It's all in the family for Archipelago. The ECN turned stock exchange for

Nasdaq and listed trading has much of Wall Street watching closely as it goes public. That's because the metamorphosis of Archipelago Holdings is the result of its close connections to its customers, investment bankers, competitors and a regulator.

Many of these parties hold a stake in the company, which operates Archipelago Exchange (ArcaEx). Some have bought a stake. Others have earned it through large-scale executions. Now the stakeholders are betting that these relationships will be profitable. And that Archipelago can survive with the other two big boys of the trading industry, Instinet and Nasdaq.

Archipelago Holdings officials, who declined comment on the story because of IPO rules, hope that more than strong volume and their pure play matching engine will keep the company in the black. Some trading executives question whether this will work at a time when many players are practically giving away their services to obtain vital liquidity pools.

Fighting Competition

In an offering that Archipelago hopes will raise up to $150 million, the company is asking investors to bet on its continued growth, profits, a diversification of its trading model and that the company can fight off dog-eat-dog competition.

The random element in these battles is the Securities and Exchange Commission's proposed Reg NMS. Both Archipelago and its big rivals, the NYSE and Nasdaq, are hoping the process will result in a more favorable market structure. But they all can't be winners in this sweepstakes.

So Archipelago, which last year executed 104.3 billion Nasdaq shares as well as relatively small amounts of NYSE and Amex listed business, is about to go public. Many of the biggest trading firms, several of them with a share in the one-time ECN, will be monitoring these events. A number of them, including Goldman Sachs, CS First Boston and Merrill Lynch, will serve as investment bankers in the deal. Indeed, officials of many trading firms and investment bankers, who normally speak to Traders Magazine, declined comment because of potential conflicts of interest. Another official, Archipelago CEO Gerald Putnam, understandably can't comment. He has a 3.02 percent stake in the company.

Does Archipelago, with its Pacific Exchange/ArcaEx facility that is also a regulator, have the right formula to survive in a very competitive trading and regulatory environment?

The Archipelago IPO prospectus, which notes that the company was in the black in the first quarter after years of red ink, outlines some rocky and hopeful scenarios for this would be public company.

"Our status as a facility of PCX Equities allows us to generate revenues from two additional sources, market data fees and listing fees, which we were ineligible to earn as an ECN," according to the 328-page registration statement. Proceeds of the offering would be used for the expansion and diversification of product offerings.

Archipelago, which began in 1996 as one of the original four SEC "qualified" ECNs, was created in the wake of the order handling rules. The company expects that its greatest expansion will come at the expense of the Big Board and Nasdaq.

But that could be a difficult proposition. If the plan goes as projected, it would mean that Archipelago will have to succeed in an area in which it has so far failed, according to some industry observers.

Archipelago's growth in Nasdaq business in the last three years has been dramatic – from just under six percent market share in 2001 to just over 25.5 percent in the first quarter of this year. However, the unsuccessful part of the business has been on the pure listed side. It has made almost no impact on the New York Stock Exchange.

Listing Trading

Archipelago's share of Big Board listed business was less than one percent back in 2001. Today, it is only 1.6 percent. ArcaEx has frequently highlighted its much larger share of trading in ETFs. But listed trading overall is weak, even though there has been some isolated success in a handful of single listed stock names. "The NYSE has significantly more liquidity in trading securities listed on its exchange than we do," Archipelago said in the offering.

"This means that market participants send more orders for purchase or sale of NYSE-listed securities to the NYSE than ArcaEx. It is easier for sellers to find buyers, and for buyers to find sellers, in a large group of buyers and sellers than in a small group (i.e., a more liquid market). Market participants are also more likely to get the best price for their orders when their orders are exposed to the largest number of buyers and sellers."

Of course, there is a concerted effort by electronic trading players, including Archipelago, Instinet and Nasdaq, to further open up the doors for them to listed stock trading. That could follow if the SEC takes their side in some of the proposals in Reg NMS. Archipelago concedes that the current trade-through rule could curb its ambition to expand in listed trading. Therefore, uncertainty rules at least until the SEC decides on the Reg NMS proposals.

In the meantime, Archipelago officials, in their IPO document, acknowledge the risk of a model that has been in the red through most of its history.

