SuperMontage is Coming -- Should ECNs be Worried?

With the launch of the Nasdaq Stock Market's next-generation order display and execution system on the near horizon, questions about the future of electronic communications networks are once again beginning to arise. ECNs, according to one recent industry report published by JP Morgan H&Q, accounted for roughly 47% of Nasdaq's share volume in the third quarter of last year, and have in fact collectively grown slightly since the launch of SuperSoes -- a transitional, Nasdaq-developed order delivery and execution system -- in July of 2001.

But SuperSoes is not nearly as functionally rich as SuperMontage, the next-generation system, is expected to be. Unlike SuperSoes, for example, SuperMontage will feature significant market depth. Whereas SuperSoes only displays the best bid and offer for any given stock, SuperMontage will display, in a dynamically updated window, the five best bids and offers. Moreover, whereas SuperSoes only cover Nasdaq national market stocks, SuperMontage will eventually cover all Nasdaq stocks -- including small caps.

SuperMontage will also effectively eliminate SelectNet, a Nasdaq-supplied order-routing network that offers end-users a non-direct tool for accessing ECNs. In the current environment, SelectNet is the sole Nasdaq-supplied system market participants can use to send orders to ECNs, while SuperSoes is the exclusive order-entry and execution pipeline for all market-maker-addressed orders. But SuperMontage will unite those disparate systems, offering market participants the ability to reach both ECNs and market makers.

The primary goal of SuperMontage, Nasdaq officials say, is to centralize liquidity in the over-the-counter market. But if SuperMontage is even partly successful in achieving that goal, will it put the very existence of ECNs in jeopardy? The answer is both yes and no, says Sang Lee, an analyst covering e-trading at the research and consulting firm Celent Communications.

Post-SuperMontage, he says, ECNs like Instinet Corp. and Island, which match all of their orders internally, should continue to thrive. But ECNs that actually route out a large portion of their order flows may be in trouble. "The firms that may suffer a bit are those ECNs that are ... routing a lot of orders outside to get matched. SuperMontage is really not a true central limit order book. If anything, it's a large order routing network. And these smaller ECNs that have been not been able to attract large (amounts) of liquidity are really nothing more than a small network of order routers. So SuperMontage could effectively just get rid of them, by becoming the largest order router out there," Lee theorizes.

SuperSoes, to date, has been successful in cannibalizing a large portion of SelectNet's share volume. But it has not really lured many market participants away from ECNs. Indeed, according to the JPMorgan H&Q report, ECNs' collective share of Nasdaq's volume increased from about 45% in the second quarter of 2001 -- when SuperSoes was launched -- to roughly 47 percent in the third quarter. In contrast, last September, SuperSoes was responsible for 18.7 percent of Nasdaq's volume, while SelectNet handled 10.7 percent, the report states.

However, Lee says that its not fair to project the success of SuperMontage based on the performance of SuperSoes, because everyone in the market knew that SuperSoes was going to only a "transitional" platform from the time it was launched. SuperSoes, he says, should in fact help Nasdaq entice more market participants to send orders to SuperMontage, because it has proven that Nasdaq is capable of developing a system that can automatically execute large orders.

Speaking at a recent SuperMontage information forum held in New York City, Dean Furbush, executive vice president of transaction services at Nasdaq, emphasized that Nasdaq is trying to reel in order flow to its exchange via the launch of SuperMontage. "This is a competitive offering. Nasdaq is not the only place people can go, and we realize that we have to build a system that attracts people," he said. "The whole idea of this is (our) hope that we can centralize liquidity."

But one project that could throw a monkey wrench into Nasdaq's liquidity plan is the development of a so-called alternative display facility (ADF). As a condition of granting Nasdaq its desired status as a full-fledged exchange, the Securities and Exchange Commission has essentially required the National Association of Securities Dealers -- Nasdaq's regulator and former parent -- to build an alternative facility, through which market makers and ECNs can display their quotes and post their trades.

The NASD has complied by hiring OM, the hybrid Swedish exchange owner/technology provider, to build the ADF, based on OM's Saxess electronic trading system. Since the rules governing the ADF have yet to be published, its potential as a competitor to SuperMontage remains unclear. But Furbush said that Nasdaq is trying to work with each of the ECNs to prevent them from taking their business to the ADF, which will not route or execute orders. "The ADF will exist -- it's a quote and print facility. But we hope and expect that the critical mass of liquidity will be on Nasdaq's (SuperMontage)," he said.

Lee says that there is a chance that the ADF could make the Nasdaq market "even more fragmented" than it is currently, but emphasizes that "nobody really" knows exactly how the facility is going to operate right now. "There is huge confusion there, and I'm not even exactly sure if anyone has thought about the consequences of this ADF," he says.

Starting in April, Nasdaq expects to perform a series of user acceptance tests on SuperMontage. If everything goes as planned, Nasdaq will begin implementing the platform, in stages, in July. The SuperMontage rollout is expected to be completed, said Furbush, by "late summer/early fall."