Electronic communica tion networks are staking their claims to a piece of the listed market as regulatory and technological barriers are swept away.
Six of the nine active ECNs are positioning themselves to match limit orders for listed securities as they do for Nasdaq issues.
"A significant amount of listed trading will migrate to electronic platforms," said Greg Smith, an analyst at Chase H&Q. "Many of the most liquid names will move very easily."
Smith says success for the ECNs is dependent on two factors: membership in or access to the National Market System and a steady stream of orders.
Three ECNs-BRUT, Bloomberg Tradebook and MarketXT-gained access to the NMS when they joined Nasdaq's third market last month, the newly-named InterMarket. That was made possible by Securities and Exchange Commission approval of a Nasdaq rule change and modifications to the third market's interdealer trading system.
Three others – Archipelago, Island and Nextrade – are angling to become stock exchanges. Archipelago has signed an agreement to merge with the equities division of the Pacific Stock Exchange. SEC approval means Archipelago will gain both membership in the NMS and an existing source of trades.
Island, the second largest ECN after Instinet, applied to the SEC a year ago for exchange status. It is getting impatient. In April, Island put pressure on the SEC by calling for it to mandate the inclusion of ECN quotes in the Consolidated Quotation System. The CQS, essentially one half of the NMS, broadcasts the quotes of the seven stock exchanges and third market dealers to traders everywhere.
Access to the CQS is the ultimate prize for ECNs. Island wants visibility for its customers' orders and the ability to drive listed quotes. Without that exposure those limit orders could languish, unseen by the broader marketplace on an ECN's book.
Island's proposal is apparently being taken seriously by Washington. In May, hearings were held by the Subcommittee on Finance and Hazardous Waste of the House Committee on Commerce.
The issue is whether non-self regulatory organizations such as alternative trading systems should have the benefit of the CQS without holding any oversight responsibilities. Testifying were executives from the National Association of Securities Dealers and the New York Stock Exchange among others.
Tradebook President Kim Bang does not see the SEC granting Island's request anytime soon. Tradebook has decided to work with the SROs and not against them.
"We prefer to see the SROs and exchanges compete for our business," Bang said. "We want them to treat us as a client. We are a consumer of exchange and SRO services."
As members of the third market, Tradebook, BRUT and MarketXT gain immediate access to both halves of the NMS-the CQS and the Intermarket Trading System (ITS).
The ITS is the order routing mechanism used by exchange specialists and third market dealers, such as Bernard L. Madoff Investment Securities and Knight Trading Group's Knight Capital Markets.
ITS Concerns
Trading in the InterMarket is done through Nasdaq's Computer Assisted Execution System (CAES). The CAES, in turn, plugs into the ITS. Market makers like Knight and Madoff must accept automatic executions over CAES. Nasdaq modified the system so that the ECNs are able to decline a trade that would subject them to a dual liability.
The ITS is apparently inadequate for Island, which declined Nasdaq's invitation. "We don't want to become part of ITS," said spokesman Andrew Goldman. "We've had longstanding and profound concerns with ITS and its technological capability. People come to Island because of our speed, efficiency and reliability. ITS would completely undermine our business model." Goldman's ire echoes statements made by SEC Chairman Arthur Levitt who calls the 25 year old system "creaky" and "archaic."
Island's president Matthew Andresen recently told officials of the North American Securities Administrators Association (NASAA) that the ECN favors "direct access" as a complement to CQS representation. He would like to see specialists, market makers and order-entry firms bypass the ITS and establish private links to ECNs.
Jostling for Position
As the jostling for position becomes intense, at least two prominent ECNs remain on the sidelines. Conspicuous in their absence from the Nasdaq deal are Instinet and REDIBook. Instinet's no-show is interpreted as a lack of interest. It already does a limited business in the matching of listed orders, but has indicated its future lies in its role as an agency brokerage. A 16 percent investment in Archipelago is apparently the extent of its ambitions in listed order matchmaking.
REDIBook is also not convinced listed trading will produce the expected bonanza. "It's not clear how many people want to trade listed stocks through ECNs yet," said Larry Leibowitz, REDIBook's president. "Instinet has been offering it for a long time and its market share is minimal. I wouldn't just assume that what works in Nasdaq will work in listed stocks."
NYSE's SuperDot
Leibowitz offers two reasons for his uncertainty. First, and perhaps most obvious, is the overwhelming success of the NYSE's SuperDOT system.
It offers the same anonymous access that ECNs offer, but at a slower rate. It handles about 85 percent of all NYSE orders. Second, much of the Nasdaq volume going into ECNs comes from Nasdaq market makers. Leibowitz says it is not clear to what extent they will be a source of listed order flow.
He adds though that the picture will become clearer if dealers step up their internalization of order flow. The NYSE's Rule 390, which prevented the practice, has been rescinded.
Large wirehouses, like Merrill Lynch, Pierce Fenner & Co. and Salomon Smith Barney, have indicated they will step up their inhouse trading of listed securities.
REDIBook offers order matching in all listed stocks after hours when customers do not expect CQS representation. It has no immediate plans to offer trading from 9:30 a.m. to 4:00 p.m.
Smith at Chase H&Q is not ready to predict a winner. He gives Archipelago a slight edge because of its CQS representation and pre-existing order flow.
"The recent moves are just baby steps," he said. "But the floor will go away at some point. There are just too many positives behind electronic trading."
