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April 30, 2002

A Better Listed Alternative

By Josh Rose

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  • A Better Listed Alternative

Alternative Trading Systems (ATSs), which have revolutionized equity trading, do not solve all market structure problems.

Still, the ATS approach has worked well for Nasdaq stocks. Electronic communications networks capture nearly 50 percent of Nasdaq trading volume. But ATSs have failed to gain traction with NYSE-listed stocks, especially on block trades.

Despite intense efforts and the repeal of Rule 390, the ECN and ATS penetration of NYSE volume is languishing at only five percent. Logic, therefore, suggests that it might be better for David to work with Goliath in a spirit of cooperation, combining the innovations of the ECN/ATS world with the strengths of the NYSE.

Little Success

Why have ECNs and ATSs met with little success in head-to-head competition with the NYSE? For starters, while the NYSE auction market has evolved from the days of its founding under the Buttonwood Tree, one bedrock principle has remained - there is an inherent logic in bringing all market participants together in a single place to transact. The auction itself may not be perfect, but it succeeds largely because of its ability to centralize order flow and discover market-clearing prices.

The structure of Nasdaq, in contrast, is that of a decentralized dealer market with liquidity scattered across market maker desks. ECNs have thrived in this environment. ECNs have somewhat reconcentrated' the fragmented liquidity into fewer liquidity pools. ECN consolidation, intelligent order routing and SuperMontage will continue this trend. However, the OTC market will also be more fragmented than the NYSE because of its distinct market structure.

ECNs function best for smaller orders in the most liquid stocks, e.g. the most active Nasdaq names and ETFs. That's where speed and low commissions are priorities, prices are quite transparent and the type of price discovery that a centralized auction market like the NYSE facilitates best is not necessary. However, on all but the most liquid of listed names, investors face some measure of price risk in trading size away from the Big Board, where more than 80 percent of listed volume trades.

A telling illustration is a comparison of the software glitches experienced by both Nasdaq and the NYSE last summer. On June 8, 2001 when the NYSE was shut down for 85 minutes, The Wall Street Journal reported that there was no measurable spike in ECN volume.

This suggested that, without the liquidity and price discovery/validation mechanism of the NYSE, traders simply preferred to sit on the sidelines. In sharp contrast, when Nasdaq experienced its own technical glitches on June 29, ECNs saw sharp upticks in daily volume (ranging from 25-40 percent).

With this and the historical structural differences between the NYSE and Nasdaq in mind, the consequences of breaking up the world's largest pool of liquidity should be considered, as ECNs and ATSs set their sights on trading listed shares. Market participants should ask a fundamental question: Are we really better off fragmenting the NYSE's 200-plus years of centralized liquidity for the associative benefits of electronic trading? Or is there an easier way to achieve a similar outcome without breaking up the great liquidity pool itself?

The answer involves not a radical rethink of listed equity trading, but rather a meaningful enhancement of the existing market itself.