Pete Kendall's Socio Times: A Socionomic Commentary

The lengthy mating dance among European stock exchanges may be entering its final whirl, as a potential American takeover of the London Stock Exchange has driven two rival exchange operators, Euronext and Deutsche Borse, into serious merger talks.

On Wednesday, Deutsche Borse welcomed Euronext's expression of interest in striking a deal that would create a pan-European company with a dominant franchise in derivatives trading. It would be the world's largest market for futures and options trading. The economic logic behind mergers is compelling: by pooling the trading of groups of stocks, bonds or derivatives, the exchanges can offer lower prices to buyers and sellers while making more money on the increased trading volume.

Derivatives would be by far the biggest franchise of a combined Deutsche Borse and Euronext. With annual trading volume now estimated at 1.54 billion contracts, the successor company would be solidly ahead of its next larger rivals, the Chicago Mercantile Exchange and the Chicago Board of Trade.
The New York Times, March 16, 2006

Crossing the Pond
Even if the merger doesn't happen, the mere possibility illustrates convergent and accelerating trends among the world's exchanges. These include a shift from mutual ownership to listed exchanges, rapid advances in and dissemination of technology, and increasingly sophisticated users who want to trade across borders and asset classes. Meanwhile, exchange shareholders have not been shy to let managers know what deals they should and should not pursue—and that if the bosses do not listen, they risk losing their jobs.

Shareholders in most big financial exchanges are sitting pretty.
The Economist, March 16, 2006

Taking Stock of, and in, the New York Stock Exchange
USA Today - Mar 8, 2006

NYSE Stock Surges In First Day of Trading
Investors welcomed the NYSE Group Inc. to Wall Street Wednesday, sending shares of the newly public New York Stock Exchange up 25 percent in its first trading session on the Big Board.

After nearly 214 years as a not-for-profit exchange, the NYSE transformed itself into a public company following its $10 billion acquisition of electronic rival Archipelago Holdings Inc. on Tuesday.

“It feels good,” said John Thain, chief executive of NYSE Group and the architect of the deal.
MSNBC.Com, March 8, 2006 

NYSE Files Statement for Secondary Stock Sale
Marketwatch.com, Mar 13, 2006


SEC Chief Urges Look at Oversight of NYSE
The rapidly changing landscape of the markets, with big stock exchanges transforming into for-profit businesses, means that regulators must reexamine the system of U.S. exchanges' self-regulation, the government's top securities regulator said yesterday.
Associated Press, March 15, 2006

NYSE Group Debut Shows Big Boards Market Share Loss
Investors who flocked to shares of the New York Stock Exchange yesterday chose to do much of their buying and selling elsewhere.

The Big Board handled 60 percent of the 18.2 million shares of NYSE Group Inc. that changed hands on the stock's first day, according to data compiled by Bloomberg. That's an even smaller share than the 71.7 percent of trading the NYSE corralled in January in the other 2,800 stocks listed on the exchange.

The comparison illustrates the market-share erosion that prompted Chief Executive Officer John Thain to transform the world's largest stock exchange by taking over an electronic market (Archipelago Holdings ). The Big Board's share dropped almost 8 percentage points in the 12 months ended January.
Bloomberg March 9, 2006

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U.S. Overture to London Exchange Stirs Talk of a Merger by European Rivals
Category: MEDIA
By: Pete Kendall, March 16, 2006
Unfortunately, there could well be structural risks in dealing with stocks and associated derivatives during a major retrenchment. Trading stocks, options and futures could be extremely problematic.
Conquer the Crash

The last 10 days have produced a frenzy of speculation in and about many of the major financial exchanges. It started with a public offering by the New York Stock Exchange on March 8 and roiled through Europe yestereday as a likely takeover of the London Stock Exchange by NASDAQ or NYSE, quickly caused the two major European exchanges to quickly agree that it's time for them to hook up. These clips brings together two key elements that only tend to appear when a big-time peak in social mood at its point of maximum ripeness: hold-outs finally succumb to the "convergent and accellerating" force of the bull market (mentioned by the Economist above) and the valuations placed on financial exchange rise to peak levels. 

