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October 19, 2006

Vying to Become the Next ITS

By Peter Chapman

Scheckel and some of his top lieutenants at OES have been in the order routing game since the late 1980s. As a part of SG Cowen in the 1980s and 1990s, his team supplied order routing facilities to regional specialists and options market makers looking to lay off equities positions, largely on the NYSE.

In 1996, the group joined trading house Herzog Heine Geduld, where it serviced Herzog's broker-dealer correspondents as well as the regional specialists and options market makers. While most Herzog staffers were engaged in trading Nasdaq names, Scheckel and his team handled the listed flow.

In 2000, Merrill Lynch bought Herzog for about $1 billion. The subsequent market rout left the venerable wholesaler in tatters, and Merrill eventually disgorged what became OES in 2002.

Since March 2002, OES has been a private company based in Princeton. It now has about 35 employees and a couple hundred broker-dealer customers. Prominent investors in the firm include trading technology pioneer Bill Lupien, founder of OptiMark.

The first few years of OES' independence witnessed a clamor by electronic players to reform the U.S. stock market, specifically calling for the elimination of the ITS trade-through rule. OES began to see a bright future for itself. So when the SEC finally threw Reg NMS on the table, OES pounced.

Commenting on Reg NMS' "fair access" provision, OES told the SEC in spring 2005 that it was "the sole service provider that has already built and currently operates a functional linkage that provides linkage for ECNs, exchanges, third market firms and broker-dealers. OES provides private linkages that can act as hubs to all market centers for any broker-dealer."

Outbound Traffic

Much of that experience, according to OES executives, came from providing the outbound routing for the ECN-turned-stock exchange Archipelago.

The ECN's attraction for traders in its early days was its policy of sending unexecuted orders to other market centers, something the dominant ECNs at the time, Island and Instinet, did not do.

"We took that model that Dave [Scheckel] built for Arca and leveraged that as an ITS replacement," Barth says. "We spent a good deal of time with the exchanges and the regulators to formulate this idea and convince them our model was the appropriate one."

Under Reg NMS, exchanges are required to do everything in their power to ensure that an order hitting their system does not trade through a better-priced order elsewhere. If they receive such an order, they must ship it out.

OES claims to have the compliance and smart routing technology necessary to accomplish that. In the case of the Philly, for example, such an order will be handed off to the OES broker-dealer, called PRO Securities, which will act as the agent for handling PHLX routing decisions.

The Philly decided to outsource the operation for two reasons, according to Bob Miller, an advisor to the exchange.

"We saw a potential for a conflict of interest between operating a broker-dealer and an exchange," Miller says, "and we don't operate a private routing network."

The issues involved with exchange outbound routing are complex and OES has not been shy about pointing out the perceived flaws in certain exchanges' routing programs.