When confronting a clearly stronger foe, should you look him in the eye and try to punch him square in his nose? Or should you avoid a head-to-head tussle and use a more subtle strategy to move in on your opponent's turf? In a nutshell, in the U.S.-listed equities arena, that's the dilemma facing electronic communications networks (ECNs) today.
Though they have increased their significant presence in the dealer-friendly Nasdaq Stock Market over the past 18 months, ECNs are still struggling to gain even a small piece of the listed business transacted by auction-driven U.S. equity exchanges. Indeed, despite recent system enhancements and rule changes enacted to level the playing field for stocks traded on the New York Stock Exchange, ECNs have collectively managed to snag less than 5 percent of the Big Board's volume. In contrast, according to an industry study performed by JPMorgan H&Q -- JPMorgan's San Francisco-based research and consulting arm -- ECNs accounted for nearly 47 percent of Nasdaq's volume in the third quarter of 2001.
Based on those numbers, it should come as no surprise that several ECNs are concocting strategies designed -- at least in part -- to boost their share of the listed equities pie. Clearly, however, there is no ECN consensus on the way to go about this. Archipelago, Island and Nextrade want to take the NYSE Goliath on face-to-face; Archipelago, in fact, just received approval to operate as a self-regulated exchange (see sidebar). But other ECNs, including the likes of Instinet, Tradebook, Brut, Attain and MarketXT, have decided to maintain their existing status as National Association of Securities Dealers-regulated broker/dealers.
ECNs that receive the green light to become exchanges will be subject to more scrutiny but will also be granted new freedoms, such as a direct connection to the Intermarket Trading System (ITS) and direct representation on the National Consolidated Quote System (NCQS). ITS, which facilitates intermarket routing of listed stocks, is the trading network that electronically links Nasdaq, the NYSE and seven other national securities exchanges; the NCQS is the market data platform that displays the best bids and offers from all ITS participants.
Through its partnership with the Pacific Exchange, of course, Archipelago is set to become the first ECN to make the exchange transition. Starting early next year, the Archipelago Exchange's ArcaEX trade-matching engine will replace the Pacific's equity floors, and the former ECN will, for the first time, be able to compete for listed order flow with the NYSE and American Stock Exchange, as ITS equals. "In terms of trading listed securities, we're much more comfortable being out there competing head-to-head with the NYSE and Amex," says Archipelago president Mike Cormack.
ITS: To Join or Not to Join?
Interestingly, Archipelago, in its current role, is the only ECN that both participates in the ITS and displays its quotes on the NCQS -- the consolidated quote platform that gives end-users the power to advertise their best bids and offers for listed stocks to everyone participating in ITS.
A while back, Archipelago joined the Nasdaq Intermarket, a market that Nasdaq set up in the summer of 2000 specifically to allow its ECN and market maker members to electronically trade listed stocks. By joining the Intermarket, Archipelago gained access to Nasdaq's Computer Assisted Execution System, a platform that has a built-in interface to ITS. And through CAES/ITS, Nasdaq Intermarket participants are granted the ability to have their listed quotes posted on the NCQS.
But while joining the Nasdaq Intermarket did provide Archipelago with an indirect mechanism for trading listed stocks, it also subjected ECN to unfriendly rules that could potentially compromise its business model. One such rule states that any broker/dealer that participates in ITS must maintain two-sided quotes (both a buy quote and a sell quote) for any orders it enters into the system. ECNs, however, only match trades on behalf of their customers. In other words, they don't commit their own money to match trades because they don't trade on behalf of their own accounts.
But under ITS, an ECN that does not have a buy and a sell order for a given stock would be forced to submit its own quote for one side of a trade. "Our business model is a pure agency model, so any time you require us to do something that could potentially put us at risk by (forcing us) to take a proprietary position causes us a problem," explains Joel Steinmetz, senior vice president of equities and director of strategy for the Americas at Instinet -- the global agency broker that owns and operates the largest ECN in the United States.
Instinet, which also has a minority equity stake in Archipelago, has yet to join the Nasdaq Intermarket. Steinmetz says that Instinet wants its ECN to have direct access to ITS "rather than go through a third party." But he also says while Instinet plans to keep "a real sharp eye" on the PCX/Archipelago alliance, it has no current plans to transform its ECN into an exchange.
Unlike broker/dealer-regulated ECNs, the Archipelago Exchange will not have to worry about compromising its business model by becoming a part of ITS. Since the exchange will employ its own market makers, the two-sided quote issue will become a moot point.
Today, one way in which ECNs can get around the two-sided quote rule is by posting one bid or offer so far away from the inside market -- also known as the the best bid or offer -- that nobody will touch it. For instance, if the national best bid for a stock is $18 and an ECN is forced to sumbit a bid according to the two-sided quote rule, it could submit a very unappealing bid of, say, $15. But Greg Smith, senior research analyst at JPMorgan H&Q, says that it's unreasonable to ask ECNs to do that. Rather than requiring ECNs to use this "roundabout" strategy to avoid the market making rule, he says, the ITS committee should just create an exception for them.
