Almost two decades ago, the IPO craze was hitting the stock market – literally – as both the NYSE and its main competitor NASDAQ – were both considering going public and moving to a profit-oriented model. But has the exchanges shift towards money-making enterprises hindered their primary mission as being the place where companies could come too raise capital?
Spencer Mindlin, analyst at Aite Group explained that back in 1999, the exchanges were under co-operative ownership and as a result were left behind in a rapidly changing market structure and the on-going advances in electronic trading. They were losing market share to newly launched electronic communications networks, ushered in by recent changes to regulation.
“It is unlikely that the exchange members would have had the fortitude to effect the required transformation. Going public likely saved the exchanges,” Mindlin told Traders Magazine. “Once the exchanges went public though, management’s duties shifted from the member firms to the thousands of shareholders. And it’s a difficult scale to balance with so many varying interests: the exchanges shareholders, the companies that choose to list on their exchange, the exchange’s customers, and the country’s investing public. Conflicts abound.”
Exchanges are a fixed-cost, scale business, he added. The exchange must compete, and in a scale business they need to focus on their return on assets. “They would be remiss if they didn’t seek ways to leverage their scale and provide products beyond basic order matching. This ultimately brings down costs for the entire industry.”
Richard Repetto, Principal at Sandler O’Neill Partners said he believed the IPOs of the NYSE and Nasdaq drove broad changes at these national exchanges. And those changes, he added, were good for the market and investors.
“The drive for efficiency, namely through technology and automation, moved to the forefront of the exchanges priorities as the benefits to membership was no longer their prime objective,” Repetto said. “The exchanges became more nimble, entrepreneurial, and diversified as profits & profitability became critically important to the exchanges.”
So where does that leave us?
“Despite the fact that U.S. Exchanges have been publicly traded for over a decade, the debate over whether this is good or bad for the marketplace still continues,” said Adam Sussman, Head of Market Structure at Liquidnet. “On the one hand, some of the fears that brokers had in the lead-up Exchange public listings have come true. For example, Exchanges have become a more direct competitor by offering outbound routing. Other market participants feared Exchanges would take advantage of their regulatory status. The lack of non SRO representation on NMS Plan rulemaking and decisions and the subsequent inclusion of rules favoring Exchanges in the Tick Pilot validates this fear.”
On the other hand, Sussman added, as publicly-traded entities, Exchanges have delivered scale and breadth to global capital markets via mergers and expansion into new asset classes and services.
“Its hard to be a capitalist and argue against its efficiency in the one market where competition can hurt you.”
The following article appeared in the July 1999 edition of Traders Magazine
The Two IPOs of the Century?
By William Hoffman
The New York Stock Exchange is looking to go public, a move that comes just a few weeks after Nasdaq said it might do the same thing.
Asked about these reports, a Big Board spokesman Ray Pellecchia said the exchange had no comment.
But days later the Wall Street Journal reported that Big Board staffers had quietly approached investment banking giants Merrill Lynch & Co. and Salomon Smith Barney to explore the IPO route. That is the same route that Frank Zarb, chairman of the National Association of Securities Dealers, held out as an option for Nasdaq in the NASD’s ongoing restructuring efforts.
Merrill Lynch and Salomon Brothers, along with several other Wall Street investment banks, declined to comment on both the NASD and Big Board reports.
But some traders were not so reticent.
“I’m in favor of an IPO for both exchanges if it materially benefits the bottom line of our firm,” said Ben Marsh, head of Nasdaq trading at Boston-based Adams, Harkness & Hill, an NASD and Big Board member firm.
Disparaging of the Idea
The Big Board has been almost disparaging of the idea of an IPO for its organization. Big Board Chairman Richard Grasso was quoted in May saying that, with only 18 percent of trading systems capacity used during an average day, analysts and shareholders might demand a career change for a chief executive who suggested taking the exchange public. Nonethless, the Big Board needs to invest in extra capacity for trading spikes, Grasso noted. “Those are investments, as a public company, I’m afraid we would not be willing to make,” he said.
According to the Wall Street Journal, however, it was Grasso who instructed Big Board staffers to approach Merrill Lynch and Salomon Brothers.
By contrast, NASD Chairman Frank Zarb, recently addressing the National Press Club in Washington, said an IPO is one option executives are considering to revamp the organization.
Most recently, the NASD board increased the likelihood of an IPO for Nasdaq. The board authorized a plan that calls for staff to consult with NASD members on the implications of a for-profit Nasdaq in which the NASD is a minority partner.
The plan also requires the NASD staff to start work on the registration process with the Securities and Exchange Commission and, separately, to make provisional agreements with potential equity participants.
