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Friday, July 07, 2006

LaBranche: Down, But Not Out

What was LaBranche really saying in their earnings warning?

Being a specialist on the NYSE (NYX) and other exchanges has been tough in recent years. That is part of the reason that the NYSE (NYX) acquired Archipelago, but this in turn has essentially put the exchange in competition with its key operators (the specialists). Imagine how difficult it will be to be a pure-play specialist operator when the NYSE closes its deal with Euronext and other exchanges down the road.

You would think that the good news for specialists is that they own NYSE stock, but if you look at the warning you will see that didn't help either. The company had a $17 million non-cash charge on its books due to the decline in value of its NYSE shares. Part of today’s exacerbated losses look to be based on the partial reliance on the value of the NYSE stock. While they are a specialist and NYSE member, they cannot ultimately control what happens to NYSE’s stock price.

The operating losses according to the company are noted:

The estimated operating loss is primarily attributable to a decline in principal trading revenue in the Company's specialist and market-making business to approximately $20 million dollars in the second quarter of 2006, from principal trading revenue of $47 million in the second quarter of 2005. These lower principal trading results were due to adverse market conditions in May and June 2006. The Company reported that its estimated operating loss includes an after-tax reduction of its discretionary and incentive bonus estimate by approximately $5 million, or $.08 per diluted share, to reflect the Company's performance during the period.

This loss isn't just from a bull market or bear market. The specialist business is not dead, but it takes time to adapt to new models and to adapt to a changing industry. This is systematic now affecting all specialists. Each specialist operation will continue to change, but do not count on them dying out.

Knight Trading (NITE) is not a direct comparison, but one that needs to be addressed. They are more electronic market makers, but this had been perceived to be an at-risk sector before as well. NITE used to be perceived as a company that was at risk because of trading losses and risks from its electronic market makers, but they adapted and have been a great turnaround story.

Specialists have faced what has seemed to be ever-growing competition from ECN's, direct trading, Pipleline, other exchanges, dual-listings, and the like. They have survived this far, and they should continue to survive. It doesn't mean it will be the growth and glory days of the 90's and it doesn't mean it won't be without pain and adaptation, but they have a purpose.

Without a physical exchange run by people you are at the mercy of technology. Do you remember the Emulex hoax in 2000? If Emulex, which is subsequently NOW NYSE-listed, had been NYSE-listed at the time the specialist could have immediately halted trading and it could have averted massive losses some traders had to endure as a result. This is why specialists are needed. Yes, they will have to endure some losses from time to time and will face more competition in a global land-grab occurring in the global exchanges. Without specialists, you cannot execute orders when systems crash and you may not have an orderly market when drastic news events occur.

LaBranche (LAB) is down 20.2% at $9.92 on their warning. This also has even pulled down Van der Moolen (VDM), a Dutch market making company that operates as a specialist on the NYSE, by 5.1% to $7.01.

These companies have all been down on what the street had treated as close to death, only to recover drastically off their lows. LAB stock fell from $30+ in late-2002 down to as low as almost $5 in 2005. Shares of VDM were also at $30+in 2002 and traded under $5 in 2005. As it stands now, specialists may be down but should not be counted out.

Jon C. Ogg
July 7, 2006
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