NYSE goes electronic
KAREN GIBBS: This week will mark an historic landmark for the New York Stock Exchange -- and it has nothing to do with the level of the Dow or the price of stocks. In an unprecedented move, the 212-year-old Big Board has finally begun the process of replacing the vaunted human floor traders with computers. By agreeing to merge with the electronic trading firm Archipelago, the old way of buying and selling stocks will likely be changed forever, and we thought it would be a good time to revisit how stocks are traded and who gets a piece of the action.
(video package begins) GIBBS: Here is an anatomy of a stock trade.
LINDA JAY: SBC, $23.62 for 44 at $23.63, take 44 trade at $23.63. Sold. 15,000 trade at $23.63. I just sold him15,000 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, director of equity trading at 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 trader is sort of the middleman for your stock trader. Twenty-year NYSE veteran Joe Cangemi's company takes the call from the stock trader.
GIBBS: 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. 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: 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.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 is 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 firm might only make pennies by cheating on a large stock trade, but those pennies add up.
The SEC says improper trades cost the investor -- you and me -- $155 million.
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 $23.62 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: 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 sends notice of the transaction to the firms placing the orders. And that's it. It took a lot of people and a lot of expensive technology, but the deal is finally done… And the stock is traded.
(video package ends)
GIBBS: FORTUNE’s Shawn Tully has followed the behind the scenes action at the NYSE for years, and he joins us now from New York.
Well, Shawn, the headlines are saying this is a big change. How big of a change is it really?
TULLY: This is not as big a change as has been advertised at all, and the reason is that the New York Stock Exchange, instead of being essentially deregulated and having to give up a lot of its market share and really compete on price with a multiplicity of electronic exchanges, such as Instinet and Archipelago, which it's now buying, is going to be able to keep its dominant market position. The reason is because of the recent decision by the regulators, the SEC, to keep a monopoly rule called the trade-through rule that essentially ensures that the NYSE will be able to keep 80 percent of the trading in its own listed stocks, which is what it has now. GIBBS: So, Shawn what you're saying is that the playing field will not be leveled between the Nasdaq, the dominant electronic network, and the New York Stock Exchange.
TULLY: No. The Nasdaq is in a very weakened position now. It's in the process of trying to buy Instinet. It doesn’t have either the deep pockets or the brand name that the NYSE has. You're only going to have two big players here, and the NYSE is probably going to take a lot of market share away from the Nasdaq, and in fact could establish a quasi-monopoly position in the Nasdaq stocks, the same kind of quasi-monopoly position it has in the large-cap industrial stocks that are mainly the mainstay, the staples of the NYSE. It could extend that monopoly position to the stocks that are created on the Nasdaq. And whenever you have two big competitors dominating a market, it's an oligopoly.
It's not a good situation. Prices usually are not terribly competitive. So even though they may be able to trade cheaper and those savings should be passed on to consumers, they may not be. You're going to have a lot of high pricing, lack of competition. What we really want is a multiplicity of the electronic exchanges. That didn't happen.
GIBBS: So this lack of competitiveness cannot be good for investors. How can investors expect to benefit from this?
TULLY: Well, they can't. That's the problem. There’s all this happy talk about these mergers, and what no one is really talking about is that you have essentially two competitors in the market, one of which is going to be at a big disadvantage, and that's Nasdaq. You're going to have the NYSE with a very, very strong share, probably still 80 percent that it has now, in its own listed stocks.
In other words, the big stocks, the Exxons and the General Motors and the big industrial stocks and some of the very large tech stocks like IBM, but then you're going to have them taking a dominant position as well in a lot of the smaller stocks, a lot of the Nasdaq stocks, and taking that market share away from the Nasdaq. And you’ve got the ECNs selling out to these two big players and not being able to survive on their own. There won't be anymore creation of major ECNs out there, and ECNs are the way to go. I mean ECNs, especially a multiplicity of them, with very competitive pricing that are fighting for market share, that's the kind of market you want. That's not the kind of market we’re getting.
