Why Is There A Philadelphia Stock Exchange? It couldn't be just because a bunch of its traders are making a bundle. Or could it?
(MONEY Magazine) – Warren West speaks softly and carries a big wad of papers, the scribbled record of a full day's work on the stock-options trading floor of the Philadelphia Stock Exchange. "I should make $500 on the 10 lot," says West, who is standing on the floor at the Dell Computer trading post. The "10 lot" is a complicated trade that involves selling 1,000 shares of Dell along with 10 options to buy Dell shares in the future. Although the price of an option generally tracks the price of the stock, there are discrepancies and lags that present opportunities for traders like West. In this instance, West has gambled that the price of Dell shares will fall faster than the price of its options. And that's exactly what happens, which means West nets a tidy $500 profit--for a few minutes' work. "I'm not that interested in how a company will perform in a month or a year," says West. "I'm interested in how its stock will perform in 10 seconds or 10 minutes."
These days, traders like West can make a surprisingly good living betting on the minutiae of capitalism. But where the Philadelphia Stock Exchange was once one of the engines that fueled the Industrial Revolution, it is now little more than an afterthought. Given the dominance of the New York Stock Exchange (the Big Board), the American Stock Exchange (ASE) and the Nasdaq electronic market, many investors might be surprised to learn that the Philadelphia Stock Exchange even exists, along with regional exchanges in Boston, Chicago, Cincinnati (sort of) and San Francisco (partly). In fact, the five U.S. regionals (see the box on page 142) do more business than many would suspect, carrying trading volume equal to more than a tenth of the traffic handled by the Big Board and the ASE. Perhaps more important, the scrappy regionals have been at the forefront of numerous innovations that might never have occurred on the stodgy New York exchanges. But ultimately, there's a more fundamental explanation. The regionals continue to exist because they continue to make money for their members.
Six-figure incomes are typical on the Philadelphia exchange, where the most successful traders among the 400 or so who prowl the floor every day earn $1 million or more a year. "We have a trader working for us who's been doing this for 18 months," says Stan Pressman, 66, a senior partner with Penn Options Co. "He made half a million dollars last year."
On Philadelphia's trading floors, college dropouts stand shoulder to shoulder with part-time concert musicians, while former fruit peddlers walk the same halls as former mayoral candidates. What they all have in common is the ability to make split-second decisions worth thousands or millions of dollars. "Exchange floors are meritocracies," says John Egan, 66, a high school dropout and former chairman of the Philadelphia exchange, who twice ran unsuccessfully for mayor of the city. "A cab driver has as much chance at success as a Harvard graduate."
THE BEST-KEPT SECRET
Actually, a hack would have to have ferried some pretty big tippers to launch a trading career in Philly, and he'd also have to pass a couple of licensing tests. You can't trade without obtaining one of the exchange's 505 seats, which can be leased for about $5,000 a month or purchased for $300,000. That's the going rate, up from $190,000 just five months ago--reflecting both a recent surge in equity options trading (from 10 million contracts in '93 to 25 million in '97) and the recent speculation of a Chicago investor, Paul Liang, managing partner of PBL Partners. A native of Hong Kong, Liang, 58, began acquiring seats on Philly's equity options floor two years ago. He now owns 53, more than anyone else. Regional stock markets, Liang asserts, "are the best-kept secret in financial markets."
Beyond the cost of a seat, a beginning options trader also must have at least $25,000 in capital or most clearinghouses will refuse to process his transactions. Still, exchange lore is filled with stories of undercapitalized wannabes who give it a shot anyway and bail out quickly. "You need $100,000 to start trading effectively," says Warren West.
All traders look pretty much the same on the floor--dressed, like race horses, in colored jackets that signify corporate allegiance as they manically bark shorthand orders at one another. But as an African American, West, 41, is a rarity--as he would be on any trading floor in the U.S.In the mid-1970s, he ran a small fruit stand on Chicago's South Side when he wasn't studying to be an architect at the University of Illinois. After reading an article about the Chicago Board of Trade, he figured his experience haggling with produce wholesalers would translate to the trading of grain futures. "They laughed at me when I applied for my first job," West recalls. "But they said they admired my chutzpah." He was hired as a broker's assistant in 1977 and eventually wound up in Philadelphia in 1981. Two years later, West persuaded a group of investors to back him in the pits. "There's a risk you'll lose everything," he says. "But you can make a lot of money on this floor."
