Call it: The Rise of the ECNs, Part 2. Led by Kansas City-based BATS Trading, new electronic communications networks, or ECNs, have once again gobbled up exchange execution volume. Their popularity is reminiscent of the late 1990s, when new order-handling rules gave birth to ECNs such as Island and Archipelago.
In 2007, BATS and rival Direct Edge rapidly built reputable franchises, handling double-digit percentages of Nasdaq-listed stock executions and making headway into Tape A and Tape B securities.
BATS’s growth has largely stemmed from providing streamlined and cheap pricing, plus fast technology, and receiving an early liquidity kick from its broker-dealer owners. The ECN launched in January 2006 with abundant liquidity provided by high-volume electronic market makers Getgo and Tradebot, which were also stakeholders. It also helped that CEO David Cummings, a majority owner of BATS and sole proprietor of Tradebot, was intimately familiar with how to attract that type of liquidity.
By the end of 2006, BATS had pulled in more owners, including high-profile Credit Suisse and Morgan Stanley, and had connected 50-odd subscribers that traded upward of 130 million shares a day, or about 6 percent of Nasdaq consolidated volume. Cummings said then that executing 10 percent of Nasdaq shares was crucial to achieving “critical mass.” That prompted the ECN to institute the first-ever inverted fee schedule. The “January special” rebated $0.003 per share to provide liquidity and charged $0.002 per share to take it.
This aggressive strategy defied conventional wisdom that liquidity couldn’t turn on a dime to other markets. By the end of the month, BATS had more than doubled its volume, capturing low double-digit percentages of Nasdaq volume. Since then, its Tape C volume has hovered around the 10 percent mark, but overall volume had more than doubled by November, mostly from executions in Amex- and NYSE-listed stocks, the latter of which began trading over BATS in early February.
The exchanges–including the regionals–took notice of BATS’s aggressive pricing and adjusted their fees schedules to compete. “BATS has been very effective in holding rates to a reasonable level,” says George Hessler, head of business strategy at Lime Brokerage, an investor in BATS and an agency brokerage whose customers choose their order-routing destinations.
Like other alternative trading systems, there’s more to BATS’s volume numbers than meets the eye. The ECN drew 2.8 billion shares in the first 10 trading days of November, but it actually matched 2.3 billion, routing the difference.
Even so, BATS is still drawing that liquidity, charging a lower routing fee than Nasdaq to all but the biggest order providers. Indeed, says Hessler, BATS’s flat fee structure and lack of other fees have bolstered its success. Nasdaq, on the other hand, has several execution fee levels depending on volume. It also charges $400 per month for FIX connectivity and other fees.
BATS’s technology also receives kudos. It currently can turn around orders in as little as half a millisecond, and it plans to shave that to 300 microseconds over the next several months, according to Joe Ratterman, president and CEO of BATS.
Ratterman acknowledges that Nasdaq’s technology, stemming from the Inet ECN it purchased in 2005, is a “good quality system” and fast, a factor treasured by electronic traders. That, no doubt, is partly why Nasdaq’s matched volume has actually picked up this year, despite the gains of ECNs.
“There’s definitely been growth in BATS market share this year, but not at the expense of Nasdaq,” says Brian Hyndman, senior vice president of Nasdaq’s transaction services unit.
Hyndman notes that the exchange executed 44.8 percent of Nasdaq’s consolidated volume in January, climbing to 47 percent by mid-year and dipping to 46 percent by November. “Pricing matters, but it also comes down to liquidity, and we are the largest destination for Nasdaq-listed securities,” Hyndman says.
BATS’s success, instead, appears to have come partly at the expense of NYSE Arca, which reported October and November execution-share volumes, respectively, at 14.1 percent and 15.5 percent, down from 19.1 percent last January.
Cummings, who still owns Tradebot, left BATS management in June to make way for the ECN’s next big step: becoming an exchange. BATS talked earlier this year to regional exchanges about possibly acquiring one to achieve exchange status. Finding their asking prices too high, BATS filed its application with the Securities and Exchange Commission on Nov. 5, a daunting endeavor given ECNs’ past difficulties in gaining exchange status via regulatory channels. Given that BATS’s execution volume has far outstripped any of the regionals, one insider called the move a bargaining chip for future negotiations, adding, “If BATS could get approval, those regionals’ exchange licenses would become effectively worthless.”
