February 15, 2011

Explosive Growth in the OTC Market

You might think “OTC” stands for “off the charts,” which is how we’d rate both the skiing in Winter Park last week and the 70-degree temperatures in Denver Sunday that allowed me to get a post-skiing tan on the back deck.

Actually, OTC stands for “over the counter.” It describes brokers doing business directly with each other, and it’s a big reason why NYSE Euronext and the Deutsche Bourse (everybody spells it differently) are merging.

Our friend David Weild, former vice-chair at the Nasdaq and current market-structure expert at Grant Thornton said of the impending deal: “Scale, scale, scale.” Duncan Niederauer, expected to lead the combined entity, said today: “This is an industry that lends itself to scale.” It seems that what began here in 1792 under the Buttonwood Tree at the foot of Wall Street is at an end of sorts. Why?

Businesses need scale when markets are commoditized and currencies debased. But beyond that, it’s the result of monumental revitalization of the over-the-counter market. Big brokers are trading with each other, avoiding exchanges. And because they are experts at managing risk, institutions choose them not just for execution but as counterparties for transferring risk from asset class to asset class. This is fast becoming the main reason that natural liquidity – trading lingua franca for shares not driven by high-speed intermediaries – moves around.

Did any of you see Investment Technology Group’s 10-million-share block trade last month? ITG POSIT is one of the earliest and largest “dark pools” for matching up institutional buyers and sellers outside the noise of the market. It combines trade-execution with analytics to offer the buyside efficiencies. Yet ITG’s revenue, trading volumes, and profit are down versus 2009 because, according to ITG’s earnings release out Feb 3, 2011, “continued low levels of trading activity by domestic long-only institutional investors negatively impacted our client mix.”

ITG competes with both exchanges and big broker-dealers like Goldman Sachs and Morgan Stanley. So if ITG sees flat long-only institutional demand, and big exchanges are merging – the London Stock Exchange is also marrying the operator of the Toronto Stock Exchange – what’s going on?

Answer: big brokers are controlling the supply of securities liquidity. Here’s the irony. Regulators decided back in the 1990s that intermediaries – the network of broker-dealers comprising the National Association of Securities Dealers – were making too much money. Stock trades were decimalized. The Global Settlement of 2003 between Elliot Spitzer and major bulge-bracket firms effectively ended capital-formation predicated on valuable research. The aim: To “level the playing field.”

The result? The exact opposite. Instead of shrinking the power of intermediaries, these same brokers are now threatening the whole exchange construct.

Want more irony? Gigantic broker-dealers would have gone largely extinct in 2008. But governments, now desperately dependent on the very same brokers to make markets in government securities comprised of wasting fiat currencies, gave them free access to public purses and treasuries.

No surprise, they feasted. Thus, with the phrase “too big to fail,” government set in motion what now may transform the seminal emblem of American capitalism. There is a tangled web strangling the Buttonwood Tree.

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