Another part of Archipelago's vulnerability is that it now garners almost all of its income from transaction-based business. That means diversified competitors are better equipped to survive sour markets in which transaction volume levels decline. Indeed, between 2000 and 2002, Archipelago lost between $35 million and $39 million each year.

"Some of our competitors," according to Archipelago, "derive their revenues from more than one source as a result of a more diversified product and service offerings. For example, Nasdaq realizes substantial revenue from listing fees. As a result, lower transaction fees or market data fees may impact our operating results and future profitability more significantly than our competitors, providing them with a competitive advantage in pricing their products and services or withstanding a reduction in trading volume."

Institutional Flow

At the same time, Nasdaq is also trying to block one of Archipelago's most important potential resources – institutional order flow.

Archipelago, through ArcaEx, has in the past tried to undercut Nasdaq by sponsoring institutional order flow from buyside desks through its Wave Securities, the brokerage headed by former SEC official Joseph Lombard. Nasdaq recently tried to counter that Archipelago strategy by purchasing the BRUT ECN, which as a registered broker dealer can sponsor similar order flow. The BRUT acquisition will "augment Nasdaq's existing position by deepening Nasdaq's liquidity pool," Robert Greifeld, president and CEO of Nasdaq, said when the purchase was announced.

BRUT is a unique ECN. It has positioned itself as a business that would not pursue institutions directly. Instead, it takes a back door by working with sellside clients. So BRUT, unlike INET and ArcaEx, has never intended to disintermediate the sellside.

With the acquisition of BRUT, Nasdaq appears to be loaded for bear. Greifeld has also said that he expects the BRUT acquisition will pay more dividends after regulators are finished implementing various market structure plans now under review. Recently, he was quoted as saying that these changes will help market centers to access each other through a broker dealer.

Legal Exchange

The BRUT purchase certainly changes the nature of Nasdaq, a business in the midst of trying to transform itself into a legal exchange. Buying this upstart competitor will pay off, Nasdaq officials claim. That's because this would-be exchange now will be able to tap new pools of liquidity, including other exchanges and Electronic Communication Networks, Nasdaq officials say.

Still, the move also has its downside. Nasdaq, in buying BRUT, bought a broker dealer/ECN that competes against many of its customers. But Nasdaq/BRUT, if it emulates the ArcaEx/Archipelago corporate structure, should still be able to canvass and sponsor institutional order flow. Nasdaq could split BRUT in two parts – one for institutional and the other part for the smart routing business. That's what one trading official told Traders Magazine.

"They [Nasdaq] really need a routing business because, if Nasdaq wanted to route to INET, they would require a broker dealer to accomplish that because only broker dealers can subscribe to INET," he said. He added that, because of the precedents set by ArcaEx, Nasdaq could do that. But whether it will actually do that or not will be based on business needs, he added. "What would Goldman say if a Nasdaq affiliate started talking to their clients?" the official asked.

Meanwhile, Archipelago, in going public, is also trying to convince the investors that it has figured out the trading world.

Archipelago's gamble is also on a model that depends on matching orders for profits, while competitors don't see matching as a big profit center, according to one trading industry official well acquainted with the company.

"Archipelago is really the only player matching on a pure play basis. I think of Nasdaq, for example, as a matching engine business that needs to be good enough to keep people there. Hence the BRUT transaction. But the difference is that Nasdaq isn't looking to make money doing it. They're looking to make money listing companies," the executive says.

The executive added that, just as Nasdaq expected to make money from its new brokerage affiliation, so Instinet is going to derive profits from its brokerage connection. Unless Archipelago, this executive says, finds a "way to hang some business on the matching engine, I think they're in for a struggle."

Several trading executives, who also couldn't be quoted by name because their firms had some connection to the IPO, praised Archipelago. "It's a great matching system, highly-technologically advanced," says one trader. "But it's a little hard to grow your way to profitability when the product is free," he quipped.

Still, an executive of an electronic firm had a different take on Archipelago's competitive position, saying he likes its long-term prospects.

"Nasdaq's buyout of BRUT is unlikely to have much of an effect on the Arca business," according to John "Wally" Sullivan, a co-founder and CEO of Pulse Trading. "Pricing is so low now that clients' focus will shift to product quality and service – two areas in which Arca has done very well."

