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June 30, 2002

OTC War and Peace

By John A. Byrne

The consolidation among investment banks and brokerage firms is as predictable as the rising sun. But for industry executives, it is as unnerving as a tornado that thunders through the land. The consolidation is propelled by a squeeze on profit margins, a squeeze that's a byproduct of the mass production of certain products and services. Sometimes it is the result of a vicious turn in the business cycle. The consolidation is the result of the repeal of the Glass-Steagall Act, the Great Depression law that once separated banking and brokerage activities. The consolidation is also the result of the natural competitive drive to capture market share in places where two or more firms operate.

One change, in this heated atmosphere, was the departure by the Four Horsemen, from research, underwriting and trading in emerging growth companies. The quartet, which switched instead to trading Nasdaq's blue chips, is sometimes called the HARM group: shorthand for Hambrecht & Quist, Alex.Brown & Sons, Robertson Stephens and Montgomery Securities. The retreat by the firms was the wake-up call for a boutique investment banking firm, Adams, Harkness & Hill. The business is profiled in this month's cover story by Peter Chapman, who visited the firm's Boston headquarters.

Consolidation hit a critical phase in the ECN community when Instinet and Island announced their engagement. The Nasdaq SuperMontage, in response to the competitive drive of ECNs, added an intriguing twist that could turn recent history on its head: It could take the trading industry back to that moment when Nasdaq was the only serious OTC game in town. That was a time when an alternative called Instinet was the largest barbarian at the gate. Since SuperMontage could become the most powerful ECN Empire of them all, operating as a customs and excise border post for the industry's scattered collections of stock trading fiefdoms, it has the power to establish the colonial tariffs. The loyal subjects who take the Oath of Allegiance and join the SuperMontage are rewarded with lower transaction costs; the muckrakers beyond the Pale will pay more and get token colonial status on the Empire's Alternative Display Facility. But many ECNs will remain restive on access fees.

Still, some of the rebel forces have willingly surrendered, announcing their plans to participate in SuperMontage. At the same time, some have been fighting a rearguard price war and a battle of the rebates. They aim to capture institutional and retail order flow. On a 1,000 share order, Instinet, for example, bills $3 for an execution and rebates $2 for providing liquidity. But it is an exhausting battle in which supplies can run low. Some ECNs, seeking better opportunities, have chosen consolidation. It started in earnest with the merger of Archipelago and Redi ECNs, and it continues with the Instinet and Island engagement. It may conclude once Bloomberg and all the rest decide to strike back as one giant alternative ECN. But in all wars, mythological and real, there are usually no clear winners. The borders extend and sometimes contract. This might be the moment Nasdaq can reestablish its direct market dominance. Still, other players, distracted by a horrible stock market and unprecedented consolidation, will not surrender.

John A. Byrne