Aplethora of firms operating so-called electronic communications networks (ECNs) is shaking up competition among traditional stock exchanges in the U.S. as never before.
At the moment, the volume of stock orders matched electronically by ECNs is just over 30 percent of overall U.S. equity order flow. Before the onslaught of ECNs about two years ago, one computer system, Reuters Group's Instinet, electronically matched around 20 percent of Nasdaq order flow. Significantly, Instinet still matches roughly 15 percent of Nasdaq stock orders though its overall volume has increased.
With nine ECNs now scrambling for the same equity order flow, slippage in the market share of that order flow for Nasdaq and the Big Board is not huge. But the potential threat posed by ECNs is enormous.
For one thing, the Securities and Exchange Commission approved new rules that allow these ECNs to register as stock exchanges and to compete for listings under the agency's Regulation ATS. Switching to stock exchange status would give ECNs a chance to muscle in on competition for listed order flow that is funneled through the Intermarket Trading System – a network controlled by the traditional listed exchanges. For another thing, individual investors are increasingly logging on to ECNs, such as Datek Online Holdings' Island (which has the capacity, moreover, to stay open fulltime and trade non-U.S. stocks.)
"[An ECN] eliminates the middleman," said Mark Yegge, co-founder of the Clearwater, Fla.-based NexTrade ECN. Yegge boasted that his outfit could easily handle the entire volume of the NYSE with a handful of people. "We are like an eBay for stocks," he said, referring to the Internet-based auction for consumers.
The threat hanging over Nasdaq and the Big Board, in large part as a result of these developments, is so significant that both are considering becoming for-profit companies by selling their shares to the public via initial public stock offerings.
"People understand that the speed of change ahead of us will be unprecedented," said Kenneth Pasternak, president of Jersey City-based Knight/Trimark Group (Nasdaq:NITE), which runs the largest Nasdaq wholesaler and is arguably an ECN (since it electronically matches most of its Nasdaq stock orders). "For the traditional players to compete, they need to transform to privatized entities, into a business model that can be more dynamic and responsive," Pasternak added.
With the large amount of capital IPOs would likely generate for Nasdaq and the Big Board, both exchanges would be able to up the ante through investments in infrastructure. Indeed, both are considering extending their trading day and partnering with ECNs.
While the idea of IPOs for stock exchanges in the U.S. is exotic, several foreign stock exchanges have already become public companies.
"In a very few years, trading securities will be digital, global and accessible 24 hours a day," said Frank Zarb, chairman of the National Association of Securities Dealers, the self-regulatory organization that runs Nasdaq.
"Our thinking is to open up our stock markets to investment from market participants and eventually to the public, so they can participate in our growth and financial success and so we can raise the needed funds to grow and continue to modernize," he said.
Estimates vary widely of how much an IPO might raise. Scott Appleby, an e-finance analyst with San Francisco-based BancBoston Robertson Stephens, estimates that Nasdaq and the Big Board might raise about $500 million each. Irv Degraw, an IPO specialist with WorldFinanceNet.com, likens a stock market going public to the IPO of investment banking giant Goldman Sachs, which raised $3.7 billion. He estimates that Nasdaq could raise about $3 billion while the Big Board's potential is $4 billion. "[An exchange] IPO would be spectacular, absolutely one of the most notorious of all time," Degraw said.
While it is not clear how the deals would be structured, exchange members say that each of them will receive stock in exchange for their seats. The Big Board's tighter structure might make it easier to accomplish an IPO than Nasdaq's sprawling network of affiliated market makers.
The NASD looks favorably at an IPO for its Nasdaq subsidiary. The Big Board hired investment bankers Salomon Smith Barney and Merrill Lynch to study the possibility of going public. The exchange then offered a statement from its chairman, Richard Grasso, expressing his desire to explore strategic options while setting his sight on an IPO by Thanksgiving.
As the exchanges become nimble, some ECNs, many partially owned by large investment firms and brokerages, are graduating to exchange status. The Iselin, N.J.-based Island ECN, New York's Eclipse, Archipelago in Chicago and New York-based on-line brokerage Wit Capital (Nasdaq: WITC) have filed with the SEC to become stock exchanges. Goldman Sachs, which purchased a 16.5 percent stake in Wit Capital in April, also has a stake in Archipelago. Instinet recently took a stake in Archipelago, signaling its commitment to broaden its franchise.
"With Regulation ATS, the possibility exists for a lot of innovation," Pasternak said. "Entities transform themselves. You can do transactions and kind of grow up to become an exchange."
The next logical step for an ECN-turned-stock exchange would be its own IPO, Appleby says. "ECNs are taking market share away from the older players. The market maker model, or the option market model with the specialist in the middle, are less efficient models for trade executions," he said.