However, the other question facing Archipelago is: Will it have trouble keeping up with competitors who have broader revenues and a better model?

Besides the lack of diversification and the battle for buyside order flow, another potential problem for Archipelago is a brutal marketplace. Intense competition forces effective players to discount aggressively and rebate in order to maintain or expand market share. That's even though that may cause some or all of these players to lose money. This has been one of the factors that put Archipelago in the red in the past few years.

In April 2002, Archipelago had to cut transaction fees. Archipelago was caught in a vicious cycle. The discounts and rebates meant "our revenues per transaction executed on the Archipelago system declined and the growth of our transaction fees was significantly lower than the growth of our trading volumes over the period," according to Archipelago.

"For example, in 2002 our transaction fees increased by 107 percent although our trading volume increased by over 170 percent in the same period. Similarly, in 2003 our transaction fees increased by 20.5 percent although our trading volumes increased by over 40 percent in the same period."

Another potential problem for Archipelago is Nasdaq's new pricing schedule changes for its SuperMontage platform, announced in April. These changes were designed to attract high volume customers, customers that could be taken away from Archipelago.

Healthy Competition

But Pulse's Sullivan says Archipelago will be able to cope. "With their quality product and service, Archipelago should continue to be a significant player in the OTC trading landscape," he said. And Sullivan also argued that Archipelago, unlike many other electronic competitors that were swallowed, should survive. "In my opinion, a competitive electronic market structure needs at least three healthy participants so we are currently at the minimum level," Sullivan says. He added that a strong Archipelago is critical for competitive markets.

Archipelago concedes in the IPO prospectus that ECNs and alternative trading systems could ultimately undercut efforts to stay profitable. But Archipelago now faces a huge ECN called SuperMontage.

"We rely on high volume market participants for a significant portion of our trading volumes and revenues," according to Archipelago. "If Nasdaq's new pricing schedule succeeds in encouraging high-volume participants to shift trading activity from ArcaEx to Nasdaq, our trading volumes and our revenues will be materially and adversely affected."

Access Fees

One example was cited in the IPO document. Nasdaq no longer charges clients for "taking liquidity." This could hurt Archipelago's attempt to expand its weak listed business. That's because Archipelago currently charges customers a penny for taking liquidity from ArcaEx in NYSE securities. The pending Reg NMS process could also be problematic for Archipelago. The SEC is proposing to cap access fees at a penny.

"If the proposal is ultimately adopted in this form," Archipelago warns investors, "we believe that the amount of transaction fees we earn, which represents over 99 percent of total revenues, would potentially decrease by a material amount. Our analysis assumes, however, that trading activity and market share would remain constant and does not give effect to changes investors may make in their trading patterns as a result of or in response to the proposed regulation. Under the proposed rule, we would be potentially unable to increase our revenues through higher pricing of transaction fees in the future, which would have a material adverse effect on our revenues and operating results."

Archipelago's customers could be considered unusual. They are often its investors. That's because between 2001 and 2003, investors each year indirectly generated about 40 percent of Archipelago's annual revenues.

Another challenge for Archipelago, if it is to be consistently in the black, is its listing fee business. This is an area in which Nasdaq and the NYSE are dominant and in which Archipelago has so far lagged. It has been deriving less than one percent of its revenues directly from this line.

"Almost all of our listing revenue is derived from dual listed NYSE-issuers that selected the Pacific Exchange as an additional listing venue prior to our launch of ArcaEx. Only two issuers have listed their equity securities on the Pacific Exchange following our launch of ArcaEx, and both listings resulted in little or no trading activity," according to Archipelago.

One trading industry official added that Archipelago's efforts to obtain listing business will likely be successful. His reasoning is that, in an era of greater shareholder demands, there is going to more pressure for multiple or dual listings.

At the same time, the launch of Archipelago's AraEx has put the company in a position to gain new advantages. The company now gains data fees that it couldn't when it was an ECN and it no longer incurs clearing charges for transactions matched internally. As an ECN, it was paying clearing charges, the IPO noted. And Archipelago also pointed to what was a big turnaround in the first quarter. That's when the company earned some $22 million on total revenues of $146.7 million, a huge turnaround from the previous quarter when it lost about $20 million.