The Philadelphia exchange is housed in the basement of a blocklong office building on Market Street in Center City, a structure whose ivy-festooned atrium looks like nothing so much as the inside of an Embassy Suites hotel. A century ago there were more than 20 regional stock exchanges in the U.S., in places as far-flung in location and disparate in character as New Orleans and Salt Lake City. Gradually, as technology improved and the New York trading posts mushroomed, most of the regional exchanges merged or disappeared.
The five that hung on have done so through a number of tactics. Regional exchange officials will tell you that they exist to provide competition, and they have a point. In much the same way that you wouldn't want Sears to be the only place to buy a pair of Nike Air Jordans, you wouldn't want traders on the New York Stock Exchange to have the monopolistic power to set the price on Nike stock.
But with the advent of the National Market System and Intermarket Trading System in the 1970s, which resulted in a simultaneous listing of stock prices on regional, national and over-the-counter markets, the odds that XYZ Corp. might be selling for $100 in Boston and $102 in New York became virtually nil.
The regionals, therefore, have had to come up with other reasons for brokerage firms, mutual funds and other buyers and sellers of stock to funnel orders to them. Their primary strategy is as effective as it is inelegant--they buy business. Unlike the Big Board or the ASE, which charge customers for doing business on the exchange, the regionals don't levy transaction fees. In fact, they pay for order flow--that is, they give a portion of their profits from trades to the firms that place orders. This entirely legal kickback is akin to the ante that poker players pay to participate in a hand.
The practice, also common in the over-the-counter market, is one reason for the growth of discount, deep-discount and online brokerages such as Olde Securities and Ameritrade that have cut costs to as little as $8 a trade. "How do you think discounters can afford to charge so little?" asks Robert Battalio, a professor of finance at Notre Dame. "They're routing orders to the regionals and getting paid for it."
The Big Board has long contended that the execution on regional trading floors is not as efficient as in New York, which means customers may not always be getting the best price. But numerous studies have shown otherwise. "We look at this issue closely," says Shelley Bays, senior vice president in charge of exchange trading for discount broker Charles Schwab, which routes half its orders to regional exchanges. "We see every bit as good execution on the regional exchanges as we see in the primary markets in New York. Sometimes better."
WHERE POOR KIDS GET RICH
The execution debate is serious business on the equity trading floor in Philadelphia, which is sedate compared with the raucous bazaars of the Big Board and the ASE. The exchange's three trading floors make a market in 2,800 listed stocks, 750 stock options and a dozen foreign currencies--vs. the Big Board's 4,200 stocks.
The livelihood of the traders here hinges on their ability to keep their phones ringing. "Customers have to know that when they call us, they'll get the best price and service," explains Kevin McNamara, 54, a partner in McNamara Trading Co., one of the largest trading firms on the Philadelphia equity floor, with direct phone lines to more than three dozen brokerage firms. "If there's a problem with a trade, we get back to them in seconds, which may not always be the case in New York."
McNamara and his partner, Al Perry, 45, are earthy men who seem to have been birthed from a stock ticker machine. But in fact, McNamara waited until age nine to buy his first stock, with the help of his mom. "I bought [tractor maker] J.I. Case at $10 a share and sold it two years later at $17," he says. "I was making $1 a day working weekends in my father's grocery store. I thought I could do better in the market."
Perry dropped out of LaSalle University in 1971 at age 18 to get into the business, first on the trading desk of a brokerage firm and then, in 1975, on the equity floor at the exchange. It may take $100,000 to get started as an independent trader, but it costs nothing to start as a clerk. Moreover, even for the more than 800 support workers at the exchange, salaries in the mid- to high five figures are not unusual. "This place isn't about degrees," Perry says between staccato bursts into the phone receiver. "It's where poor kids like me come to get rich."
Like many trading floors, Philadelphia's has something of a locker-room mentality. Last October, the stepsister of a former exchange chairman filed sexual discrimination and harassment charges against the bourse. Neither exchange officials nor the woman's attorney would comment on the charges, which are reportedly under review with the Equal Employment Opportunity Commission. "It's a man's world, or a boy's world," says Lisa Waring, 33, an equity options trader. "It's intimidating but not mean-spirited. The guys are probably more respectful to me because I'm a woman. And, truth is, because I'm marrying one of them."
