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September 30, 2000

Market Makers vs. ECNs

By Michael T. Dorsey

In the national discourse on market structure, there is talk that electronic communication networks will replace liquidity providers such as OTC market makers and exchange specialists. We at Knight Trading Group believe that reports of our imminent demise (as well as the downfalls of our fellow OTC market makers) are greatly exaggerated.

ECNs display limit orders and match those limit orders with others existing in their systems. ECNs' main virtue is that they are brokers that never take the other side of a customer limit order. ECNs also provide anonymity and a high degree of control for their subscribers.

ECNs remove themselves from trades by procuring executions rather than giving them. While some may view this as a virtue, we view it as a limitation. ECNs, by removing themselves from trades, may also be removing their subscribers from trading opportunities. Indeed, orders sent to an ECN may go unfilled if no other liquidity can be procured. Consequently, routing an order to an ECN may prove detrimental. This is the reason that informed subscribers such as direct access firms, institutional investors and OTC market makers, comprise most of the total ECN subscriber base. In these informed hands, ECNs are tools that provide anonymity and control. However, if certainty of execution is preferred over anonymity or control, an ECN may not be the best execution destination. A liquidity provider like a Nasdaq wholesaler may be the better execution venue, as it handles both limit and market orders.

By supplying liquidity, wholesalers attract orders that demand immediate liquidity. These orders are matched against limit orders held by dealers when the price of those limit orders either equals or improves the inside market. In this way, dealers operate like ECNs. For dealers that display limit orders immediately, the ECN business model differs only to the extent that ECN limit order files are displayed only to their subscribers. This, however, may be changing.

Certain ECNs now also handle market orders. But without supplying capital, ECNs tend to procure only partial executions for such orders, thus leaving their subscribers only partially satisfied. On the other hand, dealers commit capital to provide a complete fill, often exceeding the size of the inside market. An ability to provide enhanced liquidity attracts market orders to Knight. These orders, in turn, make us an attractive limit order execution destination.

Many are also promoting a soft CLOB, or a central limit order book, through a SEC mandate of price-time priority across the marketplace, as a way to expand the ECN business model. Essentially, a soft CLOB would force dealers like Knight to route their market and marketable limit orders to the market participant first displaying the best bid or ask price.

Currently, dealers execute orders by matching the best bid or offer, taking a market or marketable limit order into inventory, and/or interacting with other market participants as they see fit in the process of managing their resulting inventory positions. ECNs argue that the first limit order driving the inside market should be rewarded for narrowing the spread.

But should such limit orders be rewarded at the possible expense of the market or marketable limit orders that may find themselves in a queue for execution? By rewarding first-in-time limit orders would not market and marketable limit orders lose some of the immediacy they demand? And, do we want the federal government making that kind of value judgment?

This is all critically important when one considers the main elements of best execution for limit orders - fulfillment rates measuring certainty or probability of fills, and rapidity measuring the quickness of those fills. With the most active and volatile stocks, material differences may not exist between large ECNs and large dealers in their respective fulfillment and rapidity rates. But as the level of trading activity or volatility decreases, material differences begin to emerge. We believe that the ECN business model will be the exception rather than the rule in the future. To think otherwise is to underestimate the limitations inherent in the ECN business model.

Michael T. Dorsey is general counsel and secretary at Knight Trading Group.