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January 1, 2007

Outlook 2007 Bodes a Return of Market Fragmentation

Markets Go Back in Time

By Peter Chapman

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The year 2007 is looking a lot like the year 2000-only more so. Back then the trading landscape was splintered into 10 electronic communication networks, seven stock exchanges, one Nasdaq and one dark pool-nearly 20 venues in all on which to trade. That number shrank considerably but now all of a sudden there are five ECNs, 10 stock exchanges and about 30 dark pools. Fragmentation is back with a vengeance.

Liquidity seekers are right back where they were at the beginning of the century. In 2007, they must navigate more than 40 possible execution venues in their search for a good fill.

"The outlook for 2007 is one of confusion and apprehension," says Michael Rosen, the resident market structure expert at Los Angeles-based brokerage UNX. "We're moving into a whole new environment."

In 2000, it was mainly Nasdaq-and not listed-trading that was splintered. Charges of price collusion among Nasdaq market makers a few years earlier had led to new regulations from the Securities and Exchange Commission permitting the quasi-stock exchanges known as ECNs.

The systems proliferated, siphoning liquidity from Nasdaq and forcing traders to monitor multiple trading sites.

Eventually that task got easier as the ECN industry consolidated. But by then the listed world was in play. Charges of front-running by New York Stock Exchange specialists lit a fire under the SEC, which soon targeted Big Board dominance with a sweeping new rule.

The SEC's landmark Regulation NMS and its centerpiece trade-through rule were approved in 2005. The effect has been to create a level electronic playing field for the Big Board and all who would compete with her.

The rule has spawned or revitalized 15 electronic exchanges and ECNs. It has given new clout to those market centers previously stymied in their quests for market share in listed flow.

At the end of last year, about half a dozen of these players revealed new pricing strategies aimed at winning over limit-order traders in listed stocks.

NYSE Arca actually started the trend when it quietly began paying rebates to liquidity providers in listed names. Nasdaq soon followed suit.

The Big Board's arch-rival, which for about a year had grown volume on its book by functioning as a cheap DOT box, took to offering traders 20 cents per 100 shares to post listed orders on its book.

Several regional exchanges have also instituted the take/pay/route fee structure common to ECNs for both Nasdaq and listed trading.

The moves put the NYSE's hybrid business on uneven footing. The floor used to be the cheapest place in the industry to trade. Now, hybrid is at a competitive disadvantage: It is still the cheapest place to take liquidity, but the most expensive place to provide it.

Some execs expect limit orders to move away from NYSE-hybrid to the venues that pay for that flow. "Pretty quickly most limits will find their way to those marketplaces," says Steve Swanson, chief executive of ATD, an up-and-coming wholesaler. "So there will not be as much liquidity on those that do not pay."

Swanson, though, expects NYSE-hybrid to abandon its practice of charging both liquidity takers and providers and adopt ECN-style pricing to stanch the outflow of limit orders.