Trading in trading
companies carries
the risk of volatility

NEW YORK » After the surprise announcement that the New York Stock Exchange plans to merge with a smaller electronic rival and go public, one thing is clear: The global market is a booming business, and it's about to get bigger.

Companies like the NYSE's merger partner, Archipelago Holdings Inc., and Instinet Group Inc., whose electronic trading platform is being purchased by Nasdaq Stock Market Inc., aren't exactly household names, but they're well-known among Wall Street professionals who rely on their services. Investing in the companies that make the markets work can be a tricky business for novices, however, and with more consolidation likely in this sliver of the financial sector, analysts say shareholders should be prepared for volatility.

When it comes to investing in the trading stocks, "you have to be able to ride the ups and downs, because their revenue will be driven by market volume," said Meghan Crowe, an equity analyst with Morningstar Inc. "They'll be more volatile than your average retail stock."

The NYSE-Archipelago deal, valued somewhere between $3 billion and $3.5 billion, was considered a major event because many observers think the speed and efficiency of electronic trading will revolutionize Wall Street. Electronic trading has already been embraced by the Nasdaq market, the Chicago Mercantile Exchange Holdings Inc. and the International Securities Exchange Inc., which are publicly traded, as well as the Chicago Board of Trade and the New York Mercantile Exchange, which are not. But while many see it as a great opportunity, the deal casts doubt on the future of the NYSE's current auction system, and the fortunes of its specialists -- the people who currently handle up to 90 percent of its trading volume.

Some of these firms are cushioned by the fact that they are part of larger financial services companies; for example, Bear Wagner Specialists is largely owned by Bear Stearns, and Spear, Leeds & Kellogg Specialists is a unit of Goldman Sachs Group Inc. But the shift to electronic trading may be more painful for others, such Van der Moolen Specialists USA, which accounts for 75 percent of its parent company's revenues, and LaBranche & Co. -- although the NYSE's current plan calls for a hybrid system that would use both electronic and floor trading of stocks.

The ramifications of the deal are particularly chilling for LaBranche, which has no other meaningful business outside its work matching buyers with sellers on the floor of the NYSE. The firm had already warned that its first-quarter earnings would come in lower than initially forecast, due to poor market conditions in January, lower volatility and increased computer-driven trading.

"The NYSE and Archipelago combination implicitly is a vote of no confidence in the specialists," said Richard H. Repetto, an analyst with Sandler O'Neill & Partners. "If you're thinking the hybrid is the complete answer to becoming a global exchange, what's the purpose of acquiring ArcaEx? It brings them Nasdaq market share, but it certainly provides NYSE with a fully electronic alternative route to the specialists."

Repetto currently has a "buy" recommendation on Nasdaq, which he praised for being a consistent cost-cutter over the last several years, and for sticking to a detailed strategic plan. On top of that, he added, Nasdaq's purchase of Instinet's electronic trading network -- a $934.5 million acquisition announced yesterday -- will provide added scale.

He's also intrigued by Knight Trading Group Inc., one of the top market makers through its subsidiary, Knight Equity Markets, which handles trading for stocks listed on the Nasdaq, the NYSE, the American Stock Exchange and the over-the-counter exchange through its subsidiaries. Its customers include institutional investors and brokerages.