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May 31, 2001

Consolidation and Convergence

By Thomas E. King

The structure of the U.S. equities market today, according to some cynics, makes the blueprint for the space shuttle look simple by comparison. While that is clearly an overstatement, most observers would agree the market environment - with its fragmentation, multiple ECNs and ATSs, competing exchanges, internalization and decimalization - is likely to dramatically change.

In the longer term, we believe, the inevitable trend is toward consolidation and convergence. The eventual winners and losers will in many cases depend upon decisions made today.

The SEC's order-handling rules in 1996 served as the principal catalyst for the dramatic structural changes in the U.S. market over the past half-decade. The market has seen major shifts in liquidity and market economics as a result of regulatory action combined with rapid advancements in technology.

Today, with multiple and competing venues for executing trades, the buyside's drive for maximum investment performance at the cheapest possible price presents an ongoing challenge for sellside firms seeking to maximize their profits as value-added intermediaries.

One obvious way sellside firms can adapt, as well as position themselves for increased opportunities in the rapidly evolving market, is to re-think the architecture of their trading desks. For instance, does it make sense, in an era of multiple trading choices, to assign traders strictly to Nasdaq or listed trading desks? Why not combine the functions on a single desk with an integrated, state-of-the-art toolset for both listed and Nasdaq at one workstation? Then, when volumes ebb and flow from listed to OTC and back - as they have increasingly done since the Nasdaq bubble burst - the sellside firm can adjust quickly and seamlessly. Some firms have already begun this process and have put themselves in a leading position for the coming market convergence.

As we see it, the trader of the future will be equipped to act as a principal or a market maker, trading on a proprietary or an agency basis, depending on market conditions and customer demand.

Similarly, with the recent abolition of the NYSE's Rule 390, the trader must become equally proficient in trading listed stocks in order to maximize the profit opportunities for his firm. Soon traders will need proficiency in trading foreign equities on overseas exchanges. Against this backdrop, we believe it will be in the best interest of most sellside firms to maintain one versatile trading desk. That desk will be home to the "Universal Trader."

The Universal Trader will require a single point of entry to the market, one that speaks directly to the liquidity of the exchanges, Nasdaq, ECNs, ATSs and the InterMarket through smart order routing technology. Along with smart routing will be books showing market depth in all or most liquidity pools, allowing the nimble trader to act as principal or agent - and step in if a price improvement opportunity appears for a customer.

In short, technology will give the Universal Trader a transparent view of the market, even if it remains fragmented through various, but interconnected, liquidity pools.

In a sense this is "back to the future." Congress and the SEC envisioned a linked but fragmented market system back in 1975 when they created the Intermarket Trading System (ITS). That system never achieved its potential as the NYSE and Nasdaq came to dominate their respective market sectors. But today Nasdaq is under intense competition from ECNs and ATSs, while alternative venues such as PRIMEX and Instinet are emerging as potential threats to the NYSE's near-monopoly status. The SEC is likely to allow competition to determine the outcome.

While it may seem counter-intuitive that fragmentation can enhance liquidity, the regulators have taken the position that fragmentation promotes competition, while technology mitigates fragmentation. In their view, this approach not only maintains liquidity, but leads to continual market innovation. The winners in this new environment will be the firms that quickly position themselves with the technology and tools - and Universal Traders - to meet the competition head-on.

Thomas King is president and chief operating officer of SunGard Trading Systems/BRASS, an operating unit of SunGard.