The Improvement

Why was Archipelago finally in the black? The company listed three factors: 1) Increased volume; 2) The migration of trading in Nasdaq securities from Archipelago ECN to the Archipelago system, and 3) An increase in the number of orders that were matched internally.

Archipelago's fortunes appear to be strongly tied to its continued internalization, strong volume and the prosperity of its clients and investors. That is why this public company will be the ultimate bet on the trading industry. As big trading firms fortunes go, so will go Archipelago's.

Principal Shareholders in Archipelago Holdings

From the beginning of 2000 until June 30, 2001, Archipelago instituted an equity entitlement program that meant that many of its customers and competitors have become major shareholders. Participating customers became eligible to "earn equity entitlements" based on "the volume or order flow on our trading platforms," according to Archipelago. The brokerage Terra Nova Trading was among the participants in the program.

Here are some of the shareholders in Archipelago.

Goldman Sachs 23.86%

GAP Archa Holdings 23.38%

Credit Suisse First Boston 7.78%

Fidelity Global Brokerage 6.76%

Merrill Lynch 5.01%

Instinet International 4.39%

Pacific Exchange,

which is one of Archipelago's regulators 4.12%

J.P. Morgan Chase & Co., 3.68%

GSP, LLC, 3.02%

Virgo Enterprises 3.02%

Charles Schwab & Co., 2.84%

TD Waterhouse Group 2.29%

E*Trade Financial Corp. 2.08%

National Discount Brokers Group 1.01%

American Century Ventures 1.00%

Gerald Putnam 3.02%

Stuart Townsend 3.02%

MarrGwen Townsend 3.02%

(The last three are directors and executive officers of the company). Archipelago Affiliates Archipelago CEO Gerald Putnam owns 40 percent of Terra Nova Trading (TNT), a broker dealer that has a 0.6 percent stake in Archipelago. MarrGwen and Stuart Townsend also have a 40 percent stake in Terra Nova. All are executives of Archipelago. Archipelago has received transaction fees from Terra Nova and has made liquidity payments to Terra Nova as well as rebate payments. "We believe that all payments to TNT, and all amounts charged to TNT, are determined based on prevailing market rates, terms and conditions, which are available to all other market participants," according to Archipelago. Other affiliated party relationships include Wave Securities, a broker dealer owned by Archipelago. ASB, LLC, a service bureau located in Chicago, which provides backoffice services to Wave Securities. These services include clearing technology and routing technology to alternative trading venues, reporting to the NASD's Order Audit Trial System. Wave Securities has been paying ASB $100,000 a month for these services since December 2002, according to the Archipelago IPO prospectus. Townsend and Putnam are both 40 percent owners of ASB. Finally, for five years through March 2004, Archipelago rented a yacht for business development functions. It has cost the company about $500,000 a year. The "domestic partner of Mr. Putnam's sister" has operated the yacht, according to the IPO document. Archipelago will not be continuing the yacht rental, the document said. Archipelago officials, citing quiet period IPO rules, were not able to comment on any of the document or the future of the company. At presstime, they also said that they were not sure when the IPO would take place.

There aren't many 35-year-old electronic trading services. In fact, there's probably only one. AutEx, a quote advertising medium of Thomson Financial, was established in 1969 and is still going strong. The vendor took a big hit with the advent of the FIX protocol in the mid-90s. But it is still billing the bigger trading houses in the six and seven figure range every year.

FIX let brokers bypass the AutEx network and send their indications of interest directly to the buyside. Indications, or IOIs, are invitations to trade that note stock, side, and with "supers," price and quantity.

IOIs are one of three AutEx services. The other two are trade advertisements and order routing. Advertisements, sent post-trade, are of size. They let brokers brag about their trading prowess and help to attract more business. AutEx's order routing service lets buyside traders send orders to brokers and brokers return reports.

FIX didn't completely kill off AutEx's IOI business. About one-third of the million messages flowing through its system every day are supers. But most of the rest are advertisements. Because of the limitations of the AutEx terminal, most buyside traders use the service strictly for the advertisements and to get recaps of previously sent IOIs. Because the data rolls off the screen as soon as it comes in, it is nearly impossible to keep track of indications in real time.

