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April 30, 2000

Best Execution ECN

By Kevin Foley

SEC Chairman Arthur Levitt places best execution at the heart of the debate on market structure. Dismissing the need for new SEC rulemaking on execution quality during a period of rapid change, Levitt has warned market participants not to put off examining the duty of best execution.

"Rather we should use this time of change to think carefully about ways to realize more fully, the promise of best execution," Levitt told the annual conference of the Securities Industry Association in Boca Raton.

This examination is underway in the electronic communication network community. Execution quality is visible to ECN customers because they can see each others orders as well as their own. These customers have demanded higher standards of execution quality. Thus have the forces of competition given rise to the best execution' ECN.

Let us start with the innovations originally introduced by traditional ECNs. Traditional ECNs differed from market makers in two respects. First, traditional ECNs published their participants' bids and offers to other participants. Second, traditional ECNs acted as agents, never as principals, only executing trades when participants responded to each others' orders.

Since the adoption of the SEC's Order Handling Rules and Regulation ATS, traditional ECNs have universally published their best participant bids and offers in the Nasdaq market and have enabled non-participants to trade with those bids and offers using linkage provided by Nasdaq. (A similar widespread publication of their best participant bids and offers is coming soon in the listed markets.)

But what transforms a traditional' ECN into a best-execution' ECN? A traditional ECN does not allow its customers to trade with non-participants' orders, whether represented in market quotes or quotes from other ECNs. Traditional ECNs instead focus on matching orders among paying participants, as well as with non-participants who pay access fees.

By contrast, a best execution ECN integrates the display of the ECN's participant orders with all available information about its competitors' orders, including the displayed quotes and orders of market makers and other ECNs. A best execution ECN helps participants obtain best prices, even if they are found at a competitor. This is what Bloomberg Tradebook and a handful of other best-execution ECNs do.

Chairman Levitt outlined the four principles upon which the integrity and efficiency of our national market system is built: competition among markets; transparency; linkages; and the best execution obligations of brokers. Competition among markets has received a great deal of attention. The other three principles also bear scrutiny.

Transparency refers to the ability of market participants to see or otherwise become aware of other market participants' orders. Linkage refers to the ability of market participants' to trade with the quotes they see, or to execute trades at those prices, in a timely manner. Linkage and transparency go hand in hand. That's because market transparency without market linkage is not worth the screen it's displayed on.

The obligation of brokers to seek best execution makes transparency and linkages relevant. They assure investors that their brokers will use these tools to get the best price possible for their clients. Enhanced transparency means improved linkages, which puts pressure on a brokerage to provide best execution. Best-execution ECNs are shouldering that burden.

Some mistakenly take an ECN's willingness to publish its internal book of orders on the Internet as a sign of market transparency. Publishing quotations on the Internet provides no additional transparency for an ECN's participants. Without including the quotes and orders of exchanges, market makers and other ECNs, those ECN participants may not know what and where the best price is. That does not meet the minimum test for transparency.

That's why a traditional ECN is still a traditional ECN. A traditional ECN gives its customers a biased display showing ECN orders in one format, with non-participant orders or quotes in a separate location on the same screen (with different access). A best-execution ECN, on the other hand, gives its customers an unbiased, integrated display of orders from participants and non-participants alike.

That's good news for investors. And good news for Arthur Levitt. The new world of institutional electronic trading is characterized by customers who watch, measure and reward improvements in execution quality. In such an environment you can expect competition to set new standards of quality that formerly would have required SEC rulemaking.

Kevin Foley is chief executive officer of Bloomberg Tradebook.