 e-mailed statement.
O’Brien, who is staying on as president of Bats, often points to the past imperfections of the market to bolster his case that criticism of its current state is overblown.
“There were bad actors in 1980, there were bad actors in 1880,” he said. “We really haven’t had to change the rules of what conduct is not allowed because of the rise of automated trading. But there are certainly new ways to break the old rules. And we have to be better, continually strive to get better, to make sure that the way we surveil, the way we deter, detect and punish the bad guys, is done more effectively over time.”
One of O’Brien’s sparring partners on Twitter is Sal Arnuk, the co-founder of Themis Trading, a 10-person shop in Chatham, New Jersey. Arnuk and partner Joe Saluzzi are among the most vocal critics of today’s market structure.
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