Date : August 8, 2005
Publication : Pensions & Investments

Philadelphia exchange makes move to expand influence

Backing from market bigwigs puts PHLX on bold new path

While all eyes are watching Nasdaq to see if it can make a dent in the New York Stock Exchange’s longstanding 80% market share in listed stock trading, the Philadelphia Stock Exchange could be the one to do it.

The reason is the recent financial backing it got from market heavyweights Merrill Lynch & Co. Inc., New York, and Citadel Investment Group, Chicago.
“If Merrill Lynch and Citadel are posting (stock orders) in Philly, people will be forced to go there if they have the best price,” said Joseph C. Gawronski, chief operating officer at Rosenblatt Securities Inc., New York.

In June 2006, the Securities and Exchange Commission’s Regulation NMS takes full effect. And for stock exchanges in the United States and the investors who use them, one of the biggest changes will be the so-called order protection rule, which will require that stock orders be sent to the market center with the best posted price — provided that order can be automatically executed.

That means if the Philadelphia exchange, which is the fourth largest options exchange in the U.S., has the best posted bid or offer for a stock and it can execute orders automatically, orders will go there before anywhere else.

Mr. Gawronski believes the Merrill Lynch and Citadel investment was driven by Reg NMS, noting the deal “illustrates one of the things that Reg NMS did, and that is that as long as a quote is automatically executable, it has to be routed to the place with the best price.”

“Without Reg NMS, I would argue that Philadelphia would have a very short lifeline,” said Seth Merrin, chief executive officer of Liquidnet, New York, an electronic platform for institutional investors to trade blocks of stock.

“With Reg NMS, what we’re going to see, I believe, is electronic market-makers coming onto some of these regional exchanges and picking specific issues that they want to make markets in,” Mr. Merrin said. “It’s an opportunity for a bunch of competitors to be making very tight spreads in a number of issues and for the first time it doesn’t matter where. There’s a much lower price barrier to doing it on Philadelphia” than on the NYSE.

Acquisitions

Shortly after Reg NMS passed, the NYSE announced plans to acquire all-electronic stock exchange Archipelago Holdings Inc., Chicago. The Nasdaq Stock Market, New York, also announced a deal to acquire New York-based Instinet Group Inc.’s INET ECN electronic trading platform.

At the time, industry players said the deals would provide the NYSE with a way to capture Nasdaq market share and vice versa.

But then in June, the Philadelphia exchange announced that Merrill and Citadel had invested $7.5 million each for 10% equity stakes, with performance warrants that will allow them to increase their ownership.

“Primarily this is an options deal,” said Ben Craig, vice president of strategic services at the Philadelphia Stock Exchange, known as the Philly or the PHLX. “It’s driven around options, which is our core business. But that being said, we’re also an exchange that has three licenses. We trade options, equities and futures.”

The Philadelphia Stock Exchange made its mark when it held the exclusive listing for options on computer maker Dell Inc., Round Rock, Texas, one of the busiest options day in and day out. But with the advent of multiple options listings in August 1999 and the move toward electronic options trading, the PHLX struggled to maintain its relevance.

In an effort to turn its fortunes around, the exchange, founded in 1790 as the first U.S. stock exchange, demutualized in 2004 to become a for-profit corporation, with its 200 seat holders becoming shareholders.

To address the advancement of electronic trading in the options world, the PHLX embarked on a plan to change the way it traded options.

In early June, two weeks before the Merrill Lynch-Citadel investments were announced, the exchange launched its new model, dubbed Directed Order Flow.

‘Different roles’

“The model basically allows folks to participate in the exchange and in our market in a number of different roles,” Mr. Craig explained. “Firms can act as both order flow providers or liquidity providers and they can do it remotely.”

Under the new model, firms that provide options order flow can send customer orders to designated specialists on the exchange floor, market makers and remote market makers. Market participants can interact with a directed order when their quote represents the NBBO — national best bid or offer.

“It’s extraordinarily competitive,” Mr. Craig said, referring to the business model, its pricing and the technology behind it. He said the model and the technology were “the two key business drivers that underpinned getting these guys in.”

Matthew Andresen, president of Citadel Execution Services, the unit that made the investment in the PHLX, also noted the valuebeyond options.

“We think a lot about options and given Philadelphia’s move toward efficient trading and given their technology platform, this deal made sense on that alone,” he said. “But given their demutual structure and their proven ability to deliver technology, there’s the potential upside of an entry” into the cash equities and futures business.

Industry experts said the deal played well into the hands of both Merrill Lynch and Citadel. Merrill is one of the options industry’s biggest clearing firms, and Citadel is the biggest market maker on the all-electronic International Securities Exchange, New York, which is the biggest options trading center, excluding index options.

“For Merrill, it’s a cheap way to protect that (options clearing) business,” said one trading executive, who asked not to be named. “For Citadel, they want a seat at the table for anything in the options business.”

Rohit D’Souza, a managing director and head of global equity trading at Merrill Lynch, was not available to discuss the deal.

“I would suggest a cornerstone of the rationale for the deal is recognizing how the market for options trading and the inevitable domination of electronic trading in the options market has been an attractive growth area,” said William F. Cline, a managing partner at Accenture, who heads the firm’s global capital markets group.

Equity trading

But given the personalities behind the deal, other industry players said the longer term implications most likely have to do with equity trading.

“Even if the options side of the business drove the investment decision, these players are smart enough to see the worth of Philly beyond options,” Rosenblatt’s Mr. Gawronski said. “The equities potential wasn’t lost on them.”

Mr. D’Souza “understands automation and electronic market making — someone as savvy as he is, with Merrill’s (order) flow behind it — that’s significant,” said Mr. Gawronski. “You take Rohit’s expertise and history of innovation and Merrill’s order flow, combine that with Matt Andresen and Citadel’s big-time goals and you’ve got something that could be meaningful.”

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