Cannibalizing Cantor's bond trading has paid off

September 3, 2001, Business Week, "eSpeed's Trading Secrets: Cannibalizing Cantor's bond trading has paid off, but growth is slowing," by Spencer E. Ante,

http://www.businessweek.com/magazine/content/01_36/b3747619.htm

On the 105th floor of New York's World Trade Center, a bond broker is sleeping, legs stretched out, head resting softly on the back of a chair. When he's awake, he takes phone orders for U.S. Treasury securities at Cantor Fitzgerald, once the leading wholesale broker of government bonds. Two years back, he would have been surrounded by 220 screaming comrades hard at work matching buyers and sellers. Now, he's one of just 25 brokers whiling away the day and waiting for the phone to ring.

The new center of action lies down the hall at eSpeed Inc. (ESPD ) In March, 1999, Cantor spun off eSpeed, an electronic marketplace for bond trading, in a bid to reinvent the brokerage as an e-business and prevent online upstarts from siphoning off trades. Cantor has kept its equity brokerage, which the company says remains healthy. But most of its bond trades have moved over to eSpeed--in which Cantor holds a 55% stake. In the upstart's offices, computer screens silently record billions of dollars in bond and commodity trades every hour with almost no human intervention. "Nobody believed we could go electronic so fast," says Tim Coughlin, Cantor's head of government bond trading.

While most e-marketplaces are in a financial tailspin, eSpeed has been gaining altitude. The company has become the de facto exchange for U.S. Treasury securities, with about half of the $300 billion in daily trades taking place on its system. In the second quarter, eSpeed saw revenues of $34.1 million, up 52% from a year ago. Although the company continues to lose money--$1 million in the second quarter--executives and analysts expect it to turn profitable in the current quarter. Next year, eSpeed is forecasted to earn $24 million on $195 million in revenues, says J.P. Morgan Chase & Co. analyst Greg Smith. That prospect has helped cushion its shares, which have fallen only 10% this year, to $12, compared with the 85%+ drop of many Internet stocks. "ESpeed is going to be one of the survivors," Smith says.

Even so, the highflier may be headed for stormy weather. ESpeed faces slowing growth in its bond-brokering business as it takes an increasingly large chunk of sales from Cantor. In the second quarter, Cantor Fitzgerald completed 25% of its transactions by phone, compared with 63% in the first quarter of 2000. That's starting to affect eSpeed: In the first half of 2001, the upstart's trading volumes grew less than the overall Treasury market for the first time--by 11% vs. 33% for the total market. Within 18 months, eSpeed will have taken everything it can from Cantor, says Robertson Stephens Inc. analyst Justin J. Hughes.
ESpeed may also suffer from slowing action at the Federal Reserve. Since January, the Fed has cut interest rates six times, which makes the government bond market more volatile and boosts trading. As the Fed slows rate cuts, analysts say eSpeed's trading volumes will shrink. "A dull market is not a good thing," admits eSpeed President Frederick T. Varacchi.

Another red flag: Howard W. Lutnick, the 39-year-old chairman and chief executive of both eSpeed and Cantor Fitzgerald, has had run-ins with the Securities & Exchange Commission. In 1994, while Lutnick was president of Cantor, the SEC fined the firm for improperly funneling the brokerage's bond trades through small investors' accounts. The firm paid a $100,000 fine but didn't admit any wrongdoing. Then, this past June, after an SEC investigation of eSpeed's accounting methods, the company agreed to amend its financial statements. The issue: The SEC believed eSpeed overstated revenues by including charges billed to Cantor for processing trades. The change doesn't affect profits, but it takes a bite out of revenues. In the first quarter, for example, eSpeed had to cut its reported revenues by 26%, to $31.9 million. Still, most analysts aren't concerned. "We don't think it changes the economics of the situation," says analyst Diane B. Glossman of UBS Warburg. Lutnick agrees, calling the affair "simply a presentation change."

Lutnick is a classic Wall Street overachiever. He grew up in a middle-class home on Long Island, the son of a college professor and an artist mother. His mother died when he was 16, and his father passed away during Lutnick's first week at Pennsylvania's Haverford College. Upon graduating with a degree in economics, Lutnick joined Cantor Fitzgerald, founded by B. Gerald Cantor. A onetime Yankee Stadium hot-dog vendor who later amassed a $500 million fortune and the world's largest private collection of Rodin sculptures, Cantor took a liking to Lutnick. Under Cantor's guidance, Lutnick prospered, and he soon viewed Cantor as a surrogate parent. In 1991, Cantor made Lutnick, then 29, president of the firm. The two ran Cantor together for the next five years. "He was my family," Lutnick says, glancing at the four-foot-tall portrait of Cantor hanging behind his desk.

Like many families, Lutnick and Cantor had their share of disagreements. In the early 1990s, Lutnick wanted to push into electronic trading. But, he says, Cantor feared the move would hurt the brokerage. "It is very hard when it is your baby to make those tough decisions," says Lutnick. Meanwhile, Cantor's health was declining due to diabetes, and in January, 1996, he was put on life support. Cantor's wife, Iris, tried to take over the firm, Lutnick says. In response, Lutnick convened a five-member incapacity committee provided for in the brokerage's partnership agreement and was granted control of the company. Since then, Mrs. Cantor and Lutnick have been engaged in intense legal warfare, suing each other over issues ranging from funding for a foundation she heads to a dispute over payments from the spin-off of eSpeed. Through her attorney, Barry Slotnick, Iris Cantor declined to comment.

With control of Cantor Fitzgerald, Lutnick was free to push the brokerage into the e-future. He invested $250 million in an electronic trading system. In March, 1999, realizing that Cantor brokers had no incentive to make the switch to electronic trading, he created eSpeed. Outsiders laud Lutnick's bold move. "In the high-tech business, the rule is to cannibalize yourself before anyone else cannibalizes you," says Michael Cusumano, a professor at Massachusetts Institute of Technology's Sloan School of Business.

To keep eSpeed growing, Lutnick has created an online supermarket of wholesale commodity exchanges. So far, he has built 48 marketplaces for everything from foreign exchange to Eurobonds to electricity. "The world is going to trade these commodities like it trades stocks," says Lutnick. "And eSpeed wants to be the place where that happens."

Insurance policy. So far, he has met with mixed success: Trading of products other than Treasuries has grown to represent about half of eSpeed's revenues. ESpeed, though, is unlikely to dominate many of those markets the way it does the U.S. Treasury trading that it pioneered. More than 70 companies have built electronic exchanges for fixed-income securities. The biggest threats: Garban-Intercapital PLC and Tullet & Tokyo Liberty PLC, two London brokerages with electronic-trading operations. Tullet is strong in emerging markets and Garban is the dominant player in many of the more esoteric markets that eSpeed is trying to attack, such as foreign government bonds. While eSpeed rules in U.S. Treasury securities, "they are not the largest broker of any other instrument," says Michael Spencer, CEO of Garban.

Lutnick acknowledges that he faces plenty of rough patches on the road ahead, but he remains optimistic. In his capacious corner office adorned with a Rodin sculpture, Lutnick predicts 50% annual growth through 2002. Clearly, eSpeed's connection to Cantor is a unique insurance policy, assuring it won't end up in a dot-coma. And Lutnick can draw confidence from his past success and eSpeed's strong start. Considering the challenges ahead, however, Lutnick may want to fasten his seat belt for a bumpy ride.