It didn’t take long for the New York Stock Exchange to react to a Securities and Exchange Commission decision that increases the importance of electronic trading. The big board, one of the world’s last refuges for floor traders, is merging with Archipelago Holdings Inc. to form a new public company, NYSE Group Inc.

The new entity will be 70%-owned by NYSE shareholders and 30% by ArcaEx’s owners.
Analysts initially valued the combined entity at US$3 billion-US$4 billion. The NYSE’s regulatory function will be spun off into an independent non-profit entity.

The proposed deal achieves a number of important objectives in one stroke: it increases the NYSE’s electronic trading capability, converts it into a for-profit public company and defuses some of the criticism of its oversight function.

The pressure to shift away from traditional floor trading toward more electronic trading came with the SEC’s controversial decision to extend trade-through protection to Nasdaq and other markets. The NYSE was already planning more electronic trading by going to a “hybrid” model that, pending SEC
approval, would expand electronic trading while preserving the specialist system. By merging with Archipelago, it quickly gains competitive electronic capacity.

In announcing the deal, NYSE CEO John Thain said the combination and the public listing will lead to greater efficiency and innovation. “As we look to the future and to the challenge of competing globally in a high-speed electronically connected world, it is clear that we must do more,” he said.
“This transaction will mean we will be more diversified and transparent, and better able to compete, grow and serve our customers.”

Analysts caution, however, that the transaction carries a fair amount of execution risk.

The NYSE insists the transaction doesn’t mean it’s abandoning floor traders, yet the specialist system appears to be facing an increasingly bleak future. The growing popularity of program trading and the migration to electronic trading has been eroding floor trading’s market share in recent years, and its reputation took a blow when the SEC and federal prosecutors alleged illegal trading offences (including front-running client orders) against 20 traders, that were said to have taken place between 1999 and 2003.

The SEC is bringing civil charges against 20 individuals, and federal prosecutors have filed criminal complaints against 15 traders.
None of the allegations have been proven.
The SEC also settled allegations against the NYSE for improperly supervising traders in that period. As part of the settlement, the exchange will spend US$20 million implementing high-tech surveillance of traders and funding audits of its oversight.

The news isn’t good for the floor traders, but it’s not as life threatening as the inexorable demand for electronic trading. Even before the Archipelago deal, brokerage firm Jefferies & Co. Inc. cautioned in a report:
“While the NYSE’s bad news might be behind us, we believe the persistently high levels of program trading and potential threat posed by the NYSE’s hybrid trading proposal pose serious risks to specialists’
business models.”

The NYSE-Archipelago transaction is subject to approval by members of the NYSE, shareholders of Archipelago, the SEC and other government bodies. The merger is expected to close in either the fourth quarter of 2005 or the first quarter of 2006.

If approved, Thain will become CEO of the new NYSE Group and Archipelago CEO Jerry Putnam will become co-president along with two NYSE executives. Also, three independent Archipelago directors will join the existing 11 independent NYSE directors.

The other big result of the deal is creation of a non-profit self regulatory organization, NYSE Regulation. It will fund its operations from dedicated regulatory fees and long-term regulatory service contracts. This should defuse some of the criticism that the exchange has faced in recent years, most recently when the SEC found its oversight of specialist trading inadequate.

Of course, the Canadian markets spun off market regulatory function several years ago, and Market Regulation Services Inc.
rarely faces criticism about conflicts of interest that other self-regulatory organizations, including the NYSE, regularly endure.

RS recently completed its own investigation into dodgy trading practices in the Canadian market. The review, which was in response to traders’ complaints, found no evidence of systematic front-running. It did, however, uncover some gaps in the rules, its powers of surveillance and brokers’ understanding of the rules. The resulting report contains 13 recommendations designed to resolve the issues the review uncovered. The regulator says that it will now begin studying and implementing the recommendations, including preparing notices on the importance of maintaining confidentiality and developing training materials on front-running.