Here's a riddle. What's the difference between a stock exchange and an electronic communications network? The answer could soon be not much' if the Securities and Exchange Commission approves the Archipelago Exchange.
Chicago's Archipelago ECN has allied with San Francisco's Pacific Exchange (PCX) to form a totally electronic, for-profit, competing-dealer U.S. stock exchange to be called the Archipelago Exchange. It will trade both listed and Nasdaq securities. The proposal, submitted to the SEC in July 2000, has cleared the public comment period and now awaits a yea or a nay from the regulator.
If approved, it will be the only stock exchange in the United States to operate on the twin planks of openness and strict price and time priority. There will be no insiders with information advantages because prices and share quantities will be broadcast to the world. There will be no insiders with trading advantages because orders will be executed first come, first serve.
In addition, there will be no members. Traders are customers first and last. That means no users will have undue boardroom clout.
CLOB at Heart
The Archipelago Exchange will function much as the Archipelago ECN does today. A central limit order book will form the heart of all trading. Most orders will flow to it and not to dealers as they do on most of the country's seven stock exchanges. Dealers will still occupy a higher standing than other traders, but they will not run the show. In sum, the exchange of tomorrow is the ECN of today.
"Archipelago is all about lowering the barriers to entry for trading securities," said Mike Cormack, Archipelago's president. "We want to make it easy to post a bid or an offer or to reliquify your position. And, if you think you're good at it, to make markets."
The Archipelago ECN is far from the largest ECN. Instinet and Island share that distinction. Archipelago (identified as Arca' on trading screens) runs with a pack of second-tier ECNs that include Bloomberg TradeBook, BRUT, and REDIBook. Daily volume averages between 90 million and 100 million shares, according to Cormack.
Like most of the top six it is backed by well-heeled owners. Wall Street firms with a stake in Archipelago include such heavies as Goldman Sachs and American Century. Among ECNs it is one of three with aspirations to become a stock exchange. Island and NexTrade are the other two.
But becoming a stock exchange is an expensive and time-consuming process. Operating as one guarantees hawk-like scrutiny from the SEC. Archipelago already trades listed stocks through Nasdaq's Intermarket. So why bother?
To abuse an old real estate adage, it's all about Nasdaq, Nasdaq, Nasdaq. Archipelago, like all ECNs, is a member of Nasdaq. It yearns to break free. Unlike Instinet and TradeBook, which consider themselves agency brokers and are comfortable in the Nasdaq fold, Archipelago and Island see themselves as competitor markets.
"This will provide us with a level of autonomy," Cormack explained. "It will allow us to control our own destiny and actually gain revenue from the price discovery process."
Being part of the Nasdaq family is frustrating, according to Cormack. Paying transaction fees to Nasdaq partly earmarked for SuperMontage, Nasdaq's vaunted "ECN-killer," is especially galling. Generating a substantial amount of quotes on the inside contributes to Nasdaq's coffers from market data sales, but not Archipelago's. "If some of our clients are discovering price, we feel we should be rewarded for that through tape revenues," Cormack added.
The Archipelago Exchange will not be the first electronic exchange. The Cincinnati Stock Exchange won that stripe in the early 1980s. The Chicago Exchange has been largely electronic since 1982 and appears to have no tangible economic need for its floor.
The Archipelago Exchange will not be the first multi-dealer exchange either. Cincinnati and the Boston Stock Exchange have had competing dealer structures for years. Finally, the Archipelago Exchange will not be the first to trade both listed and Nasdaq stocks. The CHX has had a successful Nasdaq program for several years.
Where it does claim a first is in its plan for an open book that displays every pending limit order. It will broadcast the numbers out through market data providers like Reuters or Bloomberg.
Signing the Deal
The deal to create the Archipelago Exchange was signed last March. Archipelago had filed a Form 1 earlier with the SEC to become a stock exchange in its own right, but decided falling under the umbrella of an existing Self-Regulatory Organization (SRO) would be more expedient. The ECN paid the PCX $40 million to serve as its in-house regulator. That saves it from creating a regulatory structure from scratch and is expected to ease SEC concerns. The Archipelago Exchange will become an SRO by virtue of its contract with the PCX.
At the same time, the PCX was in the process of demutualizing its equity trading business. Members were to be strictly customers. It planned to close its two floors and change its modus operandi to remote dealing by multiple specialists. The deal with Archipelago means the 118-year-old Pacific will cease operating a stock market, but continue to operate an options trading floor.
There was no merger. Neither party bought any part of the other. Each will, however, contribute one member to the other's board.
PCX members may trade on the Archipelago Exchange by obtaining exchange trading permits (ETPs). The free licenses let them (and any other broker dealers that qualify) route orders to the system. Period. Their status is that of subscribers or customers and their influence over exchange policy begins and ends there. Buyside traders may not become ETP holders, but can directly access the exchange if sponsored by ETP holders.
