Best of W$$WF: Aug. 6, 2004
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KAREN GIBBS: Last November we visited the floor of the New York Stock Exchange while controversy swirled over the illegal trading of stocks by traders of specialist firms. These firms, all seven of them, cheated customers by putting their own trades ahead of others, and they have since paid for it, to the tune of $246 million to the SEC.
Now this week, the NYSE unveiled a plan to increase electronic trading that could diminish the role of these firms. We thought we'd take a gander again, at how stocks are traded on the New York Stock Exchange and who gets a piece of the action. Here is the anatomy of a stock trade.
Anatomy of a stock trade -- originally aired Nov. 7, 2003
(video package begins)
LINDA JAY: Okay, SBC, ($23.62) for 44 at ($23.63), take 44 trade at ($23.63). Sold. 15,000 trade at $63. I just sold him 15,000 at ($23.63), and I still have two other buyers here. I’m going to sell you 10,000 at ($23.63) on dot. 11,000, that’s fine. 11,000 cleans him up. 10,000 is dot.
GIBBS: Whoa. That was 30,000 shares sold in 20 seconds. But how did we get to that? What happens first?
Your stock trader makes the call. Your trader is the middleman in the stock purchase. Andy Brooks of T. Rowe Price walks us through how the purchase gets started.
ANDY BROOKS: Well, what we do here is we buy and sell stocks, securities for our clients, our mutual fund clients and our separate accounts.
GIBBS: Walk me through it. What is the first thing you do?
BROOKS: So let’s say I get an order to buy 50,000 shares of SBC, and that’s going to come to our trading desk and it’s going to come to us electronically on a blotter, so if you follow me we’ll go through the process. I’m going to send you an order to buy 50,000 shares of Southwest Bell, and what I’d like to do is, I’m good to buy it right here.
GIBBS: So who is on the other end of that call? A floor trader. The buy and sell process really slows down here. The floor broker is sort of the middleman for your broker. Twenty-year NYSE veteran Joe Cangemi's company takes the call from the broker.
GIBBS: Joe, can you take me through a trade? Let’s talk about SBC Communications. What happens? You’re an institution, say my mutual fund company calls you, which phone do you pick up or who picks it up, that simple.
JOE CANGEMI: My account managers are right here in the booth, right here on the trading floor. They’re talking directly to institutions, mutual funds, it may be very well, it could be your mutual fund. So, for example, my account manager, Danny, head trader, Danny is requesting a look in exactly SBC. I look at my handheld. It says give me a look in SBC for Karen.
Customers have that power of choice. They have the ability to call a firm like ours right here on the trading floor, talk to an account manager who’s managing their interest right from the trading floor, using experienced brokers in the trading crowd. Hopefully that’s where I kind of fit in. You’re going to see they can send me orders electronically out from here to my handheld, and I travel to the point of sale, interact with the specialist, the electronic order flow, the specialist book to make investment decisions. My job is to head into that direction of SBC.
GIBBS: But wait. The NYSE says they use latest technology to keep track of buy and sell orders. But just like it did 100 years ago, the order actually gets walked over to the specialist. And the trade still gets made face to face.
CANGEMI: As the order flow comes in from the customers, you’ll see them in the booth facility, and it travels wirelessly from my handheld and we’ll move from one location to the other. Mining that information, executing orders. As it is right now, we’re heading to SBC. The customer would like to look in the stock.
GIBBS: Okay. That’s Southwestern Bell.
CANGEMI: Southwestern Bell. A customer of mine would like to look in the stock, so we’re going to head out to the point of sale where we’re going to interact with a specialist out there.
GIBBS: And Linda’s the specialist that covers SBC. Linda Jay started on the trading floor in 1984. A mother of two, Linda became one of the first female specialists five years ago.
JAY: I’m a specialist for LaBranche. I work here on the floor of the New York Stock Exchange, and I’m making a market today in SBC Communications.
GIBBS: Wait a minute. Okay, so far you called a middleman, who called a middleman who still needs to talk to one more person before the stock actually gets bought. And remember, all of these people get a commission, a cut of your trade.
Now this where the really big problems exist. The whole idea of specialists has come under fire.
Wall $treet Week with FORTUNE has learned that the SEC is investigating whether several companies illegally made trades by "trading ahead" of customer's existing orders: The specialists would see interest in a stock, hold customer orders and buy the stock for themselves; then the specialist waited for the price to go up and quickly cashed out at a profit to one of the waiting customers. The specialist's firms might only make pennies by cheating on a large stock trade, but those pennies add up. The SEC says the illegal trades cost the investor -- you and me -- $155 million dollars.
SBC Communications, the stock is so deep, it’s so liquid, why do we need a specialist to do that?
