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December 1, 1999

Washington Viewpoint: Ambushed by ECNs?

By Dr. Robert A. Wood

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  • Washington Viewpoint: Ambushed by ECNs?
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The epic struggle on Wall Street at the moment is not between the bull and the bear. The struggle is between the entrenched market mechanisms - the New York Stock Exchange and Nasdaq - and the upstart trading systems.

Before I examine the ability of the Big Board and Nasdaq to compete with the new mechanisms, let's consider why there are suddenly so many electronic communications networks (and other alternative trading systems). The order handling rules notwithstanding, there are three possible reasons, which are not mutually exclusive.

First, excess profits on the Big Board and Nasdaq invite competition. Second, the Big Board and Nasdaq have failed to efficiently implement new technology. Finally, there are niche markets (reflecting the economic segmentation of order flow.)

Since liquidity attracts liquidity, it is quite difficult for a new trading venue to attract enough order flow to gain a foothold. Thus, the existence of so many new competitors reflects the particularly large gap between the lower competitive trading costs on upstart trading systems, and the higher costs on the Big Board and Nasdaq, even though trading costs in both of these market centers have been falling. Further, recent SEC regulations, especially Reg. ATS, foster competition. Reg. ATS, in retrospect, may be regarded as a brilliant regulatory change.

Computing Power

We are experiencing radical improvements in computing power and networks. These improvements make it easier and less costly to find the other side of trades. Hence, the cost of intermediating trades should fall as new technology is introduced. Traditional market mechanisms, however, have provided serious resistance to fundamental changes that would incorporate new technology and reduce costs. In contrast, ECNs and ATSs are aggressively adopting new technology.

Both the NYSE and NASD view demutualization as the path that will enable them to meet the onslaught of competition. Yet the NYSE has significant obstacles - for example, the enormous tax bite that will hit those holding seats, the huge change in their culture, etc. Nasdaq has fewer demutualization obstacles, but it potentially faces greater immediate competition resulting from its failure to maintain what should be its core competence - namely, a highly efficient network. Further, antitrust enforcement might block demutualized traditional markets from acquiring ECNs and ATSs and thereby limit the budding competition.

At present, SelectNet lags far behind at both the open and even at the much smaller surge at the close of the regular trading day, because of the poor performance of Nasdaq's computing center in Trumbull, Conn. A super montage, decimal pricing, OptiMark cycling, etc., will add enormously to the processing load. Consequently, ECNs are developing their own direct links to avoid both SelectNet slowness (which causes them to eat unwanted trades) and expensive SelectNet charges.

While these links may temporarily reduce the load on Trumbull, they open up the possibility of even more serious competition. How difficult would it be for the ECNs to take the next step of jointly forming their own network to compete with Nasdaq Level II and SelectNet, while contracting with the big-five accounting firms to perform the SRO function?