Instinet and Island should be able to integrate their ECN businesses, and adopt a single matching engine, within one year. That's the latest news coming from Ed Nicoll, Instinet's newly-appointed chief executive officer.
Nicoll -- the former Island chairman who took the reigns as Instinet's CEO after Instinet and Island finalized their merger on Sept. 20 -- says that executives from Instinet and Island are currently working with consultants to map out their integration strategy. "Both teams are working toward an integration path which we hope will result in a single matching engine and single ECN within a six to 12 month timeframe," he explains.
In the past, sources close to Instinet and Island have said that it is extremely likely that Island's matching engine will form the core of the ECNs' integrated-trading platform, but Nicoll says that the unified system will probably be comprised of technology components from both Island and Instinet.
While an integrated system is still a ways off, Instinet has already built an electronic bridge between its platform and Island's matching engine, enabling customers of both ECNs to tap into a vast liquidity pool. "We are (ultimately) going to integrate the two ECNs into one (physical) liquidity pool. (But) we've (already) starting doing that virtually, by putting in place software and communications solutions which allow (our) two pools of liquidity to instantly interact with themselves," says Nicoll. "So when (customers go) into Instinet, they will get the benefit of interacting with all of the liquidity in the Island pool. And when customers come into Island, they will get the benefit of interacting with all of the liquidity in the Instinet pool."
Separately, Instinet has also recently significantly altered its strategy for exchange-traded funds (ETFs) -- open-ended mutual funds that Island has had great success trading over the past two years. From October 2001 through September of this year, Island was, in fact, the largest market for trading of the QQQ -- the most popular ETF. Island had surpassed the American Stock Exchange, the home market for the QQQ and several other high-profile ETFs, while refusing to participate in the Intermarket Trading System -- a trading platform that electronically links together the Amex, New York Stock Exchange, Nasdaq Stock Market and six other regional equity exchanges.
Island consistently maintained that the ITS' so-called trade-through rule -- which states that each ITS member cannot trade a stock at an inferior price if there is a better price available at another market -- would negatively impact its speed-driven business model. But roughly two weeks ago, Island agreed to trade the QQQ and the SPY, the two largest ETFs, via Nasdaq's Intermarket -- a market that will require Instinet/Island to obey the trade-through rule that they have previously so vehemently opposed.
The rule states that any ITS participant must route an order to an away market if a market has a better price for a specific stock than its own quote. But Island has in the past argued that the rule could greatly inhibit the speed of its ETF executions, because the market on the receiving end of an ITS order has a maximum of 30 seconds to respond.
By agreeing to obey the rules of the ITS, Instinet/Island will now be able to post its QQQ and SPY quotes in the National Consolidated Quote System -- a real-time market data platform that displays the best bids and offers for listed stocks to everyone participating in ITS. Up until Sept. 23 of this year, Island, in lieu of displaying its quotes in the NSCS, had posted its ETF prices on its order book -- a book that was accessible to Island subscribers, as well as anyone who logged into the ECN's web site.
But on Sept. 23, facing a regulatory display mandate issued by the Securities and Exchange Commission, Island decided to terminate the posting of its top five ETF contracts on its book. The commission's ruling stated that, by Sept. 23, any ECN that held more than five percent of the volume in an ETF for four of the last six months had to display its prices for those instruments in the NCQS. Island subsequently decided to eliminate the posting of its ETF quotes all together, rather than display on the NCQS, because it did not want to be subject to the ITS trade-through rule.
Since it decided to go dark on Sept. 23, however, Island saw its market share in ETFs -- particularly the QQQ and the DIA -- decrease significantly. Consequently, says Nicoll, Instinet decided that it had to take a chance in participating in the ITS, because it needed a mechanism for making its ETF quotes transparent. "We have lost significant market share in the ETFs, at Island, since we stopped publishing our quotes. We are still, I believe, the largest market in the QQQs. But we freely admit that we have lost customers for whom a published quote is important, in terms of the way they interact in the marketplace," he says.
The one positive thing that ITS has going for it, says Nicoll, is a recently instituted exemption to the trade-through rule. The so-called de minimis trade-through rule exemption enables firms to trade-through another market's price for a specific ETF, as long as the transaction is no more than three cents away from the best bid or offer displayed in the NCQS. The exemption, which is limited to the three largest ETF contracts, was created by the SEC and put into effect on Aug. 28. "We are trying to determine whether posting in the ITS, with that de minimis exception in mind, creates a better set of market dynamics than being outside of ITS but being unable to post our quote," says Nicoll.
Basically, he says, the SEC's Sept. 23 ruling created a no-win situation for the Instinet/Island team, in terms of trading ETFs. "On one hand, we could not publish a quote and have a poorer marketplace as a result of that. On the other hand, we can publish our quote and participate in the ITS and have, in our view, a poorer marketplace as a result of that. So it's not an easy decision for us, " Nicoll explains.
Currently, Nicoll is in the middle of a six-week global customer tour, during which he plans to meet with many of Instinet's largest clients. Throughout the tour, says Nicoll, he will not only explain the Instinet/Island integration schedule to clients, but also get customer feedback on the pros and cons of both companies.