GIBBS: Interesting then all the headlines screaming that it's going to be such a seismic change, and it's really not. Now the New York Stock Exchange will become a publicly traded company. Won't market forces then kind of rein in the dominant position that the New York Stock Exchange, at least you say it's going to have?
TULLY: Well, the New York Stock Exchange should be a publicly traded company. Dick Grasso probably would not have gotten his enormous pay package if the light of day had been shining on their financial statements, which it wasn’t. I think that's a very healthy change. It will be de-mutualized. It will be under true owner pressure, whereas the owners who were the seat holders were barely on the board and had almost no impact on the way that the company was run. It was a not-for-profit, everything was secret. We’ve seen what was going on there. It was not very tasteful. So that is a good thing.
GIBBS: What’s going to happen to the value of the floor and the value of those seats that are sold on the floor?
TULLY: Well, it's soaring. We’re seeing seats that are being sold for 11 percent more this week than they were sold for last week. We’re seeing the value of Archipelago’s shares going up very rapidly, which means that were the New York Stock Exchange publicly quoted, their shares would be going up as well. So we’re seeing very, very favorable valuations being applied to the NYSE. Why? Well, because of the monopoly rights. Why else? We have a company now that would be valued at about $4 billion that was in serious trouble just recently, and the reason is because they’re going to have a lock on a substantial share of the markets that's going to be unshakable.
GIBBS: Well, where's the regulation in all of this?
TULLY: The regulation is the problem. The SEC could have eliminated the trade-through rule, which is what the ECNs like Instinet and Archipelago were counting on. It didn't happen. It was strengthened in effect by being extended to Nasdaq stocks, so they were put in a very poor position where they essentially had to sell out at prices that were lower than the ones that they had hoped to get.
GIBBS: Shawn Tully, thanks for joining us.
TULLY: Thank you, Karen.
Performance philanthropy
GEOFF COLVIN: What if you started thinking about charity the way you think about investing? They aren't so different -- you're laying out money that you expect to produce a return, in one case for yourself, in the other, for the world. Now a growing movement says if you were just as tough-minded a giver as you are an investor the world would be a lot better off.
Eric Thurman runs Geneva Global, which promotes performance philanthropy -- we'll explain what that's all about. And Tim Stone is president of NewTithing Group, which contends Americans could easily give away tons more money than they do. He joins us from San Francisco.
Tim, you say people could give away a lot more than they do. Now that's sort of self evident. We could all always give more. So what exactly do you mean?
TIM STONE: Well, first of all, what we really emphasize is that it's really everybody’s right to decide on their own magic number for how much to give to charity each year. And so although it is true that we think that if more people budget for charity that many people, particularly at the higher end, may conclude on their own that they can give substantially more.
We emphasize that it's important enough to everybody to decide for themselves how much to give. So we think that a byproduct of budgeting for charity and turning charity from perhaps more of a reactive obligation to a proactive passion could well leave many people to conclude that they could give more, particularly at the higher end.
COLVIN: Well, you do focus at the high end. Now you’ve done some calculations, if I'm not mistaken, about how much more the sort of wealthiest Americans could give. What did you come up with?
STONE: What we found was that those donors who are in the middle class and below are actually giving a higher percentage of their investment asset wealth to charity -- roughly three quarters of a percent of their investment asset wealth or one percent -- as are people who are in the upper middle class to middle rich, those earning about $200,000 up to $10 million in income with investment asset wealth, not counting their homes, of about $1.7 to $46 million in assets, that huge amount of wealth. Those people are on average giving roughly half a percent of their investment assets to charity each year.
So our point is that if all those people in the upper middle class and the lower rich gave as much as everybody else above or below them, there would have been an additional we estimate $41 million to charity in 2001 alone.
COLVIN: A huge number, very substantial. Eric, you at Geneva Global are promoting this concept of performance philanthropy, which is a very striking phrase. Most people have not heard it. And it almost sounds contradictory. What do you mean by it?
ERIC THURMAN: People aren't used to hearing those two words side by side are they?
COLVIN: No.