JAY: No, I completely understand. I mean that’s been probably the most-often-asked question lately. Here’s the thing in the stock with SBC Communications, and it’s very, very liquid. You get a stock like this and it has bad news. Let’s just go with the bad news scenario for today. Let’s say you have eight or 10 sellers. If you only have two or three buyers, without a specialist in that scenario, SBC is going to trade much, much lower. If a specialist steps in and buys stock on the way down and makes that ride a little less bumpier, okay that’s what we’re here to do.
GIBBS: The floor traders you see here want to buy shares of SBC. Linda follows the rules and promptly sells the shares she has on hand.
JAY: He bid for 25,000. I sold him 10. Half of that was out of my inventory. Now we’re going to make it a $62 bid. At this moment, if you can see my book, I actually do not have a big sell side here. And now I’m getting a little, a buy here in the system. So let’s do this.
GIBBS: So you’ve actually got more people wanting to buy the stock than people selling. Linda then closes the gap between the current price and the asking price by matching buyers with her inventory.
JAY: Exactly. Offer it at ($23.64). Oh, that’s even better. Okay, SBC, ($23.62) for 44 at ($23.63), take 44 trade at ($23.63). Sold. 15,000 trade at ($23.63). I just sold him 15,000 at ($23.63), and I still have two other buyers here. I’m going to sell you 10,000 at ($23.63) on dot. 11,000, that’s fine. 11,000 cleans him up. 10,000 is dot. Now, I just sold 30,000 shares there.
GIBBS: The specialist's assistant then sends notice of the transaction to the firms placing the orders. And that's it. It took a lot of people and lot of expensive technology, but the deal is finally done, and the stock is traded.
(video package ends)
GIBBS: Do we really need all those people? Is this the best way to trade stocks? Jerry Putnam, CEO of the electronic trading exchange Archipelago, says this is absolutely not the best way. New York Stock Exchange president Robert Britz obviously disagrees.
Well, Jerry, we just saw how many people it takes to make a trade. Tell me why this isn’t the best way, the best system, and it doesn’t serve the interests of all investors.
JERRY PUTNAM: I think I probably actually would answer that in a different way. It is a system for trading large volumes of stocks. But, for example, ArcaEx, our exchange system, is all electronic. There’s no specialist, there’s no intermediaries, and there’s no one that actually joins together in that process. From my view, the role or the value of that role is overblown. But then again, it’s just, it’s the New York Stock Exchange’s business model, and they’re free to pursue that model. Ours is un-intermediated: Everyone gets the same deal, a level playing field, fast executions, and it’s just a different choice.
GIBBS: Bob, your thoughts on the specialist system.
ROBERT BRITZ: I think there is no best way to trade stocks other than the way investors want to trade stocks. And clearly with an 82 percent share of market in NYSE-listed stocks, they’ve embraced our value proposition, and that value proposition is very straightforward. We provide investors with the best price. We provide them with the greatest certainty of execution. We have the highest fill rates in the industry. We provide them with the lowest cost of trading anywhere in the world. And we give them the greatest choice in terms of how they want to do business.
GIBBS: But, Bob, even you have to admit that the New York Stock Exchange did find some problems with the specialist system and fined five of those companies, and the SEC is conducting an investigation. So something seems to be a little off kilter there, and the individual investors’ interests aren’t being best served.
BRITZ: In fact no charges have been brought against any specialist firm, either by the stock exchange or by the SEC. There is absolutely a pending investigation to see whether or not some specialists acted inappropriately. Having said that, and it’s a very serious issue, whether it involves $1.98 or $100 million, if what is alleged to have happened -- i.e. that specialists interposed between natural buyer and natural seller where they should not have -- that’s a very serious matter. Having said that, we looked at three years’ worth of transactions -- not a sample -- every single transaction, and we found substantially less than 1 percent of the transactions that even had a question mark attached to it.
PUTNAM: If I could go back for one second about one thing Bob said, though, and Bob, I’ll challenge you on the 81 percent market share. There are certain rules and regulations that protect New York’s floor-based system that makes it impossible, almost impossible for a system like us or an exchange like ours to compete with it, because we’re always forced to the lowest common denominator, which is that human system on the floor.
BRITZ: Karen, it’s all about what investors want. We have an electronic execution not unlike Jerry’s execution, one second turnaround time. Seventy-five percent of our orders are eligible to transact that way day in and day out, and yet only 6 to 7 percent of our orders choose to do that.
GIBBS: Bob, how can investors be sure that they are getting the best price in the system?
BRITZ: Because it’s published, Karen, and 94 percent of the time the New York Stock Exchange has the best bid and the best offer. So you’re talking about a small window where the other so-called competing markets will have a better bid or better offer, and that’s why the markets are electronically linked. They’re effectively, every market in the national market system is a portal or a gateway to every other market, and orders flow to wherever the best price is. As it happens, better than 94 percent of the time that best price is going to be on the New York Stock Exchange. And you’ll forgive me, Karen, if I don’t apologize for the New York Stock Exchange providing investors with the best price.
