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January 1, 2003

ECNs and Profitless Prosperity

By Duncan Niederauer

The past 12 months, a time of disappointing returns, is remembered for more regulatory reforms and market structure changes. Traders want unprecedented access to liquidity. It is an environment that portends both challenges and opportunities in direct access trading.

Some ECNs have become strong competitors of the dominant market centers - the NYSE and Nasdaq. However, as broker dealers regulated under Reg ATS, these ECNs can also compete for institutional business.

Attracting highly portable broker dealer liquidity is not lost on ECNs. It would be difficult, if not impossible, to capture higher margin institutional business without it. Unsurprisingly, 2002 saw the advent of "liquidity provision rebates." That happened as the pricing competition for broker dealer volume became a race to zero.

The consequences could be described as profitless prosperity. As a defensive strategy, several ECNs are examining alternative revenue sources: exchange market data and listing fees. Some ECNs have filed for exchange status. Others seek to acquire, or embark on joint ventures with exchanges.

Why would broker dealers support alternatives that are competing for the same institutional customer? Accessing liquidity on these venues is non-controversial, as best execution obligations take precedence. However, assuming that an order posted on SuperMontage, Instinet or Archipelago has an equal chance of execution, why would broker dealers continue to contribute liquidity to alternatives that subsequently utilize this volume to compete for institutional orders? One rationale often suggested is that the ECNs afford a measure of post-trade counter-party anonymity that SuperMontage cannot. Until Nasdaq can overcome this, successful ECNs can be expected to compete effectively in a market in which fees have converged.

As destinations continue to compete, and the SEC considers appropriate regulation, market participants face tough decisions. The resulting unlinked markets raise issues about best execution obligations. For those ATSs that participate in SuperMontage and continue to collect access fees, the negative impact of this approach has caused buyside and sellside traders to step back. As one mutual fund trading desk head said, "I'm generally in favor of helping the upstarts remain competitive...until it impairs my ability to execute effectively."

The more successful ATSs have chosen regional exchanges and the ADF rather than SuperMontage. Early returns suggest that access fees will likely be eliminated, liquidity provision rebates will be reviewed and standards for quote accessibility will be enforced in lieu of mandated linkages. Some degree of fragmentation will persist. The roles of broker dealers and exchange-like entities will blur.

An analyst at Celent predicts increasing demand for direct access trading technologies by many types of customers. Historically, the majority of direct access products were aimed at the OTC market and inextricably linked to destinations. The ECN desktop technology tools had one thing in common: The search for liquidity began in the ECN's own affiliated liquidity pool. In the Instinet and Island cases, they ended there too. Intelligent order routing for smaller marketable orders existed, but predominantly resided within the respective ECNs functionality rather than the client facing applications.

Buyside and sellside customers are going to be demanding more information, better tools, robust customer service and enhanced functionality. How should the direct access community respond? The winners need to:

* Aggregate the desktop. Provide consolidated market data and depth of books, from all venues for all instruments.

* Be destination neutral. Execute orders in an unbiased way, prioritizing liquidity and best execution above affiliations.

* Develop sophisticated, algorithmic trading strategies for larger orders to complement the existing intelligent routing of smaller marketable orders.

* Invest in client site technology integration, to enhance the value of clients' existing trading technology.

Duncan Niederauer is a managing director of Goldman Sachs. He manages the equities division's direct access and electronic trading efforts.