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Reinventing Trading Venues: How AI Can Help Create a More Efficient Market

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April 1, 2002

The Winds of Change: How internalization changed the course of history for a Midwest dealer.

By Peter Chapman

Lilien notes that many of E*Trade's institutional customers only direct their listed business to the broker. They typically execute their Nasdaq orders through a market maker. "We have a lot of great institutional clients who've always said: If you were a market maker we could double your flow.'"

Role in Europe

Lilien also expects Dempsey to play a crucial role in making E*Trade's new European venture a success. In fact, he sees Dempsey as the "glue" that makes all its disparate brokerage activities come together. The e-broker has bought 18 companies in the past four years.

The main reason E*Trade bought Dempsey, however, was to "realize the full value of its order flow," according to Lilien. At its inception in 1996, E*Trade was a member of the Roundtable, a group of online brokers with stakes in Knight Trading Group. It sent the wholesaler a large chunk of its orders and profited from rebates as well its equity stake.

But with spreads declining, Knight and other wholesalers have become less inclined to pay for order flow. In some instances, now, wholesalers even charge brokerages to execute certain orders.

Under such circumstances, Lilien says, it makes more sense to hold onto the order rather than pass it along to a third party. "Going forward, the power of being an order flow originator means to be able to control it from front to back," he said.

(Buying Dempsey meant diverting its order flow away from its other transaction suppliers, of course. Lilien won't say how much less order flow Knight now gets, only that "everybody lost a little.")

Lilien adds the above is true in a strong market as well. Even if rebates aren't declining it makes sense for E*Trade to handle the order itself and make the dealer's turn, rather than just a small piece of it. "Why not own the whole pie and control how it is split up between ourselves and the customer rather than have a third party in there as well?" Lilien asked.

Would E*Trade eliminate commissions altogether and rely completely on trading as does online newcomer Brokerage America? "That's not in the cards right now," Lilien said. "But never say never."

Actually, Brokerage America does not execute 100 percent of its orders. The trend towards internalization has its limits. Klobuchar expects the market to evolve in a somewhat schizoid fashion. Brokers with market making and/or specialist operations will still vie for retail investors. But, for the sake of best execution and profitability, their trading desks will outsource at least some of those executions.

"Firms that compete against one another for order flow on the front-end will still route orders to one another," Klobuchar said.