Period. Their status is that of subscribers or customers and their influence over exchange policy begins and ends there. Buyside traders may not become ETP holders, but can directly access the exchange if sponsored by ETP holders.
Archipelago's biggest departure from its ECN model is to pay broker dealers to make two-way markets. To induce them to post bids and offers, it intends to pay them one-tenth of a cent per share on every trade executed against their quote, or Q' order.
"If we're going to tell somebody to be here everyday with Q' orders they have to get something out of it," said Bob Hill, an operations executive at Archipelago and a former CHX specialist. "We can't force them to play." Q' orders are defined as limit orders and share the same status as any other limit order on the book.
Archipelago execs say dealers are important to the success of the exchange, but not critical. Market makers are certainly important to the Archipelago ECN. "The vast majority is market maker business," Cormack said. "Some of it is posting bids and some of it is liquidity taking."
Cormack, a former buyside trader at American Century, explains that dealers use Archipelago to "reliquify," or cover unwanted short or long positions and to trade anonymously or quickly.
In addition to the money the firm will receive for executed orders, market makers on the Archipelago Exchange will be granted one other perquisite. A dealer may preference and cross its own orders. Preferencing occurs when a broker routes an order to a stock exchange specialist employed by his firm. The specialist then trades against the order. Crossing is matching a buy or a sell order with all or part of a contra and sending the trade down to the exchange for a print.
Both techniques allow a brokerage to execute listed orders "internally" rather than expose them to the floor for trading. They have been used for years to circumvent exchange rules such as NYSE's now-rescinded Rule 390, which prohibited executions against a house's inventory.
Internalizing at the Archipelago Exchange will not be without cost. Market makers will have to price improve the order by one cent or ten percent of the spread, whichever is greater. That could deter some retail dealers that are now permitted to trade in-house (since 390 has fallen) or have similar set-ups at other regional exchanges which do not require the order to be price improved.
Officials at Archipelago say the price improvement requirement is the only way to accommodate dealers in an environment of strict price and time priority. If a market maker is not quoting the best price or is, but was not the first to post, then he must offer a better price to win the right to trade against orders "directed" to him.
While Archipelago dealers won't have the clout that a specialist does on most exchanges they won't have the risks either. Unlike specialists on the New York Stock Exchange, for instance, the Archipelago market maker is, by and large, not required to act as a buyer or seller of last resort. While both bourses charge their dealers with "maintaining a fair and orderly market," only the New York views its specialists as semi-public servants.
"We believe the economics of the market will take care of imbalances," Hill said. "There isn't a specialist out there big enough to do it by himself. A large imbalance should be communicated to the marketplace. People should see that and be able to react to it." Archipelago's plan to broadcast its book in its entirety stands in sharp contrast to all other exchanges that display only the best bids and offers.
Call Auctions
Archipelago market makers aren't totally off the hook when it comes to mopping up imbalances. The exchange will run two call auctions prior to the opening – one for limit orders and one for market orders. The process is similar to the New York's opening rotation. If there is an imbalance in the market order auction, market makers are required to submit "cleanup" orders of no more than 2,500 shares to complete the trades.
"It would be kind of silly not to be able to match 300,000 shares because we were off by 200," Hill said. Archipelago also plans to broadcast its pre-opening imbalances much as the NYSE's specialists do.
Potential market makers are starting to sniff around the proposed bourse. Archipelago says some PCX specialists are transferring over, but not all. Some of those declining say they prefer the floor and don't want to trade electronically. Others say the structure is unsuitable for their business.
"I think this is a positive move for the exchange," said Jon Werts, a specialist on the San Francisco floor. "It has needed to do something bold and innovative for a number of years. This is it. Overall there is a lot of optimism over the plan."
Werts says the Archipelago Exchange will marry the best of what the specialist has to offer, price improvement and liquidity, with the best of the ECN, low cost and speed of execution.
Arnold Staloff, president of Philadelphia brokerage Bloom Staloff which operates posts on the PCX, BSE, CSE and the American and Philadelphia stock exchanges, is more circumspect. "We're waiting to see what the SEC approves," he said. "Until we know exactly what the story will be – how the rules are going to read – we're not totally certain we'll trade there."
Staloff claims his price improvement statistics are among the best in the country. He says he does not want to operate in any environment that could cause a deterioration in the quality of his services. "We have a tremendous responsibility to the firms for which we are executing orders," Staloff said. "They expect high quality. So, wherever we are trading will be crucial."
Other Pacific dealers also confess to a certain amount of nervousness. "I'm making a good living," said one. "Anytime something new comes along that might jeopardize that, I'm nervous."