Like Instinet, Island, the second largest ECN, has also thus far rejected overtures to join Nasdaq's Intermarket. Unlike Instinet, however, Island wants to become an exchange. In fact, after roughly two years of back-and-forth discussions with the SEC, Island is in the process of finalizing its full-fledged exchange application.
Island is rumored to have held recent alliance talks with the all-electronic Cincinnati Stock Exchange, so whether it moves forward on its own remains to be seen. But regardless of its regulatory status, Island is likely to continue to have major complaints about ITS.
Specifically, Island has publicly campaigned against the ITS trade-through rule -- a rule that prohibits each ITS participant from trading at an inferior price to a price displayed in another market. Essentially, this means that if you have an order for a listed stock but there is a better price available in another ITS market, you must either match that better price or route the order to the market with the superior price. For example, if Island were a participant in the ITS and had an internal quote for a listed stock on its book that was inferior to the price for that stock on a NYSE specialist's book, Island would then be required to either match that price or send it to an NYSE specialist for execution.
But that rule represents a significant problem for Island on a couple of different levels. Firstly, Island currently only matches orders internally, linking the buy and sell orders of its subscribers exclusively with the orders of other subscribers. In other words, Island does not route out orders to anyone in the Nasdaq market.
Moreover, just as significantly, Island's business model is built on speed. Its ECN often matches customer orders in fractions of a second, but under ITS, participants that receive an order through the system have up to a minute to respond. An Island official did not return a call seeking comment.
The ITS committee, the governing body that oversees changes to ITS, has decided to reduce the maximum time that participants have to respond to ITS orders to 30 seconds, effective Nov. 30, 2001. But whether that time reduction will spur Island or any other ECN to join the Nasdaq Intermarket and have their listed quotes displayed on the NCQS remains to be seen.
One ECN that is not bothered by the trade-through rule is MarketXT, a small ECN that plans to join the Nasdaq Intermarket in early 2001. MarketXT, a subsidiary of the direct-access brokerage/technology firm Tradescape, does not currently trade any listed stocks. But since MarketXT's customers have been "clamoring for" listed trading capabilities, the ECN recently decided to participate in the Nasdaq Intermarket, says MarketXT Senior Software Engineer Brian Nigito. "Being able to actually post a quote on the NCQS was important," he says. "That's where I feel the trade-through rule will work for us. If we're within the spread, somebody is going to have to trade with us before they can actually trade through. That will take care of some of the liquidity problems that have traditionally been there for MarketXT."
Exchange ECNs vs. NYSE
In contrast to MarketXT, Archipelago -- once it officially launches its exchange -- will be able to compete directly for order flow with the NYSE. "The advantage that exchange status provides us is a new source of revenue through tape fees, and we'll get the (privileges) that come from being an exchange. We will also get additional revenue sources from listing fees. And we'll get out from under the NASD as (our) regulator," says the Archipelago official.
Similarly, Nextrade a smaller ECN that filed for exchange status roughly two years ago but has yet to make any real progress on that front, is hoping to benefit from all the different freedoms that exchange status would yield. "I don't know how you can become a legitimate listed player if you remain under the umbrella of the NASD," says Nextrade President John Schaible. "From a listed equities perspective, having equal footing through ITS and being able to participate directly in the market data (quotations) is going to be the only thing that's going to allow ECNs to tap into liquidity and price themselves in a fashion that the traditional exchanges can't compete with."
However, Sang Lee, an analyst covering e-trading for the research and consulting firm Celent Communications, thinks that it is highly unlikely that exchange status would change the fortunes of a smallish ECN. "Nextrade never really had the volume to begin with, and I'm not convinced that just becoming an exchange will resolve all of their problems," Lee says.
The main reason the NYSE has been able to keep its market share away from ECNs, he says, is because, unlike Nasdaq, its liquidity is centralized in one location. "The price discovery mechanism within the NYSE is far superior to Nasdaq's," says Lee. "On a given stock, within Nasdaq, there are potentially 50 different market makers, which means that there are potentially 50 different pools of liquidity to choose from ... whereas, in the NYSE, there is one specialist that deals in one stock."
JPMorgan H&Q's Smith concurs that the primary reason ECNs have experienced much more success in OTC stocks is because the Nasdaq market is fragmented. However, he also believes that ECNs are "slowly making headway" in the listed equities arena.
Smith says that some ECNs, like Tradebook, are attempting to attract listed order flow by offering agency brokerage services on top of internal matching. But ECNs that go the exchange route, a la Archipelago are better positioned to compete head-on for listed equities market share. "It should be an advantage to be an exchange, because you have additional revenue opportunities and you are much more in control of your own fate. I also like the fact that (ECN-exchanges) can be self-governed, rather than be governed by a competitor," says Smith. " The NYSE still does about 85 percent of trading of all NYSE-listed stocks .... But I think we are going to see more bifurcation of the listed business, and it will come, to some extent, at the expense of the NYSE."