THURMAN: And the reason is we have some very old-fashioned ideas about how philanthropy works. I think most Americans think that what you do is you put your money into one big bucket and hope something good comes out of it. But you started out at the beginning saying that maybe we should look at this with an investing mentality. And in investment you're asking what’s the return on my investment? And we believe that that's what we should do, and if we’re looking at returns then we can talk about performance.
COLVIN: And so this is what you guys do. You attempt to measure the performance of a philanthropic donation. If you gave to a particular cause, how much return would you get, just as if you invest in a particular stock, how much return would you get.
THURMAN: Because if nothing changes, you’ve wasted your money. That's a terrible shame, to have had good intentions and you put money out there, but nothing was different. We have to begin by asking ourselves what is a bottom line in charity?
COLVIN: Exactly, because most people would think, well, it's a terribly subjective thing. How could you begin to measure it?
THURMAN: Well, it is unless you back up and ask yourself what is the evidence that something good has happened? And we think you can track it always to life change. If people's lives are changed, you actually can measure that. You can say how many people were affected and in what ways?
COLVIN: And so what happens as a practical matter when a donor with some money to give comes to your firm?
THURMAN: Well, we’ve had a fresh example of this with the tsunami, because about $9 billion, a combination of private donations and foreign aid, have gone into help tsunami victims. And just a couple of weeks ago The New York Times had a reporter standing in Bande Aceh saying something’s wrong here. I don't hear any bulldozers, I don't see any jackhammers, the water's still polluted.
What’s happening? The reason is again it's the big pot theory and you hope that something good is happening. What we do instead is that we directly connect with specific projects, so when you donate $30,000 to reopen some water systems or to reopen a school, it's something that wouldn’t happen if you hadn’t done it. And we have very specific outcomes that are forecast, carefully researched, competent, business grade due diligence, and then we report back on what actually did happen. So just like you get financial statements, you actually get to see what the yield was on the investment you made.
COLVIN: I happen to have one of your company's reports here, which is on a particular project, a hospital project in Sierra Leone. Now Sierra Leone, which I hadn’t fully appreciated, is just about the most miserable place on the planet for a human being.
THURMAN: That's true.
COLVIN: It's just terrible. Now this is a project, and you explain how lives would be changed.
THURMAN: Exactly. See we actually have more information than people realize about philanthropic opportunities. If we move from obligation to opportunity, we can start saying where are the opportunities? And the United Nations literally ranks every country in the world by standard of living, quality of life. Sierra Leone, at that time -- that was I think last year we did that project -- was at the very bottom, the poorest country on earth, and that particular province had the highest maternal death rate in the world. That project measurably will cut that in half.
COLVIN: Now that's what you mean by lives changed then. If the maternal death rate goes from X to one-half X, that's a return on your contribution.
THURMAN: Exactly, and you can measure that. And the excitement then becomes that you know that for $40,000 you did it, because there’s a direct connection between that impact and the money that you’ve given.
COLVIN: Tim, let me ask you a little bit about the money that people are giving away and how you think they might do it a little better. One thing that your organization has suggested is that people give it away sooner rather than later, sooner than they have done traditionally. What’s going on there? How come?
STONE: That's a great point. Our founder, Claude Rosenberg, he’s really come up with a number of just brilliant ideas, and one of his points was what we call Rosenberg’s rule of social inflation, which is that societal ills tend to expand at an exponentially greater rate than does return on capital. So if you have a dream, if you're planning to make some type of a larger gift than you normally would, don't wait, because the chances are that a dollar donated to charity now is going to have a lot greater impact than that same dollar donated later, and that's been underscored by some independent reports.
COLVIN: Now I know what a lot of people are thinking when they hear this. One, they think, well you know, I might need that money myself. Maybe I'll have some kind of medical emergency or some other emergency. I might need it myself. Why don't I hang on to it and just leave the money in my will? And then the other thing they think is, well, if I hang on to the money, it can grow as it's invested in the stock market, so if I give it later I’ll be able to give more.