Stock exchanges and their members are a curious breed. On the one hand, seat holders share an insular camaraderie born from the knowledge that they enjoy a license to print money. On the flip side, exchanges are notorious for the kind of bickering and self-interest that you might expect from a group of men in a high-stakes card game. This past February, for example, eight floor brokers at the New York Stock Exchange were charged in federal court with illegally profiting from information about upcoming orders and other tips the brokers picked up on the exchange floor. That's illegal because floor brokers--unlike traders such as McNamara, Perry, Waring and West--are privy to valuable and exclusive information and are thus not allowed to trade for their own accounts.
In Philadelphia, the rough-edged culture endemic to all exchanges may have played a part in one of the bourse's more embarrassing moments. In 1996, then chairman Vincent Casella resigned after it was found that he had a financial interest in a firm that was picked to install a multimillion-dollar trading system at the exchange. The incident prompted an investigation of the exchange and a slap on the wrist by the Securities and Exchange Commission and led to radical governance changes--including the appointment of 11 outsiders to the 22-member board of governors.
It also led to the appointment of Leopold Korins as chairman and chief executive officer late last year. Korins, who was chairman of the Pacific Stock Exchange from 1990 to 1996 and who spent 32 years before that with Merrill Lynch, brings a new level of sophistication to Philadelphia. But he's reluctant to talk about past scandals. "There's no point looking back," says Korins, 64, who prefers to speak about the future. "We've made our name developing new products, new ways to get people in the store. That's what we'll focus on."
The exchange has been a pioneer. In the early 1970s, it was the first to use an automated trading system that allowed small orders from retail customers to be executed more efficiently and economically by computer. In 1982, it was the first exchange to trade currency options. More recently, it has been a leader in the development of so-called stock-index options, which allow investors to bet on the future price of a large group of similar stocks. In recent years these options have become synonymous with the Philadelphia exchange and are often used as hedges for people who own the stocks represented in the index. They include the widely known "SOX" semiconductor industry index option and an oil services index option ("OSX").
The OSX was conceived in the fall of 1996, when an options trader noticed that the stocks of oil services firms--the firms that supply pipes and rigs and such--were far more volatile than the shares of the oil companies themselves. Since volatility--price swings--indicated a lot of investor interest in the sector, the trader thought there might be a market for an oil services index option. He mentioned this to Joseph Rizzello, who's in charge of new products at the exchange. Rizzello filed the necessary paperwork with the SEC, and by February '97 the OSX options were trading. "Innovation is our lifeblood," says Rizzello.
Of course, it wasn't that long ago that currency trading was considered the brainstorm that would save the exchange. In the early 1990s, the currency options floor was the most hectic at the bourse. These days, it's relatively quiet, as the number of currency option contracts traded has dropped precipitously, from more than 12 million in 1993 to fewer than 3 million last year. In part, that's because many of the world's biggest currency traders--such as banks--now deal directly with one another, rather than trading in Philadelphia.
This development is a blow to the exchange, which has a committee studying the future of the currency floor. "We'll have to do something dramatic," says Arnold Staloff, 53, one of the exchange members who helped develop the currency business. But the currency floor isn't the only area of concern. Although a record 1.5 billion shares of stock were traded on the equity trading floor last year, its market share of all U.S. stock trades has dropped from 2% eight years ago to 1% today. That's because most stocks traded on the equity floor in Philadelphia can be bought in other places.
In some ways, these pressures are unavoidable, given the growing role of technology in financial markets. It may be that even the big exchanges face an uncertain future. "I'm not sure the best way to achieve efficient markets," says Junius Peake, a professor of finance at the University of Northern Colorado and a longtime consultant to various exchanges, "is to put people on trading floors around the country and have them yell at each other."
On a recent Wednesday morning, Warren Fuchsel, 35, a floor broker with Hurricane Trading, is yelling on the currency options floor in Philly. He's hawking 300 British pound "put" options--the right to sell more than $9 million worth of sterling in a month. There's little interest, reflecting both a price that's too high and the falloff in currency options trading.
"I've got 300 at 13," the trader says to no one in particular. "Does anyone care?"