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July 31, 1999

The Mother of all IPOs

By Avital Louria Hahn

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Aplethora of firms operating so-called electronic communications networks (ECNs) is shaking up competition among traditional stock exchanges in the U.S. as never before.

At the moment, the volume of stock orders matched electronically by ECNs is just over 30 percent of overall U.S. equity order flow. Before the onslaught of ECNs about two years ago, one computer system, Reuters Group's Instinet, electronically matched around 20 percent of Nasdaq order flow. Significantly, Instinet still matches roughly 15 percent of Nasdaq stock orders though its overall volume has increased.

With nine ECNs now scrambling for the same equity order flow, slippage in the market share of that order flow for Nasdaq and the Big Board is not huge. But the potential threat posed by ECNs is enormous.

For one thing, the Securities and Exchange Commission approved new rules that allow these ECNs to register as stock exchanges and to compete for listings under the agency's Regulation ATS. Switching to stock exchange status would give ECNs a chance to muscle in on competition for listed order flow that is funneled through the Intermarket Trading System - a network controlled by the traditional listed exchanges. For another thing, individual investors are increasingly logging on to ECNs, such as Datek Online Holdings' Island (which has the capacity, moreover, to stay open fulltime and trade non-U.S. stocks.)

"[An ECN] eliminates the middleman," said Mark Yegge, co-founder of the Clearwater, Fla.-based NexTrade ECN. Yegge boasted that his outfit could easily handle the entire volume of the NYSE with a handful of people. "We are like an eBay for stocks," he said, referring to the Internet-based auction for consumers.

The threat hanging over Nasdaq and the Big Board, in large part as a result of these developments, is so significant that both are considering becoming for-profit companies by selling their shares to the public via initial public stock offerings.

"People understand that the speed of change ahead of us will be unprecedented," said Kenneth Pasternak, president of Jersey City-based Knight/Trimark Group (Nasdaq:NITE), which runs the largest Nasdaq wholesaler and is arguably an ECN (since it electronically matches most of its Nasdaq stock orders). "For the traditional players to compete, they need to transform to privatized entities, into a business model that can be more dynamic and responsive," Pasternak added.

With the large amount of capital IPOs would likely generate for Nasdaq and the Big Board, both exchanges would be able to up the ante through investments in infrastructure. Indeed, both are considering extending their trading day and partnering with ECNs.

While the idea of IPOs for stock exchanges in the U.S. is exotic, several foreign stock exchanges have already become public companies.

"In a very few years, trading securities will be digital, global and accessible 24 hours a day," said Frank Zarb, chairman of the National Association of Securities Dealers, the self-regulatory organization that runs Nasdaq.

"Our thinking is to open up our stock markets to investment from market participants and eventually to the public, so they can participate in our growth and financial success and so we can raise the needed funds to grow and continue to modernize," he said.