Those adverts, called BlockDATA' by Thomson, are important though, and, sources say, the main reason why AutEx is still hanging in there. Also, the competition is weak. About 300 broker dealers and 500 money management firms use AutEx. Thomson charges both the buyside and the sellside, but takes in the majority of its annual revenues from the sellside.

However, Thomson isn't coasting on BlockDATA. The vendor sees opportunity in the recent changes sweeping the trading business. With more buyside traders taking control of their orders and more electronic tools at their disposal to do so, Thomson is betting it can grow its order routing business.

Technology editor Peter Chapman sat down with Bob Moitoso, a Thomson senior vice president responsible for AutEx, to talk about the vendor's initiatives.

Traders: From all reports, your indications business sounds stagnant. What's the story here?

Moitoso: The IOI business is not contracting. It is growing. Order routing though is certainly a higher growth business. It's growing at a much faster clip than indications.

Traders: Given that IOIs supported block trades. And given that blocks are losing ground to programs and algorithms. Isn't the trend bad news for indications?

Moitoso: Certainly, in the past, IOIs supported the buyside in the trading of large blocks. Large blocks have dwindled somewhat, but the tool is still important. But now maybe I'm looking at advertised trades more. And I want more electronic access or order routing.

Traders: Bigger trades are being chopped up.

Moitoso: Exactly. For example, in our order routing network, a few years ago, for each order we would see three or so execution reports come back. Now we see eight. Not only are they getting chopped up, they are getting executed in the marketplace in even smaller pieces.

Traders: Why are you optimistic about order routing?

Moitoso: More and more asset managers and buyside traders are taking responsibility for their own transactions. A few years ago, the buyside trader would place a lot of emphasis on a particular broker dealer. The broker dealer would work the order. But now with all the different liquidity pools and fragmentation, the institutions are stepping up to the plate and managing their own executions in a more proactive way. They have access to tools like Lava and Sonic and Newport and the algorithms. Crossing networks. POSIT. Liquidnet. Harborside.

Traders: And the buyside trader can route more to these newer venues?

Moitoso: With the institutions taking more responsibility for more and more transactions, they are interacting more and more electronically, which has helped us grow our order routing business.

Traders: Lava Trading, the ECN aggregator and direct access service, is now a destination. Would you please explain the arrangement?

Moitoso: Typically, you must be a large institution to have access to Lava tools. We made it available to everyone. Lava has smart order routing and best-ex type algorithms. So, you can get the Lava front-end called ColorBook and interact with Lava directly. Or, in our case, we deliver orders to the Lava platform. Limit orders or market orders. And then Lava will take that and execute accordingly. It's a little less control than they would normally have. They are not looking at the Lava interface. They are just sending orders to Lava. Which will find me the best price.

Traders: Smart order routing technology?

Moitoso: Right.

Traders: How many of your 800 users route orders through AutEx?

Moitoso: About 200 institutions send orders to 225 traditional and non-traditional broker dealers. Traditional' would be the Morgan Stanleys of the world. Non-traditional' being the Instinets and the Pipelines. The execution destinations.

Traders: You entered the order routing business in the mid-90s with the advent of FIX. The system is called TradeRoute?

Moitoso: Not anymore. We retired that name on March 31. It's now called AutEx Order Routing. AOR is the third generation order routing service Thomson has put together. TradeRoute was a North American order routing system. AutEx Connect, which we established a few years ago, was our international piece. With AOR we combined the North American piece with the international into one massive system.

Traders: Previously, the 200 buyside and 225 sellside were using TradeRoute?

Moitoso: It was a mix. TradeRoute and AutEx Connect. But the vast majority was on TradeRoute.

Traders: TradeRoute was on a FIX network and indications were on a separate proprietary network? And now the IOIs will also run over this new network?

Moitoso: Yes. TradeRoute was on its own system. The IOI system was on its own hardware and infrastructure. The IOI system had a mix of FIX connections and proprietary APIs and our own interfaces that sat on the client's desktop. AutEx Connect was on yet another infrastructure. We've collapsed all this into one robust environment that uses FIX as an API. We've standardized everything. We've made it a lot easier for our clients to interact with us. Whether it's for IOIs, orders, execution reports or allocations.

Traders: Merrill Lynch is one of the first to sign up?