Seat Prices

This chart is updated from the October issue of EWFF. It shows the extent to which the current advance has produced an unprecedented popular valuation for the exchange. With a new high today of $90 a share, the NYSE rose to an equivalent value of more than $7.2 million per seat, or 2.7 times the last peak of $2.65 million in 1999 when the major averages were approaching their all-time highs. The situation reminds of what Joseph Granville used to talk about in his investment “shows” back in the late 1970s and early 1980s. Granville enjoyed explaining that when buyers no longer politely ask, “Please sell me your stock,” but instead grab your collar and scream, “Gimme that bag!,” don’t argue with them, “just give it to ‘em!" At this point the public is so sure that the bag is the thing that they're buying up the bag makers. 

As the article notes, everything hinges on the "economic logic" that says these financial intermediaries will be "makling more money on the increased trading volume." History  suggests otherwise. After an upward voltility spike that will be anything but pleasant for the exchanges, volume is likely to dry up. As trading activities slows,  the fierce competition, fast-changing technological pressures and renewed regulatory scrutiny discussed in passt issues of EWFF (for some of that discussion see additional references below) should mount. As the last two articles above indicate, these pressures are surfacing even as the "war" for exchange ownerhsip reaches its most feverish pitch in history.

Additional References

November 2005, EWFF
The Market Itself Is on Offer
Back in 1999, when the NASDAQ and NYSE started making noise about going public, the NY Times reported, “On its face, it’s hard to imagine a less appealing investment.” Still, the Times concluded that the deal “could become one of the most intriguing investment opportunities of the next decade.” The reason cited was the “magic” of the market. The Elliott Wave Financial Forecast identified the exchanges’ IPO plans and the media’s belief in them as a clear-cut sell signal for stocks. Last month’s century-long chart of NYSE seat prices illustrated very clearly that the main trading mechanism of the market is always most prized at important peaks. When the speculative fires are burning so hot that the exchanges themselves are being bought and sold, a truly enormous peak is at hand. The top formed in the major averages a few months later is still very much in place.

But with the small-stock averages working their way to new all-time highs in early August and many stocks rallying to countertrend bear market peaks at the same time, the enthusiasm for markets, by some measures, has actually exceeded the level of 1999. All the major financial exchanges have gone public. The NASDAQ went public through the back door in 2002 with a private placement that was later converted to public shares. The New York Stock Exchange will do likewise with its pending acquisition of Archipelago, an electronic trading platform that is already public. The Chicago Mercantile Exchange went public in a December 2002 IPO and has soared more than 1000%. The CBOT is the last to make it. It did so through a successful offering on October 18. The still ascendant appeal of financial paper and its exchange is evident in the CBOT’s aftermarket performance. The stock rose sharply from an initial price of $54 to $134. But the CBOT offering should mark the end of the line for rising exchange values, as well as for the overall market. The bear market of 2000-2002 followed just the idea of a publicly-traded stock exchange; a complete equitization of the major exchanges constitutes a much more powerful sell signal.

The discrepancy between the exchanges’ unprecedented valuations and the rising vulnerability of their business speaks to the severity of the next decline. Since 1999 when the NY Times characterized the NASDAQ as fundamentally unpromising, the viability of traditional exchanges has deteriorated. For one thing, their monopoly right to trade certain shares and instruments is eroding. As trading becomes entirely electronic, the threat of obsolescence and competition among themselves and others is also rising. Another risk is the rising wave of financial reprisal, which is focusing ever more sharply on traders and financial instruments like derivatives. In the next phase of decline, as government sinks its hooks into this free-wheeling business, exchanges will experience a big increase in costs and a loss of efficiencies due to new regulation and oversight. Then there’s the biggest challenge of all, a deep retrenchment in financial activity that still lies ahead. During the last Supercycle decline, the slackening demand for equities outlasted the bear market by a full decade. Speculators’ slow response to that decline was evident in the course of NYSE seat prices, which fell 70% between 1929 (from an all-time high of $625,000) to 1932 when stocks bottomed, and then another 80% before bottoming in 1942 (at $30,000).