Stock exchange IPOs offer interesting possibilities, some experts say. “It struck me as innovative, to say the least,” said Kathleen Cerveny, a partner at Falls Church, Va., commercial law firm Hazel & Thomas, PC. Joel Barth, principal in the corporate finance group at regional accounting and consulting firm Richard A. Eisner & Co., in New York, said of Nasdaq, “It’s a brand name known ’round the world, which portends well for an IPO. It’s unique.” No doubt the same is true for the NYSE.
Cash Flow
Stock markets especially Nasdaq offer a steady cash flow from fees, observers noted. A publicly-traded exchange stock could also forestall opposition to NASD self-regulatory plans.
These plans include the revived yet still contentious consolidated limit order book and the pending agency quote proposal. Some traders and broker dealers are hot under the collar, arguing that the agency quote proposal could make the organization a competitor of its own member firms.
NASD’s future plans – including extended trading hours, expansion in Asia, enhanced cooperation with the American Stock Exchange, and development of an electronic futures contract business – could also be invigorated by a public stock offering.
Of course, there are challenges aplenty. One controversy to be settled between the two exchanges would be the future of their self-regulatory organizations. Zarb suggested in a press statement that NASD Regulation, the regulatory arm of the NASD, could be spun off “into a well-funded, stronger independent entity to be merged with the New York Stock Exchange’s for efficiency, savings and higher quality.”
But so far, the Big Board is having none of that, according to Pellecchia.
The Big Board prefers the idea that it will continue to police itself, while NASD Regulation assumes self-regulatory oversight for itself and the rest of the securities markets, Pellecchia said. That doesn’t appear to be what Nasdaq managers want.
“We’ve got nothing in mind at this point as far as next steps,” Pellecchia said. “But I’m sure the [Nasdaq and the Big Board] will continue to talk with the industry and the regulators about it.”
Industry experiences with the demutualization of insurance companies and public offerings by banks and brokerages offer some guidance.
“The Nasdaq initial public offering would be subject to the same risks and vagaries of the market” as more conventional IPOs, Cerveny said. Certainly the same could be said for a Big Board IPO.
Audited financial statements shouldn’t be a problem, Barth said. Both Big Board and Nasdaq are highly-visible organizations at the pinnacle of one of America’s most influential and regulated industries. Each should easily be able to assemble and present the public disclosure required of any company registering an offering stock.
Tax issues should also pose minimal exposure to the executives who organize and participate in a Nasdaq IPO, Barth said. The IPO itself can probably be conducted free of any tax, though shareholders would be assessed as they trade the stock and enjoy any gains.
Over-centralization of any first distribution could be an issue, though Barth said there should be enough participants that this, too, won’t complicate the process.
However, Cerveny noted that the extent of public disclosure required in an IPO by federal law could make exchange executives think twice.
Income and outlays, historical details of governance and operations, would have to be laid bare for the scrutiny of investors, regulators – and competitors. Past strategic and management decisions could be critiqued by member firms; future expansion and restructuring plans could be second-guessed or mimicked by competitors. Balancing the need for capital against the rigor of disclosure could put a chill on executives’ enthusiasm for the IPO process, Cerveny said.
Nominal Control
More daunting might be the reaction of exchange listed firms working with an organization over which they had once exercised nominal control, transformed by an IPO into a profit-seeking independent service company.
Cerveny wondered whether member firms would find themselves shut out of the management of the new company. What strategies would broker dealers use to make a market in a stock listed on the same exchange in which it is traded? Would traders find themselves conflicted about dealing with an equity for an exchange in which their own clients are active? Could so-called “Chinese walls” keep everyone honest?
Everyone knows what would happen if a Nasdaq or Big Board IPO were successful: Ground-floor investors would get rich, and others who got in early could also make a tidy profit.
What happens if the subsequent issue fails is less clear. Obviously, fewer people would make money on the stock. But sliding performance of listed stocks would reflect poorly on other exchange listed stocks, Cerveny and Barth agreed.
Traders and broker dealers might find themselves captive aboard a foundering ship, and managers of listed equities could run for the lifeboats.
Adams, Harkness & Hill’s Marsh said one of the questions concerns how Nasdaq would spend the money raised through an IPO. “Nasdaq is making so much money right now it doesn’t know what to do with it,” he said. “Will it know how to spend the money sensibly after an IPO?”
For now, the industry seems tantalized by the potential of a Nasdaq – and now possibly an NYSE – public offering. Cerveny, who has shepherded companies though the IPO process and onto Nasdaq, said, “I’d be interested in seeing the prospectus.”