Moitoso: Merrill moved over from our old infrastructure to just a couple of FIX connections.

Traders: Allowing them to reduce their own infrastructure?

Moitoso: Yes. Which means cost. It streamlines and gives them the ability to send us even more information and messages. Which they have done.

Traders: You are making some changes to the way the buyside receives messages as well. The AutEx terminal is supposedly being phased out?

Moitoso: Correct. What we've done…on the heels of ThomsonOne, our market data platform, we've made it easier to take our content. Whether it is IOIs or order routing. And put it where our clients live – the order management system. The OMS has become like the trader's cockpit. We are now integrating into that cockpit.

Traders: TradeRoute has always been plugged into many of the buyside order management systems.

Moitoso: That's right. Order routing has always been like that. From day one, we provided a FIX connection into the back of a myriad of these OMSs: Charles River, Linedata, Eze, Decalog, proprietary. We've done that for ages.

Traders: So, the news is on the indications side?

Moitoso: On the IOI side, we started to provide more effective ways of getting our info to live inside the order management systems. Such as with the deal with LineData. You can automatically open up an AutEx window in the LongView trading system.

Traders: How does that work?

Moitoso: Say I'm looking at the blotter. I see the stocks I am working. I can do a right mouse click: go get me IOIs.' It launches an AutEx window. It allows you to talk back to our database. Do the recaps, etc. All the things a full-blown AutEx would do. It is an AutEx window sitting inside of Longview.

Traders: You are doing deals with other OMS vendors?

Moitoso: Yes. All are in the works.

Traders: And for those who don't want to access AutEx through order management systems?

Moitoso: The new AutEx interface is totally Web-based. Inside a browser. It does everything a full-blown one does. It has all the features and functionality. That is the way we are delivering the new AutEx. It makes it easier for us to get onto the desktop.

Traders: So, at end of the day, some traders will get AutEx from within their OMS and others via the Web?

Moitoso: Yes. Onto our Website. Which will run either on the public Internet or over our leased lines. And lastly, via the AutEx interface inside a ThomsonOne terminal.

Traders: Isn't the Internet unreliable and slow?

Moitoso: For what most of our clients want… and how they use AutEx data…the Web version, whether it is running over the public Internet or over our secure network is more than adequate.

Traders: Which is the buyside likely to choose?

Moitoso: It's a combination of a lot of things. At first, people will migrate more towards our Web version because it is what they use. Over time they would want it more inside their OMS.

Traders: The Merrill announcement referred to greater selective targeting of messages and blocking.' Also, the new system will ensure intelligent message validation.' Please explain.

Moitoso: The sellside wants to make sure their best customers get the best merchandise. This goes in cylindrical fashion. It depends on where trading is at any particular moment. In the past, brokers have either been very good at segmenting their clients, or when there is a lot of business, they don't segment anymore. They just send it out.

Traders: And now brokers are being selective?

Moitoso: Now, they are setting up their A,' B,' and C' lists. They are permissioning or entitling their clients to see liquidity at certain times. Merrill might send out an A' list.

A minute later, send out a B' list. Then a C' list. We've made it easier for them to do it.

Traders: Blocking' refers to the sellside or buyside?

Moitoso: Both. Filter out or filter in. A broker can filter an A,' B,' C' list. But an institution can also filter out certain brokers. Those that just create noise for them. Let's say they have 20 trading partners and that is all they trade with. They could set up a list of those 20 and only use those 20 to filter their messages.

Traders: Most of the buyside order management systems aren't apparently built to handle the hundreds or thousands of incoming AutEx messages.

Moitoso: A few years ago, it was the rage to take IOIs and stick them into their OMSs. But nobody understood what that meant. We do a million messages per day here. To have that flow show up on your desktop… It knocks things over. It's not the easiest thing to manage.

Traders: What has AutEx done?

Moitoso: We've now been able to put better filters into our pipes. So if Charles River wanted to get a feed of FIX messages from us, we can actually throttle it down, so that only certain brokers show up, certain types of messages, for example, just naturals. Or size…those over 25,000 shares, for example. We've been able to work a little bit more with OMS guys. So we don't knock them over. Latent Zero is the same way. They've made it more robust. So it can accept more than a few thousand messages.

