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January 1, 2004

Breaking Instinet in Two

By Peter Chapman

Also in this article

Can Instinet find a more profitable course after a sweeping corporate divorce?

The marriage wasn't bad, but Instinet is hoping the divorce will be even better.

Instinet - a big industry player hard hit by a brutal two-year pricing war in its ECN business - is separating the ECN from its more profitable institutional brokerage operations. The brokerage will seek buyside order flow while the ECN, now known as INET, will pursue sellside orders.

The split seems like good news for the brokerage, a business which contributes about 70 percent of Instinet's revenues. But it could spell trouble for the ECN. It means the ECN loses access to a guaranteed source

of order flow. The institutional brokerage, on the other hand, is free to grow its business, uncompromised by any real or imagined conflict of interest that comes from its ties to a proprietary liquidity pool.

"We have clearly separated the two," Instinet chief executive, Ed Nicoll, told Traders Magazine in an interview. "I want our buyside customers to know Instinet is the one place they can go to that they can absolutely trust will do the right thing by them."

Special Advantage

The break is along legal, financial, geographic, technological, and staffing lines. It forces both groups to compete solely on the merits of their own business models. Any special advantage one group had because of its relationship with the other is now gone.

Nicoll, who says he is devoting most of his energies to the agency brokerage, has no qualms about cutting the ECN loose. "We're not in the business of trying to preserve our liquidity pool at the expense of our customers," Nicoll said. "We're in the business of trying to utilize that liquidity pool when appropriate. We are prepared to be 100 percent neutral."

Perhaps with his shareholders in mind, he added: "The other element is that we make very little money on that liquidity pool. It's a very low-margin scale business. It would never make sense for us to risk our agency brokerage business to give an order to INET."

In the coming years, the brokerage business is expected to outshine the ECN. Sandler O'Neill & Partners analyst, Richard Repetto, notes that Instinet's "long-term meaningful profitability is driven by the VAB's ability to increase penetration rather than increased liquidity on the ATS, INET." (VAB stands for "value-added brokerage," Instinet's internal designation for the unit.)

Repetto's research shows that, for every one percent uptick in market share, the brokerage adds 10 cents to 12 cents to its annual earnings per share. The ECN adds only one or two cents.

Repetto's conclusions are shared by some on the buyside. They expect Instinet to raise its prices for its services requiring a "sales trader," the new designation for what used to be termed facilitator or account rep. Instinet, though, denies it plans to raise prices.