Reg NMS Turns 1

This month marks the one-year anniversary of the passage of Regulation NMS, which was approved by the Securities and Exchange Commission on April 6, 2005, paving the way for a more interactive, electronic marketplace. Ironically, things are moving faster than anyone could have imagined - faster even than Reg NMS itself, whose implementation is likely to be delayed beyond the June 29th deadline.

Within days of Reg NMS' approval, the New York Stock Exchange (NYSE) announced its landmark merger with electronic trading rival Archipelago, while the Nasdaq Stock Market announced a deal to acquire INET ECN from Instinet Group. And over the past 12 months, the entire deck of cards has been reshuffled. We've seen the consolidation of exchanges; the formation of new ECNs, such as BATS Trading; investment in regional stock exchanges by brokers; and the registering of sell-side internal crossing networks as alternative trading systems (see cover story, page 28).

So the question is, what is the next shoe to drop?

Analysts predict that bulge-bracket firms will form ECNs on top of their investments in regional stock exchanges. "By investing in an ECN and directing flow there, and by having an investment in regional exchanges, it suggests that the sell-side firms cannot only collect trading fees, but they can also collect market data fees from investing in the regionals," comments David Easthope, an analyst in the securities and investment practice at Celent Communications.

Already, Citigroup revealed earlier this year that it's forming an ECN as a result of acquiring OnTrade from NexTrade. And analysts predict that other brokers will pounce on the ECN trend. With Lehman Brothers' acquisition of Townsend Analytics, and possibly with Merrill Lynch's purchase of Wave Securities (from Archipelago), both of those firms now own the technology to support either an ECN, exchange or crossing network, suggest trading sources. And because UBS has so much equity trading volume, "There's some speculation that they could start their own ECN," adds Easthope.

Aside from directing some of their own flow to their own ECNs, for brokers, it's a no-brainer to develop an ECN today. The barriers to entry have come down and the speed to market is faster because of advances in technology. "You can run [an ECN] only on a few servers, as long as you have sufficiently fast servers and backups," says Easthope. "It's relatively inexpensive versus what was spent by Instinet and Island to invent this technology," adds Easthope, who estimates that a new ECN could cost $50 million to $70 million, depending on the bells and whistles.

But will it be good for the market structure if brokers venture down this path? Some buy-side traders are worried that the creation of more ATSs and ECNs will lead to market fragmentation. "I think one place to trade is wrong. I also think 20 places to trade is wrong," says Joan Stack, trading manager at the Ohio Public Employees Retirement System. "I think some happy medium is where you have alternatives without splintering the liquidity."

On the other hand, ECNs and ATSs no longer exist as isolated pools of liquidity. Due to smart order routing, ECNs interact with other ECNs and exchanges, and buy-side traders have direct access to ECNs and ATSs. And brokers that run internal crossing networks are using algorithms to look for matches in external sources of liquidity. Even Liquidnet - a buy-side-only block crossing network - with its new H20 product, is pulling in liquidity from aggregators and ECNs so that retail-size order flow can interact with institutional trades.

So while some may argue that Reg NMS is unraveling the centralized market, its real legacy appears to be the creation of a fully automated market, in which ECNs and ATSs compete on equal footing with the giant exchanges in trading listed stocks. While that may be wishful thinking, let's see what happens next year, when Reg NMS turns 2.

Ivy Schmerken is a 20-year WS&T veteran. As Editor-at-Large, she covers trading for both Wall Street & Technology and Advanced Trading. [email protected]