In another Wall Street reprisal, The New York Post reports that the “Fat Cat is Back.” In May 2000 when the first phase of the bear market was about where its resumption is now, The Elliott Wave Financial Forecast stated that stocks were “extremely ripe for a downturn “ because even junior level analysts were demanding and getting lavish perks. Said EWFF at the time:
Wall Street only rarely intersects with Easy Street. The problem with careers that begin near these intersections is that they tend to stop suddenly.

Wall Street is once again veering down the Easy Street off-ramp. Annual bonuses are expected to approach record levels, and New York City real estate agents and Ferrari dealers are being inundated with calls from expectant owners. The president of Gotham Dream Cars reports that bankers and traders are lining up to drive the yet-to-arrive 2006 Ferrari F430, which will sell for $250,000: “I have certainly been getting a fair share of Wall Streeters—mostly in their 30s but some in their mid-20s—looking at buying in anticipation of bonus time.” Here too, the likelihood of a more serious crack-up is high because, this time, the brokerage community is spending its windfall bonus before 2005 is even complete. A change in the market’s fortunes will cause many to rue or cancel their Ferrari orders.

Refco’s collapse is the prototype for the new order on Wall Street. It certainly shows how fast the fallout from bear market psychology can change things. In just one business week, from October 10 to October 14, Refco, a world leader in the market for derivatives, went from a “$4 billion stock market darling to carcass.” Within another week it became apparent that Refco’s bankruptcy meant that, sadly, investors in some funds, such as Rogers International Raw Materials Fund, “won’t be able to get their money out anytime soon.” This is why Conquer the Crash continually urged readers to “arrange your finances and your life in order to survive the depression.” Cash and only the most secure cash equivalents are the priority now because, in the whirlwind of a deflationary collapse, seemingly reliable financial entities with no connection to a given financial firestorm will get burned just the same in the blink of an eye.

But even as the flight of Refco clients evokes a memory of depression-era bank runs, and as a federal investigation expands rapidly to “auditors, underwriters, lawyers” and other Refco officials, “vultures are picking over Refco the way hyenas gnaw on the remains of wildebeest.” The hearty appetite for financial roadkill is yet another sign of a peak. In 1998, when Long Term Capital Management collapsed, there were no suitors waiting to buy up its remains. At the September 1998 low, the Federal Reserve was forced to “engineer a rescue” “because it was concerned about possible dire consequences for world financial markets if it allowed the hedge fund to fail.” Now there is no such concern, meaning that the market is not at a bottom. Mr. Cramer sums up the prevailing sentiment in Business Week: “Refco was a false blowup. This is not Long Term Capital.” He’s absolutely right, LTCM’s implosion marked a bottom, while Refco simply sets the tone for a decline that is just starting.

October 2005, EWFF
Peak Seat Prices and Another Backoffice Logjam
As the chart illustrates, New York Stock Exchange seat prices are back to an all-time high, just as they were in the peak years of 1906, 1929, 1968, 1987 and 1999. The latest peak of $3 million is most reminiscent of 1968 because that was also a point at which smaller and more speculative shares soared to substantial new highs but the Dow Industrials only managed to approach its 1966 peak of 1000, where Cycle wave III ended.
In another striking parallel to the late 1960s, the latest new high in seat prices is also accompanied by one of the biggest trading backlogs in history. In the aftermath of Cycle III, the Value Line Geometric Average rose to a substantial new high in May 1968, OTC stocks peaked in September 1969 and share trading on the NYSE churned so furiously that Wall Street suffered a “record-keeping crisis.” The backoffices of investment firms were so overwhelmed that staff members worked weekends to catch up. In recent months, derivatives transactions have strained Wall Street’s ability to process the trading. According to the latest reports, for instance, it will take eight months to clear a backlog of unconfirmed trades in the credit derivatives market. The head of the New York Federal Reserve says the problem “poses risks not only to the financial institutions which use [derivatives] but to the financial system as a whole.” It is no coincidence that the booming market for the credit derivatives market is a big culprit.