PUTNAM: You know this point that less than 1 percent of the time a specialist may have (a conflict of interest) -- It’s like Coca-Cola saying, you know, only 1 percent of the time someone dies from drinking poison Coca-Cola, and it’s really pretty good. So, and investors get to speak their mind and they come here. You have to understand, the system, there’s an old system of rules in place that dictate, that dictates how we trade stocks. We’re trying, as we compete with one another, we are trying to get those rules changed so that we can compete in the way and bring the service that we bring best or what we deliver best to our customers to the marketplace.
The New York Stock Exchange stands in the way every chance it gets when those rules are challenged or attempted to be modified. They have a monopoly power over those rules. The SEC chairman right now is considering a proposal to change those rules. But up until now, every chance that New York or another member in its self interest has had a chance to block a rule change that would allow competition to flourish, they block it.
BRITZ: There’s only one way to compete, and that is to provide what investors have come to expect in the listed marketplace. And if you’re not going to compete on best price and you’re not going to compete on certainty of execution, you’re simply not going to get it done in the listed marketplace.
GIBBS: Bob Britz, Jerry Putnam, thank you very much for joining us.
Scandal scorebard
GEOFF COLVIN: The stock exchanges continue to squabble, but at least their disputes involve legal trading. As for the other kind, and all the other corporate crimes that have filled the headlines -- well, next week will mark three years since Jeff Skilling resigned as CEO of Enron, beginning a historic wave of corporate scandals that still aren't fully resolved. As we approach that anniversary, where do the major players stand?
Skilling and his one-time boss, Ken Lay, have been indicted but not yet tried. Enron's former chief financial officer, Andrew Fastow, has pleaded guilty and awaits sentencing. His wife, Lea Fastow, is in prison, as are some minor Enron figures. Tyco's Dennis Kozlowski and Mark Swartz await retrial after a mistrial. Former Worldcom CEO Bernard Ebbers has been charged with accounting fraud but not yet tried. Former CFO Scott Sullivan has pleaded guilty and awaits sentencing. Frank Quattrone, former star investment banker at CSFB, was convicted of obstructing justice and awaits sentencing in September. And of course Martha Stewart was sentenced to five months in prison and five months' house arrest but has not yet begun doing the time.
The scandal that started it all, Enron, is still frankly a mystery to most people, so head-throbbingly complex are its details. But an astonishing angle everyone can understand is how Enron couldn't have happened without the complicity of several major banks, which understood quite clearly that they were helping Enron hoodwink investors. When I asked FORTUNE's Bethany McLean to explain this last October, I asked her first what in the world these banks were doing.
Enron’s willing partners -- originally aired Oct. 17, 2003
BETHANY McLEAN: It’s really stunning, actually. The enron scandal, if you think about it, was an accumulation of transactions that misrepresented enron’s financial results. And almost every transaction involved a bank. And what’s really just stunning if the complicity of the banks and the fact that all of these bankers went along with it, and there are so few instances of someone saying, “No, we’re not going to do this.”
COLVIN: It sounds like all of these things that they were doing came down to enron borrowing money and telling the outside world that this was revenue. Is that more or less it?
McLEAN: It is. That’s a very large part of it. And what’s amazing is that the banks went along with it.
COLVIN: But if the banks knew that Enron was fabricating earnings and hiding debt, then they knew this company was essentially a fraud. And yet, some of these banks had equity analysts who were recommending the stock. How could it be?
McLEAN: Well, banks will argue that there’s a Chinese wall between what their investment bankers know and what their research analysts know. In other words, the research analyst wouldn’t have known about all these transactions Enron was engaging in. My personal opinion is that a Chinese wall is a handy excuse and banks invoke it when they feel the need to do so. And I think the research analysts also knew a fair amount of what Enron was doing, or certainly knew the gist of it. The issue is, even the banks kept on lending money to Enron, over all this time. No one added it up.
COLVIN: Well, so what you’re saying is, they could have known, and certainly, arguably, should have known that a disaster was inevitable, yes?
McLEAN: Right. Exactly. We like to believe that the biggest banks in the country should be sophisticated enough that if they were engaging in these transactions with Enron, certainly they would have seen what was coming given all that they knew. And it’s actually pretty frightening that they didn’t, and they didn’t add it up.
COLVIN: So what you’re saying is that they sort of averted their eyes from evidence that was before them. What was their motivation?
McLEAN: One, that they believed in the mystique that they had done so much to create, this illusion of this incredibly powerful company that could do no wrong. But second, it was money. The banks earned so much in fees from Enron. It was one of the biggest, if not the biggest fee payers in corporate, of all time in corporate America.
