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February 1, 1999

What's Up With ATSs?

By John A. Byrne

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What is an alternative trading system (ATS)? The definition used by regulators counts Reuters Holdings' Instinet. A hugely successful electronic-agency broker, Instinet charges commissions to institutions and dealers whenever they execute stock transactions, often negotiated between the bid and ask spread.

Under the same definition, Instinet is an electronic communications network. At the same time, it is a global broker in 40 markets servicing more than 10,000 terminals, an Instinet spokesman said. Instinet has a physical presence too, staffing a floor in New York with 100 traders.

Still confused? So are others on Wall Street. A brief regulatory history, however, makes the meaning of ATS and ECNs more clear.

Basically, an ATS is the catch-all phrase for every conceivable electronic trading system, from call markets such as New York-based ITG's POSIT and the Arizona Stock Exchange, which periodically match buyers and sellers, to continuous auction markets such as Instinet that operate around the clock, to upstart broker systems such as Brooklyn-based Datek Online Holdings' Island.

The most intriguing, if not the most-hyped ATS of them all, is the OptiMark Trading System, designed by Durango-Colo. based OptiMark Technologies.

After a sometimes fractious standoff between the New York Stock Exchange and OptiMark, triggered by the Big Board's effort to block OptiMark's access to the Intermarket Trading System (ITS), OptiMark went live late last month. The ITS members finally agreed to change the rules governing how the ITS links the U.S. listed stock markets.

The feature that distinguishes ECNs is their electronic connections to Nasdaq's SelectNet, the rather clunky vehicle delivering price-quote information to market makers under the terms of the order handling rules. Strictly speaking, that makes POSIT an ATS but not an ECN.

The number of ECNs exploded on Wall Street soon after the implementation of the order handling rules. These forced market markers to make their price-quote information more transparent and to improve their handling of retail-sized limit orders.

Thus, a market maker was forced to execute a superior-priced retail limit order, or to expose it for execution by another market maker or by an ECN. Taking a leaf from Instinet's book, trading firms soon realized the value of having their own ECN: no commissions, reduced capital risk, a vehicle for laying off business before the market closes.

Equally important, market makers sponsoring an ECN had an unintended way to turn the order handling rules to their advantage.

"They could select the order flow that is [potentially] the most profitable and move orders to the ECN that hurts their spread," said analyst James Marks, who studies the proliferation of ECNs as an electronic-commerce analyst for Deutsche Bank Securities in New York.

Bear, Stearns & Co. was probably the most prominent to lead the charge, deputizing its former Nasdaq trading ace Arthur Pacheco to run STRIKE Technologies, the consortium-owned ECN that went live in early November. The owners include trading giants such as Salomon Smith Barney, Donaldson, Lufkin & Jenrette, NationsBanc Montgomery Securities and Cantor Fitzgerald & Co..

But the proliferation of ECNs does have two potentially serious downsides: the fragmentation of price-quote information and the elimination of well-capitalized market-making desks as more institutions send their order flow to ECNs.

The explosion of ECNs, moreover, does not necessarily portend universal profitability.