Traders: So, to sum it all up, you've done two things: streamlined distribution and improved data presentation?

Moitoso: Yes. AutEx is now much more flexible.

Traders: Thanks, Bob.

Two distinguished institutional investors weigh up the prospects for the markets in two separate and wide-ranging interviews.

Lee Cooperman, Omega Advisors, New York City

What ails this market?

That's easy. What's going on in the Middle East, terrorism, Iraq etc. But the major issue is whether the economy grows in the second half of the year. In other words, the growth we've had, late last year, this year, isn't a surprise given the very stimulative fiscal policy, the very stimulative monetary policy, the very favorable tax policy on capital gains and dividends. The issue is whether the recent pick-up in employment can be sustained. We have to migrate into a self-sustained business expansion because the stimulus coming out of all the refi activity, the stimulus coming out of falling interest rates, that's going away, because interest rates are going to go up. The question is at what at pace are they going to go up?

What's your answer?

I think everything that fueled the market off the October 2002 lows is reversing. In other words, the market was fueled by falling interest rates, falling inflation and an extremely favorable fiscal policy and I would guess that every one of those variables has reversed direction. The Fed has already put you on notice that they're going to be raising rates. There is no question inflation has bottomed. Look at the world around you, the oil price, the price of natural gas, housing prices, etc. And post-election, we're going to have to deal with the fiscal problem. There wasn't one Democratic candidate who didn't advocate a reversal of Bush's tax policy and I've got to believe with the deficit as large as it is, even Bush, after his re-election, is going to have to deal with it. And since those are the kinds of things the market is worried about here, this correction could take some time. But look at the bright side.

Which is?

On the good side, the market has had a good contraction in its price/earnings ratio and the standard estimate on S&P 500 earnings this year is around $64 for next year. Some people are thinking more like $70-$72 and when inflation's been running 2-3 percent, the multiple on the market normally runs about 16, 17 – which is where the market is. The only way the market gets real exposure to the downside is if something blows up in Iraq or there is a serious terrorist incident. That never used to be part of the lexicon of things that we would worry about, but what can we do? In that case, all bets are off. But ex that, I'd say we're in a trading range I define between low end 10000 and high end maybe 12000; that's not necessarily imaginative, controversial or exciting. But I happen to personally think that if I'm wrong, it's going to be worse and not better.

Why?

Mainly because of all the structural imbalances that exist in the economy. For two years now the consumer's been spending ahead of income, they had a very low savings rate, they have a large amount of debt, 30 percent of all mortgages are tied to a variable rate and when the Fed starts to raise rates this will pinch the consumers somewhat.

Thanks, Lee.

Craig Callahan, President and Chief Investment Officer of ICON Adviser, Inc. ICON manages Denver's ICON family of quantitatively-oriented mutual funds.

The market has turned a bit hostile, but I hear you're hanging tough- It had fallen off in April and May pretty seriously, but we've ridden through it. It hasn't altered our positions much.

I have noticed that you have been promoting your covered call fund. Have you gotten indications that investor anxiety is rising? We brought that fund out a year and a half ago, thinking that in this decade holding covered call positions would appeal to investors who don't have quite the desire for the big upside they did in the '90s. That they would find a little downside cushion appealing, as well as the ability to benefit in a sideways market from keeping the premiums on calls written. And the tradeoff for that enhanced return in sideways markets is just giving up a little of the upside. That's a long-winded way of saying no, the fact that we are marketing our covered call fund now is not saying anything about the market. It's more that we see it as an appealing tradeoff for this whole next decade.

You think a lot of investors will be content to give up the search for ten-baggers? Well there was a greed overlay to the market in the '90s, but we think that's gone and people are more reasonable now. They just want a decent return. That can work for them. And you're going to get that, staying fully invested through this correction? We were very bullish a year ago based on values. And when this interruption hit, prices had still not hit our fair market value targets. So our discipline is to ride through this short-term interruption. The prices of our stocks we would expect to resume their path up towards fair value.