Credit derivatives allow participants to shift the risk of default on debt from primary lenders to third party “insurers.” After exploding more than eightfold in the three years that ended last December, the International Swaps and Derivatives Association reports that credit derivatives grew another 50% to $12.43 trillion in just the first half of 2005. For perspective, the entire annual Gross Domestic Product of the United States is $11 trillion. A general rule of thumb is that the farther a loan gets from the originating lender, the more complex the counterparty claims become and the higher the risk of default. With the weight of deflation and widespread default bearing down on the economy, those risks are rising fast. The explosion in credit derivatives is an effort to “manage” the escalating risk. It cannot end happily, however, because no one now trading credit derivatives (except possibly some of the traditional lenders that are selling susceptible credits into the market) envisions the unprecedented default rates to come. When they can’t even figure out who owns what, figuring out who owes what will be nearly impossible. As the economy heads south, the great derivatives fiasco and the implications discussed in Conquer the Crash will be close behind.

Conquer the Crash
Unfortunately, there could well be structural risks in dealing with stocks and associated derivatives during a major retrenchment. Trading stocks, options and futures could be extremely problematic during a stock market panic. Trading systems tend to break down when volume surges and the system’s operators become emotional. When the exchange floor became a hurricane of paper in 1929, it would sometimes take days to sort out who had bought and sold what and then determine whether investors and traders could afford to pay for their positions. You can experience the turmoil vicariously in any good history of the 1929 crash. To give you a flavor of what goes on, read this description, from one of my subscribers, of the tumult during a comparatively mild panic forty years ago:
I worked for Merrill Lynch in New York in 1962 during the collapse. I well recall the failure of the teletype in our office and inexperienced clerks calling in the orders to the main office. I recall many of the screw-ups: buys called in as sells and vice versa. Some stocks had nicknames like Bessie (Bethlehem Steel), Peggy (Public Service Electric and Gas), and I recall the clerks calling in the orders by the stocks’ nicknames and the person on the other end not knowing what the hell they were talking about. All the while, the market was collapsing.

Do you think investors and brokers will behave differently now that so much stock trading is done on-line? I don’t. Do you think the experience will be “smoother” because modern computers are involved? I don’t. In fact, today’s system — much improved, to be sure — is nevertheless a recipe for an even bigger mess during a panic. Investors will be so nervous that they will screw up their orders. Huge volume will clog website servers, disrupting orders entered on-line. Orders may go in, but confirmations may not come out. A trader might not know if his sale or purchase went through. Is he in or out? Quote systems will falter at just the wrong time. Phone lines from you to the broker and from the broker to the floor will be jammed, and some will go down. Computer technicians will be working overtime while being distracted worrying about their own investments. Brokers will be operating on little sleep and at peak agitation, since most brokers are themselves bullish speculators. They will enter orders incorrectly. Firms will begin to enact and enforce tighter restrictions on trading and margin. Price gaps will trigger stops at prices beyond the ability of some account holders to pay. You, the wise short seller, could survive all these problems only to discover that your broker has gone bankrupt or has been shut down by the SEC or that its associated bank has had a computer breakdown or that its assets are depleted or frozen.


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"Trading stocks, options and futures could be extremely problematic." Damn straight!
Posted by: Tony Smith
March 16, 2006 02:02 PM

Unbelievable! Very interesting commentary.
Posted by: Aussie Stranger
March 16, 2006 02:02 PM

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