Technology Squeezes Out Real, Live Traders

NEW YORK -- David Miranda got hooked on "the floor" in a millisecond.

As a teen, during a visit to the New York Stock Exchange, he quickly identified with the guys on the trading floor, the ones wearing the trademark mesh-backed smocks with numeric IDs. They're the ones you see on the evening news celebrating Dow records. "I didn't know what they were doing," recalls Miranda, 43. "But I knew that's what I wanted to do."

The guys were trading stocks of the USA's greatest companies. Face-to-face. Auction style. With rudimentary pencil-and-paper technology. The trades, which required human intervention, took nine seconds.

Miranda spent 21 years on the floor, mainly as a "specialist," or market maker. He was there on Black Monday in 1987; the emotional first day of trading after 9/11; the day an aging specialist died executing what turned out to be his last trade.

"That's how I wanted to go out," says Miranda. "I wanted to die on that floor, too."

Little chance of that now. He was let go in February by Van der Moolen Specialists. He's one of hundreds of NYSE floor traders replaced by machines.

This is the harsh new reality on Wall Street, a world dominated by computers that execute trades not in seconds, but in thousandths of a second, or milliseconds.

Speed has become the holy grail on Wall Street. That means fewer opportunities for human traders to take part in trades, grab commissions, make money. With electronic trading capturing an ever-larger piece of the trading pie, specialists are quickly losing their dominance -- and profit potential -- just as vinyl records and pay phones did in the face of whiz-bang technologies.

The economic squeeze is expected to result in further shrinkage of the human population on the NYSE floor. Some say the floor is in danger of disappearing unless specialists and floor brokers reinvent themselves and figure out how to make money in today's machine-driven market. Currently, business is so slow, most action occurs in the first and last 15 minutes of trading.

"It's difficult to see anything in the near term that will revive the specialists' role," says Ted Wolff, analyst at Solaris Asset Management. "The floor-based businesses will continue to shrink until they become irrelevant and fold up shop. The floor won't go out with a bang; it'll go out with a whimper."

But Duncan Niederauer, president of Big Board parent NYSE Euronext, who is guiding the floor through these turbulent times, insists that while the floor's workforce may indeed get smaller, he's working hard to put floor traders in a position to succeed.

"My plan is not to close the floor," he says. "No one has proven that an all-electronic market is the answer." He says he's working with the Securities and Exchange Commission to get archaic trading rules changed to better even the playing field for specialists. The SEC has approved rule changes that let floor brokers trade a variety of instruments, such as bonds, Nasdaq stocks and exchange-traded funds, in addition to NYSE-listed stocks.

There has been less reliance on the human touch ever since the NYSE completed its rollout of its "hybrid system" combining electronic and human trading in February. The declining fortunes of floor-based traders is an unintended consequence of the NYSE's aggressive push to embrace technology to stay competitive. Since the full implementation of the hybrid system, machines have shouldered the bulk of the workload. In the first three months of 2007, 82 percent of NYSE volume was automatically executed, vs. 19 percent pre-hybrid, NYSE Euronext says. There was also a 49 percent decrease in floor brokers' share of total volume between the first quarter of 2006 and the first quarter of 2007.

"The glory days of the floor are over," says Miranda, now director of client relations for Strategic Stock Surveillance, a unit of Miller Tabak that provides companies with intelligence on which big investors are buying and selling their stock.

Global Exchange Race

The upheaval at the Big Board, Miranda says, is a natural evolution.

Most of the world's major exchanges -- the London Stock Exchange, the Nasdaq Stock Market -- are fully automated, and have been for years. The "electronification" of the NYSE, says Brad Bailey, senior analyst at Aite Group, was inevitable. In March 2006, the NYSE merged with Archipelago, an electronic-trading network, and began trading as a public company. This April, the NYSE Group merged with Euronext, a Europe-based electronic exchange, to form NYSE Euronext, headed by CEO John Thain.

Big investors such as mutual funds that prefer low-cost, laser-fast, anonymous trades are driving the fascination with automation and speed. Intense competition among exchanges around the globe that covet size, speed and scale also is behind the growing reliance on machines. The fight for survival is fueling consolidation as major exchanges race to become the first global electronic exchange.

Evolution of Decline

Specialists' age-old money-making model -- part commission, part trading profits -- is basically broken. Commissions, a big part of their pay in the past, have been squeezed out of the equation. To stay alive today, specialists must make money trading just like everyone else. (For example, if a specialist buys 5,000 shares of stock XYZ at $25.50 with his own cash and the stock goes to $25.60 and he sells his 5,000 shares, he makes $500.) The problem is that, because of technology, they are participating in fewer trades. That makes it harder to make up for losses incurred when they're forced to step in as a buyer of last resort. A year or two ago, specialists got involved in 12 percent to 15 percent of floor trades. Today, it's 8 percent to 9 percent. As an incentive for specialists to keep playing that role, the NYSE now pays them a monthly stipend for providing liquidity to the market.