STONE: Well, that's a great point. I guess a couple of things. Number one, of course it's not certain that the money will grow at exactly the time when you're going to donate it. The other point is that let’s just look at an example of some child in a family perhaps underprivileged. If they don't receive some type of help from some type of charity that might result from a donor, perhaps that affects the child’s sister and the family, and the family maybe is more dysfunctional. That affects the community, which affects the society. It radiates outwards.
And look at the opposite, and that is that if they do receive more help because a donor has made that donation earlier, that family is more functional. The relationship maybe between siblings is more functional. Their relationship with their community is more healthy. The relationship of the community to the society is more healthy. So that's the first point, is that there are some great reasons and a lot of evidence behind donating sooner rather than later. The other point is that our point is that it's important to think about donating to your maximum comfortable capacity, and do that now and don't wait on that.
COLVIN: Eric, I want to ask you about another angle to this. There’s so many things people could donate their money to. In fact, it's bewildering and I think a lot of people actually get frozen simply because they can't make a decision about it. But you have said really effective donors are like effective investors in that they’re contrarians. Now what do you mean by that?
THURMAN: Yes, actually Forbes did an article on us and called us contrarian charity experts, and we love the term, because the proper concept of a contrarian is someone who sees value that others are missing, and that's exactly the theory I’d run on. Let me give you an example. Wouldn’t you say America is a pretty wonderful place to live?
Arguably it's the most prosperous country in human history. Yet for all the billions of dollars that we give, it's about $240 billion a year, 95 percent of it is spent inside of our borders. And so if we wanted to go where the best philanthropic opportunities are, where you could have the most impact and really see lives change, we’d go to the poorest half of the world. We’d go to those countries that are in the bottom half of the United Nations human development index, and that's where we find there’s colossal opportunities.
COLVIN: I can well imagine. There are so many ways to give money also, and Tim, I wanted to ask you about one of them that you talk about in your organization, which is the donor-advised funds. What are they?
STONE: Yes, well a donor-advised fund allows you to put money into a particular account, and you receive the tax benefits, the tax deductions on making a donation right when you put it into the account. And then by and large you can then decide where, to what charities those funds will then go to, but you're not as much in a rush to do so because you’ve received the charitable deduction right by putting the money into the account as a charitable contribution.
There are various kinds of donor-advised funds. There are donor-advised funds from community foundations. There are over 700 community foundations in America, and they tend to specialize in advising you if you wish on donations to charities in your local communities. There are also national donor-advised funds that, for example, are affiliated often with financial service organizations as well.
COLVIN: So it's a way to avoid being paralyzed by all the many choices. You can give the money now and figure out later exactly how you want to donate it.
THURMAN: Can I interject something about that?
COLVIN: Yes, please Eric.
THURMAN: Donor-advised funds are one half of an alternative to having your own foundation. So if you wanted to set aside a couple of million dollars to do something philanthropic, you could be much better off using a DAF, or donor-advised fund, than setting up your own foundation. But the other half that it doesn’t take care of is the decision making about how to select what projects you're going to support. That's where the kind of facilitation we do comes into play.
COLVIN: Go ahead, Tim.
STONE: I think that of course it just depends as well on your emotional needs or the types of ways that you like to go about doing business, and some people want to have some advice perhaps on a more specific local level and some people maybe want more active advice. So it just depends of course on what your particular needs are.
COLVIN: There’s a final very specific point that I want to make sure we hit, and that is this simple idea of how to give. I was amazed to find that there are people who have stock, appreciated stock, and they think that they should sell the stock and then give the money, and they shouldn’t. Is that right, Eric?
THURMAN: Well, there are some definite tax advantages to how you structure any deal, and I think that's important to consider. Because there’s really only five things you can do with money. You can spend it, you can save it, you can invest it, you can pay taxes, or you can give it. And so the interplay between taxes and giving is important, and so you need some good counsel to know how to move those transactions so that you get maximum personal benefit.
COLVIN: These are really valuable perspectives to have, and a lot of people haven’t heard them, so we greatly appreciate your views. Tim Stone, Eric Thurman, thank you.
NEXT WEEK: Financial Squeeze
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