Whither Instinet? The prob lems of this ECN are about the same as those other alternative trading systems are facing these days: low trading volumes, declining profit margins, a stock market that has turned sour on the once strong stock and a new trading platform that many ECN officials fear will hurt them.
"They're in a tough spot. There's no doubt about that," according to Adam Townsend, a securities industry analyst with J.P. Morgan.
Instinet Group LLC., once the Hertz but now the Avis of electronic communications networks, has competitive and technological challenges like Nasdaq. It has become a problem child for its parent, Reuters Group, which recently removed Doug Atkin, the longtime president and chief executive of Instinet. These problems have been building for several years.
But they came to a head with the introduction of decimal pricing. That's when profits also tumbled among Nasdaq market makers, a group that has been a major supplier of Instinet order flow and business. The reduced margins among dealers forced Instinet in turn to reduce its own pricing.
"While Instinet has an advantage over other ECNs in market penetration and liquidity depth for institutional order flow, it also faces challenges similar to Nasdaq as it attempts to upgrade its technology and compete with smaller, innovative competitors," Meridien Research wrote in a report in 2000. Those challenges have come to pass.
In short, say observers of the trading industry, Instinet, the first ECN in 1997, is experiencing the problems of a relatively old business. It is the granddaddy of the ECN business. And granddaddy is feeling his age these days.
In January, Instinet was relegated to the position of the Avis of the ECN business when it was passed by Island. Over the past year, Instinet has lost some 20 percent of its market share, which now stands at about 11 percent of Nasdaq trade volume. And this comes at a time when all ECNs are facing pressure because Nasdaq, which itself is under competition from new sources, is about to launch its SuperMontage.
The latter, Nasdaq critics charge, is a scheme designed to eliminate ECNs by penalizing those that don't use its new system or only use it for a part of their executions.
"I think Instinet, along with the other ECNs, is going to have a lot of problems surviving. It is going to have many problems. The numbers have been bad," according to Julian Rainero, a securities industry attorney in New York. These numbers have shown up already.
Hard Times
Profits took a dive last year, according to company figures. Although revenues rose in 2001 by eight percent to $5.6 billion, the bottom line was a disappointment. Operating profits were down by 26 percent in contrast to the previous year to $438 million. (Compare this to the 1995-1999 period when profits were consistently rising).
The most recent numbers have been more bad news. Instinet, in the first quarter of this year, reported a net loss of $34.7 million. For the same period a year ago, the company reported a net profit of $50.1 million, or a gain of 24 cents a share in the first quarter of 2001 compared to a loss of 14 cents a share in the first three months of this year. Mark Nienstedt, acting chief executive and president of Instinet, promised better performance in the second half of the year. Nevertheless, he conceded that, "Instinet's first quarter reflects the challenging operating environment."
But Instinet's problems could be worst than other ECNs. Instinet, in the last two years, has adopted several risky strategies. Once an institutional giant that dominated the market, Instinet has tried to broaden its reach into retail business. Also, Instinet, unlike other ECNs, has not applied for exchange status. Rather, it focused on connecting to as many markets as possible to provide the greatest amount of liquidity to clients.
Wall Street has not been happy. Those who had bought the stock as an IPO in February 2001 and held on have been taking a bath. The stock went public at $14.50 a share. Recently, it was trading at about $8 a share.
"Am I happy with the performance of the stock price?" Atkin asked in an interview earlier this year. "I am not. Although I don't think we're alone."
After giving Atkin the proverbial vote of confidence in January – Instinet Chairman of the Board Andre Villenueve was then quoted as saying "the board has confidence in Doug and in the Instinet management team"- Atkin was recently shown the door.
Analysts privately told Traders Magazine that, because Atkin had been with Instinet for years and because massive restructuring is needed, someone with few connections to the current firm would be the best candidate to carry out big changes.
Villenueve says Instinet is re-engineering itself to respond to the market conditions that everyone is facing, which are basically driven by relatively low market volumes.
The big problem is that Instinet, as the oldest ECN, has a unique situation. It has gone from being the only ECN with healthy margins to a market in which there are many ECNs and everyone is scrambling to stay in the black. And it is easier for newer firms to have lower costs.
"Instinet's cost structure is larger and tougher to pare back than many of their younger competitors," Townsend said. "There are today fewer hurdles to liquidity than there were a few years ago. There is more direct access technology that allows people to find more ways to trade," Townsend added. Those that are going to survive in the trading business, he says, are going to be those with the cheapest execution rates or with unique ways of trading that will attract new customers.
Still, Instinet, which was bought by Reuters in 1987, had once seemed to be a great idea that would attract investors. It attracted a large amount of Nasdaq institutional order flow, offering its customers deep liquidity and anonymity. The formula worked very well for several years.
Alternatives that are now open to Reuters: Take Instinet private (Reuters holds 83 percent of the stock), simply hold on to the stock until the price improves and sell it, or look around for a merger partner, possibly another ECN, and create a greater pool of liquidity.
Make Comeback
If Granddaddy Instinet is to make a comeback under the Reuters banner – and Villenueve said it is his belief Reuters wants to keep the company – there are difficult decisions ahead. Instinet is going to have to make hard pricing choices, it is going to have to find a way to cope with a formidable new competitor, Nasdaq, a for-profit exchange with a new trading platform, and it must start to become the lowest or close to lowest cost provider.
Will it find a way to undercut competitors? Will it be able to re-invent itself? Will it be successful?
The answers to those questions are not clear. However, it is clear that Instinet's ECN competitors are also going to face many of those same questions.
