What is an alternative trading system (ATS)? The definition used by regulators counts Reuters Holdings' Instinet. A hugely successful electronic-agency broker, Instinet charges commissions to institutions and dealers whenever they execute stock transactions, often negotiated between the bid and ask spread.
Under the same definition, Instinet is an electronic communications network. At the same time, it is a global broker in 40 markets servicing more than 10,000 terminals, an Instinet spokesman said. Instinet has a physical presence too, staffing a floor in New York with 100 traders.
Still confused? So are others on Wall Street. A brief regulatory history, however, makes the meaning of ATS and ECNs more clear.
Basically, an ATS is the catch-all phrase for every conceivable electronic trading system, from call markets such as New York-based ITG's POSIT and the Arizona Stock Exchange, which periodically match buyers and sellers, to continuous auction markets such as Instinet that operate around the clock, to upstart broker systems such as Brooklyn-based Datek Online Holdings' Island.
The most intriguing, if not the most-hyped ATS of them all, is the OptiMark Trading System, designed by Durango-Colo. based OptiMark Technologies.
After a sometimes fractious standoff between the New York Stock Exchange and OptiMark, triggered by the Big Board's effort to block OptiMark's access to the Intermarket Trading System (ITS), OptiMark went live late last month. The ITS members finally agreed to change the rules governing how the ITS links the U.S. listed stock markets.
The feature that distinguishes ECNs is their electronic connections to Nasdaq's SelectNet, the rather clunky vehicle delivering price-quote information to market makers under the terms of the order handling rules. Strictly speaking, that makes POSIT an ATS but not an ECN.
The number of ECNs exploded on Wall Street soon after the implementation of the order handling rules. These forced market markers to make their price-quote information more transparent and to improve their handling of retail-sized limit orders.
Thus, a market maker was forced to execute a superior-priced retail limit order, or to expose it for execution by another market maker or by an ECN. Taking a leaf from Instinet's book, trading firms soon realized the value of having their own ECN: no commissions, reduced capital risk, a vehicle for laying off business before the market closes.
Equally important, market makers sponsoring an ECN had an unintended way to turn the order handling rules to their advantage.
"They could select the order flow that is [potentially] the most profitable and move orders to the ECN that hurts their spread," said analyst James Marks, who studies the proliferation of ECNs as an electronic-commerce analyst for Deutsche Bank Securities in New York.
Bear, Stearns & Co. was probably the most prominent to lead the charge, deputizing its former Nasdaq trading ace Arthur Pacheco to run STRIKE Technologies, the consortium-owned ECN that went live in early November. The owners include trading giants such as Salomon Smith Barney, Donaldson, Lufkin & Jenrette, NationsBanc Montgomery Securities and Cantor Fitzgerald & Co..
But the proliferation of ECNs does have two potentially serious downsides: the fragmentation of price-quote information and the elimination of well-capitalized market-making desks as more institutions send their order flow to ECNs.
The explosion of ECNs, moreover, does not necessarily portend universal profitability.
"The individual trader wants to get the best execution all the time," analyst Marks said. Based on current low volume levels on most ECNs, Marks does not think these ECNs give market makers a strong material edge at the moment.
Today, the nine ECNs approved so far by the Securities and Exchange Commission account for more than 35 percent of Nasdaq transactions.
In November, Island, for the first time, transacted more Nasdaq trades than Instinet. But it is worth noting that each broker counts trades differently. Moreover, Instinet is oriented towards institutional business while Datek is a mostly retail shop.
In January, the SEC released its rules for the regulation of ATSs. One result was a shocker for traditional trading outfits. Datek announced that it wanted Island to become a stock exchange.
The SEC's new rules were explicit. An ATS had to register as a stock exchange or as a broker dealer subject to increased regulatory supervision as its transaction volume increased.
Datek, an upstart discount broker run by twenty and thirty-something yuppies, sent shudders through the establishment. With Island registered as a stock exchange, online investors could potentially narrow the bid and ask spreads on listed business, assuming it is allowed to transmit listed stock quotes via the ITS. Thus, if a Datek listed order is alone on the inside price, that order could presumably narrow the market posted by specialists similarly linked by the ITS
"The ATS rule could do for the New York Stock Exchange what the order handling rules have done for Nasdaq and narrow spreads," said David Whitcomb, who is on a one-year leave as professor of finance at New Jersey's Rutgers University. He is currently running his own day-trading firm.
The ECNs
Name Owner Market Share*
Island Datek Online Holdings 50
Instinet Reuters Holdings 30
Tradebook Bloomberg 5
REDI Spear, Leeds & Kellogg 6
Archipelago Terra Nova Trading 4
Attain All-Tech Investment Group N/A
BRUT Automated Securities Clearance 5
STRIKE Consortium & Bear Stearns N/A
NexTrade PIM Global Equities/Pro Trade N/A
Source: ABN Amro Based on reported advertised trade volume
Data as of Dec. 1, 1998
