Just what is Goldman Sachs doing buying Spear Leeds Kellogg for $6.5 billion? Is this not the same Goldman Sachs which just six months ago, together with Merrill Lynch and Morgan Stanley Dean Witter, was sending executives down to Washington to lobby regulators at the SEC and politicians in Congress, to take steps which might do away with such businesses? And didn’t Merrill buy a similar operation in June, Herzog Heine Geduld? The object of the big firms’ desire was a central limit order book (CLOB) for US equities trading. Without it, ran their argument, equities trading would continue to fragment between electronic order matching via ECNs, and electronic quote-driven market making systems. Fragmentation, they continued, would run counter to a broker’s duty to execute at the best price, so a far better platform for clients would be the CLOB.
Indeed were regulators to construct an equities trading environment from scratch today, the CLOB might well be the best model.
But that is not the regulators’ job. “We, and others like us, are coming up with market-driven, technology-based solutions to the problem of fragmentation,” says the CEO of a technology trading platform. “We don’t need regulators to sort this out.” The regulators actually took the same view, and decided not to take the advice of the MGM Group, as the three banks became known.
Gary Craft, who until last month was the e-finance analyst at Deutsche Bank (he is moving back to a former employer, Wnancialdna.com) detected clear self-interest behind the MGM Group’s desire for change. “We take a very cynical view of these overtures,” he wrote back in March. “Investment banks are unbundling rapidly. They are losing share to more efficient liquidity providers, and this throws a monkey wrench into their entire economic model.”
The ECNs and electronic market makers, by offering different classes of investors equal access to the markets, have challenged the major investment banks’ stranglehold. The MGM group may control 47.9% of the US IPO market, according to a report by Clare Nickson, brokerage analyst at UBS Warburg, yet none of them are major market makers. Goldman Sachs, for example, makes markets in 450 over-the-counter stocks (Nasdaq-listed stocks, mainly), Merrill Lynch in 650. By contrast, the major market makers each deal in 6000 or more.
More significant is the change in quality of access for non-bulge bracket investors afforded by new technology. Few of these investors will go through the major firms to get stock. As the investment banks don’t see this flow, they miss out on a large amount of intelligence on the market. For institutions which pride themselves on their distribution prowess, this is becoming an embarrassing gap.
A glance at some post-IPO trading figures confirms this. As of August 24th, Knight Securities, the leading Nasdaq market maker, traded more shares on the opening day than all dealers other than the lead manager on over 50% of the 342 IPOs this year. Add in the next two, Herzog and Schwab, and these three non-syndicate dealers were the largest or second largest traders on the first day on 78% of deals.
In part, then, the MGM Group’s call for a central limit order book was a means of defending their territory, which came rather late in the war. They quickly turned to acquisition. Merrill was the first, snapping up Herzog Heine Geduld in June for just under $1 billion, and an insider there admits that “the failure to get Washington to establish a CLOB was one of the reasons which led us to pursue Herzog”. Goldman followed suit last month, paying $4.4 billion in stock and $2.1 billion in cash for Spear Leeds Kellogg, with a further $900 million in stock set aside as a staff retention pool.
Herzog Heine Geduld is actually the larger of the two, second by volume after Knight Securities, and makes markets in over 8000 over-the-counter stocks, whereas Spear Leeds Kellogg is fourth (Charles Schwab Capital Markets is third) and deals in about 6500 stocks. The difference in price is due to the fact that Herzog is mainly a market maker with a good if small clearing operation. Spear Leeds Kellogg has more business lines, being a clearing house, an options trader, an equity funds trader as well as having its REDI technology. This includes an ECN which it has developed, called REDIBook, and sold stakes in to other institutions including Charles Schwab, CSFB and PaineWebber. And it also includes a direct access platform, REDIPLUS, which sits on 10,000 desktops throughout the US. It is designed to allow frequent traders (professional, as opposed to day traders, which others concentrate on) a quick, direct route to the major exchanges.
Spear Leeds propels Goldman Sachs to one of the major market makers in US equities with a market share of 18% on the NYSE, 5% on Nasdaq.
And it gets some good, robust, user-friendly trading technology. Both Goldman and Merrill now hope to match more orders internally in a deeper pool of stocks from a broader variety of investors. Not only does this bring in more revenue, but also a lot more information on market dynamics.
One of Spear Leeds Kellogg’s strengths, says its co-CEO Andrew Cader, “is a willingness to make our own technology obsolete in order to keep up with the markets and with client needs”. The firm first set up in 1931, when Messrs Spear and Leeds opened a NYSE specialist firm. Kellogg only joined in 1946, but quickly became the dominant partner. His son, Peter, was still the major shareholder before the deal with Goldman. The first move away from being just a specialist on the NYSE and the American Exchange was in the mid-1970s, when the firm decided that its clearing business was of sufficient size and strength to become an agent for other specialists.
By 1980 the firm had bought Trustor Singer, a Nasdaq market maker. That was at a time when everyone was assuming that the end of the NYSE was nigh, and buying into a Nasdaq player seemed a sensible business hedge.
A couple of years later the company bought First Options, a Chicago-based options clearing firm to complement the options market making business it had built organically from the mid-1970s. Today First Options is the largest clearer at all five US options exchanges, having expanded into clearing upstairs trades as well as floor trades.
And then in the 1990s the firm developed its technological offering, the REDI platforms which now includes REDIbook, the ECN which has been a big success for the firm. “The REDI system is an extension of our existing trading technology, really,” says Cader. “We joke that all we had to do was go down to the fifth floor and flick a switch. We don’t have any explicit R&D budget, so everything we develop has to be capable of being profitable pretty quickly. So we ask our traders and our customers what they want and need.”
These are all businesses which Spear Leeds has developed from its core business as a specialist. In fact it is now the largest specialist, on the New York Stock Exchange.
Specialists are the traders who stand at the booths on the exchange floor during trading hours, using their own capital to make markets in stocks for the brokers who run around the floor all day. Companies decide which firm is to be their specialist before listing their stock.
That Goldman bought Spear Leeds Kellogg came as something of a surprise, following its lobbying efforts and a series of spats between the MGM group and NYSE chief, Richard Grasso.
And Goldman’s head of equity e-commerce, Duncan Niederauer, was quoted in a Forbes article in May saying that the specialist business was “an unsustainable model”.
In fact Goldman had tried, earlier in the year, to buy Spear Leeds without its specialist division, but was rebuffed. Now, Eric Mindich, co-chief operating officer of Goldman’s equities trading business, says: “In the past, our first thought would not have been to buy a specialist, but we asked ourselves, ‘what does it mean if the markets become electronic?’ You still need people, upstairs or downstairs, and what better people to have than the experts?”
His colleague, Milton Berlinski, co-head of the firm’s financial institutions group, makes another point: “We all know the NYSE is going to change, but how it does will probably be very different from what we might have expected. Spear Leeds Kellogg further positions us to take advantage of the technological changes going on.” In effect, then, the specialist arm has become yet another hedge by Goldman on the development of the market. This one is an established and profitable business.
