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January 30, 2008

Eight for '08

Market structure predictions for the year ahead

By Jamie Selway

As we sound the closing bell for 2007, below are eight predictions for the new year, followed by a review of last year's list.

1. Equities Exchanges: Market Share Trench Warfare.

By summer, NYSE removes the last pro-Floor advantages from Hybrid, automating the open and close and rolling out reserve order functionality to all participants. As specialists are replaced with "designated market makers" who can take an unconstrained, Nasdaq-style approach to producing liquidity, the differences between the major exchanges-not to mention ECN competitors BATS and DirectEdge-drop from slim to none. Pricing remains as a competitive lever, and new NYSE management isn't afraid to turn the dial. Witness the flurry of price changes in the waning days of 2007. Market share becomes harder to move, however, as all major marketplaces are willing to go the mattresses. In NYSE names, NYSE Group holds 50% share, with Arca accounting for more than half. Nasdaq's NYSE-listed share grinds upward to 25%. (Nasdaq does better if NYSE makes the mistake of offering its new-breed specialists "parity" with the limit order book, thereby driving competing liquidity providers to fairer pastures.) In Nasdaq names, Nasdaq holds its current 45-50% share as the three-way race for second place intensifies. Market data revenue-rich Amex names emerge as a battleground, again with price as the primary weapon.

2. Volume and Volatility Persist.

As the past few years of easy credit recede further into memory, the equity market volatility of the last five months of 2007 proves the rule, not the exception, in 2008. While the herd is culled in some short volatility strategies, such as quantitative long-short, others pick up the torch. The heavy volumes of the last five months persist. In a "harder" market to trade, assumptions about execution workflow are questioned, leading to better order flow segmentation and more intelligent choices about how to use technology-driven tools. In a trading landscape evocative of the futuristic scenes in the first Terminator, the role of human judgment catches a small bid.

3. DirectEdge Graduates from ECN to Exchange, BATS Doesn't.

After wiping the mat with the regional exchanges in the race to provide alternatives to the NYSE-Nasdaq "duopoly," DirectEdge and BATS pursue different approaches to achieve exchange status-and therefore improved economics and independence. DirectEdge merges with an existing exchange: either CHX or NSX (dark horse Amex would be the bold stroke). BATS goes it alone with its application to create a new exchange. Although its market structure isn't contentious, a three-commissioner SEC and stringent governance requirements keep BATS in the ECN bin for the time being.

4. NYSE Buys BIDS.

Similar to ECNs in 1999, dark pool hysteria yields to consolidation, with exchanges as catalysts. NYSE-home of substantial, if waning, latent liquidity-takes the lead by moving past its proposed JV to an outright purchase of BIDS Trading. The negotiation features of BIDS prove powerful in combination with NYSE's neutrality and vast network, creating a "sellside Liquidnet" at a price point that's tough to beat. Others pursue successful dark strategies-think Arca's MPL order and Nasdaq's continuous crossing, which launches in the first quarter-and further combinations are bandied about (Nasdaq for Pipeline?). But NYSE-BIDS spurs the rationalization of the dark pool tangle via consolidation by low-cost exchange providers. Tiring of complexity, the industry welcomes this trend.

5. Amex and Nymex Trade.