COLVIN: I think you report that, in one year, and I believe it was ‘99, it was, Enron was in fact the biggest fee payer to Wall Street in america, $230-some million dollars.
McLEAN: $237 million dollars.
COLVIN: In that one year.
McLEAN: Which is a stunning figure. And you see in the banks internal e-mails all sorts of examples of the bank saying, “This deal isn’t quite right and they’re using it to manufacture earnings, or they’re using it to hide debt, but Enron gave us $40 million in fees last year and it’s a must for us, we have to do it.” That’s the trade-off for them.
COLVIN: This was supposed to be a big, solid blue chip company, number seven on the FORTUNE 500. Why were these sleazy transactions necessary?
McLEAN: From the very beginning of the company, it had this insatiable need for cash. In the beginning, it was a result of the heavy debt from the merger that put the company together. Later on, the company was branching out into so many new businesses, and these new businesses weren’t bringing in the cash flow yet. On top of that, Enron used a form of accounting known as mark-to-market accounting, which allows you to recognize earnings well in advance of bringing the cash in the door.
COLVIN: Sometimes years in advance of bringing the cash in.
McLEAN: And yet rating agencies who looked at Enron’s credit status wanted to see cash flow, and they wanted to see cash flow that matched earnings. Well, Enron began to resort to a huge number of techniques to create the illusion of cash flow.
COLVIN: So was Enron ever a strong company?
McLEAN: Never as strong as people believed. It certainly became weaker and weaker as the debt accumulated in its final years, but there was always a certain element of illusion to the company.
COLVIN: I get the impression from some of what you’ve written that Enron had other ways of keeping the bankers on its side, not only with fees but sort of personal favors to some of the executives. Yes?
McLEAN: Well, it’s amazing the skill that Andy Fastow, Enron’s notorious CFO, he was incredibly skilled at working the banks and getting them to go along with he wanted them to do. He had this ranking of the banks. He would rank them as tier one, tier two, or tier three based on their willingness to extend capital to Enron, their willingness to do deals at the end of the quarter, their ability to quote “deliver the institution.” -- in other words, make sure no one said “No” to an Enron request. And banks clamored to be part of Enron’s tier one crowd.
COLVIN: Because if they were?
McLEAN: Because if they were it meant millions of dollars in fees.
COLVIN: This is all part of a larger story which you and peter elkind have told in a brand new book called The Smartest Guys in the Room: the Amazing Rise and Scandalous Fall of Enron. Did Enron’s leaders really believed that they could get away with all this because they were just smarter than everybody else?
McLEAN: I think they did things because they thought they were smarter than everybody else, and that was certainly the mystique that the company created, and that’s what kept people believing in it over all these years: “These guys are so smart, their stock price is so high. Well, since they’re so smart, their stock price should be even higher.” And for a long time it really was, in a sick sort of way, a kind of virtuous circle.
COLVIN: One of the questions everybody has been asking since the whole scandal really got to be big two years ago was, did Ken Lay, the CEO of Enron for most of its life, know what was going on. You’ve spent a lot of time on this story, what do you think?
McLEAN: I don’t think he did. But I don’t think that’s any excuse. I think he should have known. And while he might not be criminally liable, because that does require knowledge, I think he is ethically responsible, because you cannot collect the salary that he did from Enron and be ignorant of the things that are happening underneath you.
COLVIN: Well, leaving aside what the prosecutors are able to prove in court, do you think that they were criminals in their hearts?
McLEAN: I think to misrepresent a company’s financial economic realty to the extent that Enron did, there’s no other word for this than a giant fraud. Did people recognize that that’s what they were putting together as they did? Absolutely not. Enron people themselves believed in the illusion that they were creating. There’s a whole ego and power thing that happens to people at companies like that, and they believed in it.
COLVIN: What’s the lesson here for individual investors?
McLEAN: I think it’s, one, to always do your own homework to the extent that you can. And it’s the same lesson as in the past: If you don’t understand something don’t invest in it.
I think, two, it’s to have a diversified portfolio, because smart people can make mistakes, and people who believed in Enron, sure, some of them were sloppy, they didn’t do their homework -- I’m talking the research analysts and the portfolio managers who owned the stock -- sure, a lot of them were sloppy, didn’t read the notes, didn’t do their homework. But some of them made human mistakes, and it is possible to get seduced by something and be wrong. And it’s one of the important reasons to have a diversified portfolio.
COLVIN: Bethany McLean, thank you so much.
Next week
COLVIN: That's our program. Next week, we're on the road again, and the streets aren't paved with gold but with opportunity: How immigrants are transforming our economy.
GIBBS: Also, get ready to make a toast, to the eye-popping profits to be had from fine wines.
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