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January 1, 2003

A Perfect Buyside Package

By Joe Lombard

What do all these things have in common? Liquidity.

Real-time depth of book. Immediate executions and cancellations. Simple priority rules. Anonymity. Effective connectivity to other markets. A transparent, single price opening.

These are the features of an efficient equity market. But you could recall all the excuses from traditional markets for why it's not possible.

One outcome in the past five years of intense competition among electronic markets is that virtually every design feature on the buyside's 25 year-old wish list has been granted. ECNs, which now account for some 50 percent of OTC share volume, are also the locus of price competition in top Nasdaq names.

In the last two weeks of June 2002, for instance, ECN orders were at the inside market more than 80 percent of the time in at least 20 of Nasdaq's most liquid names. High internal liquidity at both Archipelago and Instinet, for example, consistently produce instantaneous, anonymous fills. These often are beyond the size displayed.

Both markets as well as other institutional players, like Bloomberg Tradebook, continue to enable institutions to make size available to the market without revealing it (reserve), and to bid more aggressively than the inside market for stock without displaying their appetite (discretionary). As a result, the obstacles to lower explicit - and more importantly implicit - transaction costs in the OTC market are fewer than ever before.

Two other bright spots are worthy of closer buyside focus. First, electronic momentum is building in the listed market as well. The same tools that institutions use to work Microsoft orders are now used for ultra liquid listed names during and after core trading hours: a montage showing full depth of book; discretionary, reserve, and VWAP-producing tracking orders. The Archipelago Exchange (ArcaEx), in particular, offers full connectivity to other listed execution venues. That's including the NYSE, the regional exchanges, the third market, and ECNs using both public linkages (ITS) and proprietary connections. Fully visible and immediately accessible listed liquidity lives on an exchange. If better priced liquidity shows up on an away market, it is a smart route away.

There is a growing recognition among control-oriented buyside traders that a connected electronic market can be a viable alternative to the floor without the lion's share of market. Today, more than half of super liquid ETFs, like the Spiders, trade on electronic markets, despite originating on a floor. Intriguingly, the same story is beginning to unfold in ultra-liquid single listed names like IBM, and in information driven trading. The first week of December, for example, ArcaEx had a 3.3 percent market share in IBM, but had orders at the NBBO 28 percent of the time. In UAL, ArcaEx's share was 7.5 percent, with quotes at the inside 75 percent of the time. The point is not that electronic markets are the best home for every listed order. What they offer is stock at the touch, a way to avoid writing an option to your competitor, and alternative venues run like businesses that grow daily in viability.

The second bright spot is the arrival of a fully transparent, single-price, electronic opening. Through an opening auction at 8 a.m. ET and a market order auction at 9:30 a.m. ET, the ArcaEx, in effect, reveals the supply and demand curves forming at the open - the ArcaEx version of "color." They are delivered via screen rather than phone and scribbling on hand-helds. To be sure, modest ArcaEx market share in many listed names means that the pricing signals sent by the opening auctions today can be relatively faint. But consider the signal that ArcaEx will be sending the first quarter of next year when Archipelago's OTC volume migrates to ArcaEx in a name like Microsoft That's a name in which Archipelago typically is more than a quarter of daily volume. A single price where a critical mass of supply and demand intersected, delivered the same time every day, replacing opening minutes of confusion and scattered prices. Cross another item off the wish list.

Joe Lombard is President of WaveSecurities, an institutional broker and an Archipelago Holdings LLC company.