The sagging fortunes of floor-based specialist firms is not due only to technology. The downfall has been speeded up by the profit-eating switch to penny trading spreads, a public relations fiasco following allegations of improper trading in 2003, and the ouster that same year of former NYSE CEO, and floor backer, Dick Grasso, amid a furor about his sizable pay package.

In their heyday, specialists were the centerpiece of the open-outcry auction market. The job entails making a market in a stock, fleshing out the best price, and ensuring that shares trade orderly and fairly. It also means stepping in as a buyer or seller of last resort to avoid sharp, scary price swings. The value of specialists was reinforced last month when erroneous orders for three stocks were flagged by floor pros, resulting in a trading halt that saved investors a lot of money. A recent study by Villanova professor Mike Pagano found that specialists still play a valuable role.

LaBranche and Van der Moolen

To get a sense of the acute economic squeeze, look no further than the two publicly traded specialist firms, LaBranche and Van der Moolen. In the first quarter of 2007, LaBranche reported a loss of $5.6 million; Van der Moolen's revenue decreased 56 percent. Layoffs have followed. At the end of the first quarter, LaBranche's head count was 363, down from 525 in the same period a year earlier. In January, Van der Moolen let go one-third of its staff. CEO Richard den Drijver blamed the poor results on "less human interface" and the fact that his firm's electronic trading systems, or algorithms, were not "as clever" as the competition's. The firm is now tweaking its systems.

On Monday, LaBranche said it had hired bankers to review "strategic alternatives," a move that could foreshadow shutting down its specialist operation.

Other firms that have reduced their head counts on the floor: Lehman Bros., Sanford C. Bernstein, JPMorgan Chase and Bear Stearns, which took a $225 million charge in May to offset losses in its Bear Wagner Specialists unit.

Specialists and floor brokers are also being hurt by the growing use of algorithmic trading programs by big investors.

Algorithms are "math formulas that take large, elephant-size orders and break them into smaller pieces," says Ted Oberhaus, director of equity trading at money management firm Lord Abbett. The slicing and dicing of orders has reduced the flow of large orders to humans on the floor.

What's the Endgame?

There are two likely scenarios, says Patrick Healy, CEO of Issuer Advisory Group, a consultant specializing in exchanges. "Either the floor will shrink to a critical mass and firms will make a little money, or the whole thing goes," he says.

If the floor survives, it will be smaller, probably consisting of two of five original rooms, the main room where the bell is located and the so-called "garage." One room has already been shuttered.

The role that specialists play will also be slimmed down. Most trading action will likely be in shares of smaller, illiquid stocks, or those for which buyers and sellers are not in plentiful supply, says Oberhaus. Specialists will also be forced into duty to deal with volatile trading situations, where the specialists can inject their liquidity to smooth the ups and downs of stock prices.

Ultimately, it will be the market that decides the floor's fate, says NYSE's Niederauer: "If the market tells us to become an ECN (or electronic exchange), we will become an ECN. But right now, the market is not telling us that."

Thain the Change Agent

NYSE CEO Thain is in the crosshair of the debate. He's the architect behind the company's transformation into an electronic exchange with global ambitions, a path that experts say is the key to survival. "He had no choice," says Aite's Bailey. "His goal is to be the biggest exchange on the planet."

Still, rightly or wrongly, as the top executive, he also is blamed for the shifting fortunes of the floor community. While Thain has repeatedly stressed that specialists remain vital to the NYSE's mission, there's always been a feeling down on the floor that he prefers the automation and efficiency that computers provide.

Says Healy: "John Thain is the cover boy for their frustration."

Even as NYSE Euronext pushes forward with its goal of becoming a global, multi-product, electronic exchange, Thain is confronted with the task of preserving a key brand identity: the living, breathing floor, says James Angel, associate professor of finance at Georgetown University. "To maintain the mystique of the brand, Thain needs the specialists," says Angel. "The legacy of the NYSE floor is a small yet vital part of a new empire."

On a recent Friday at the exchange, independent floor broker Doreen Mogavero, cradling her handheld trading device, delivers an upbeat but realistic view of the changes underfoot. She acknowledges the "old floor of flying paper and screaming traders is gone." But she says the worst is over. The focus should be, "What happens now?"

The hybrid system is still a work in progress, she says. And while her business is faring OK (she expects revenue in the first half of this year to be 2 percent higher than a year ago), she admits it would be nice if more trading volume flowed her way. "I am making a go of it," she says.

"Some opted not to morph into the new world, but many of us are making a go of it," she says. "The reality is, no one can predict for sure what this place will look like in the future."

Steven Grasso, manager of institutional sales trading for Stuart Frankel, is also making a go of it. The increased automation brought on by hybrid has not made his job on the floor any less relevant. "My clients still need me," he says.

But for how long? David Miranda thought he'd be needed until he died. Now, all he has are fond memories of a past era. "There used to be an electricity when you walked onto the floor," he says. Now, most of the electricity is used to switch on the computers.