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December 6, 2006

Taking On the Duopoly

By Peter Chapman

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Market share is the name of the game in stock trading and for much of the past two years the industry has focused intently on the New York Stock Exchange's. Traders watched as the passage of Regulation NMS led to a flurry of deals intended to revive moribund regional exchanges eager to compete against the Big Board. The industry took note as Nasdaq built up its listed book by intercepting orders in NYSE names on their way to the primary market. Dire predictions that the Big Board would bleed flow are largely starting to come true. In the past year or so, the New York has shed about 10 percentage points, mostly to Nasdaq, from the 80 percent share level it maintained for decades.

And the implementation of Reg NMS, slated to begin next February, is expected to put more pressure on those numbers.

But while it looked as if open hunting season had been declared on the New York Stock Exchange, the same could not be said of trading in Nasdaq securities.

Ever since Nasdaq bought the INET and Brut ECNs two years ago, trading in Nasdaq names has been dominated by Nasdaq itself and NYSE Arca.

Last year, about 95 percent of all Nasdaq shares matched on a public book were done by Nasdaq and NYSE Arca, according to Traders Magazine's estimates.

Four remaining ECNs accounted for the balance. All were at least three years old, and none were making much headway against the dominant market centers. Two sold out last year and one long ago changed its business strategy. The market was in effect a duopoly.

That is beginning to change. Two new ECNs, BATS Trading and Direct Edge ECN, a unit of Knight Capital Group, are using a combination of aggressive pricing, fast technology and innovative order types to chip away at the status quo.

Their impact so far is incremental rather than dramatic. But it can be seen in recent statistics. In the third quarter, the amount of Nasdaq flow matched by the two giants dropped to about 90 percent of all matched volume. Nasdaq does about 63 percent and NYSE Arca does about 27 percent.

These figures do not include the number of shares traded internally by Nasdaq market makers and in broker-dealers' "dark pools." Roughly one-third of all Nasdaq shares are traded internally, never touching a public limit order book.

>>Touched Volume

Taken together, BATS and Direct Edge are matching about 75 million shares per day on average, or 5 percent of the total. The numbers are much higher if one looks at all shares touched. That includes both the volume that enters their systems and trades as well as that which fails to trade and is routed out. Combined, touched volume is about 130 million shares. "Our business strategy is to get to critical mass, as fast as possible," Dave Cummings, BATS' chief executive office says. "When you have the economies of scale, you can offer aggressive pricing to subscribers and still turn a small profit."

For Cummings, critical mass starts at around 200 million shares. That's both routed and matched. The exec says it's possible BATS could reach that level by the end of the year.