You wrote something the other day that was rather dismissive of the Chicken Littles who have just discovered rising interest and inflation rates. They weren't ahead of the curve and accurate in predicting the recent rates. They have jumped on the bandwagon only after rates have risen. And there is just such an overwhelming consensus about higher prices that it makes me think it has to be wrong. It has that feel about it because just about everybody believes it. Besides, at ICON, we are not overly concerned about inflation or interest rates. We believe that our economy can support the levels of growth we are currently experiencing. Gains in technology are driving corporate productivity. The Internet is empowering buyers as price comparisons are much easier and more transparent. Global economic integration is creating a more competitive market environment. Our methodology is focused on finding longer-term investment solutions rather than speculating on short-term macroeconomic events.

Still, there actually isn't a lot of room for rates to fall from here. Not on the short-term range, but we can see long-term rates being lower in the coming years. They were lower back in the 1940s so we can see a return to that setting. Which implies reasonable economic growth and not a heck of a lot of inflation. That's right. To word it differently, we've had a 23-year downward trend in interest rates. That's very powerful and we don't see anything powerful enough to totally reverse it. Maybe it will be interrupted at times, maybe it will slow down a bit, but think about how powerful something would have to be to take a 23-year trend and totally flip it around and reverse it. I don't see anything powerful enough to reverse it. It other words, the fundamentals that have contributed to that trend we think are still extant. And that is the setting you've described of adequate growth yet minimal inflation.

Some of the inflation readings lately have started to look a mite pesky- We think the recent CPI numbers are just a short-term oil function and not a whole new round of inflation setting upon us.

I take it then, that you're still finding plenty of stocks selling below what you call fair value? Yes, we are valuation oriented. We have on average 1,700 stocks in our database and we find that they are around 15 percent below fair value on average. We can find plenty to buy that meets our standards. Generally, they tend to be things that are cyclical, industrials, consumer-related. The market seems to be the most jittery about those, therefore they represent the best bargains here. We also tend to be industry-oriented, and those that we like tend to be made up of small and mid-sized companies that are in the S&P Small Cap 600 and S&P Mid Cap 400. Just across the board, we'd say that the market as a whole would have to move 15 percent higher to get to fair value; the better bargains in our portfolios would have to move more.

How undervalued are the industrial and the cyclical sectors by your calculus? 25-30 percent. The only ones trading near fair value are the popular techs like IBM and Microsoft.

What's overvalued? Gold mining. And some of the semiconductor and semi equipment stocks, but not all.

So that's what you're short? We do have a long/short fund and our short positions are in those three industries.

How's it been doing? Very well this year. The short positions have benefited during this choppy market. It's beating our fund that has a similar makeup but does not short, so the shorts have contributed.

Meanwhile, you're using the correction to buy stocks when they're on sale? That's a good way to put it. This just looks like an overreaction to a combination of interest rates, inflation, and oil that looks like it's gone pretty far.

What makes you so sure you're not out there trying to catch falling knives? I don't have any quantitative proof. I am just going on the valuations and the general feel of the market. Over the last 23 years, every time there was an oil spike, people would worry inflation was coming back. But they were always wrong. Given that pattern, I think it's safe to be on the side that says they're probably wrong again, until it's proven that that's not the case.

I take it your stock valuation methodology is strictly quantitative? Yes, we try to keep emotions out of it.

Does your work give you any sense for how much longer the stock markets will stay mired in this range? I'd just be guessing there, but it sure feels like it's near the end. Just because of some of the sentiment indicators. But we don't attempt to time short-term moves.

Let's hope you're right. Thanks, Craig.

Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co.., L.P. Greenwich, Conn. http://welling.weedenco.com

The SEC's efforts to reform penny stock

fraud have come under fire from Nasdaq, which says the present regulatory structure is better than the agency's proposed amendments.

Nasdaq, in a comment letter to the SEC, also singled out the American Stock Exchange in this effort. Under the SEC's proposals to adopt "the baseline exempting standards" of the Nasdaq SmallCap listing criteria as of January 2004 – and to grandfather national exchanges registered since April 20, 1992 – the SEC is making a mistake, Nasdaq contends.

"Nasdaq notes that the American Stock Exchange's initial listing standard for price is $3.00 per share, whereas the Nasdaq SmallCap Market standard is $4.00 per share," states Edward Knight, executive vice president of Nasdaq.

Nasdaq argues that this arrangement would allow an issuer with "laxer standards" to get an exemption from the penny stock rules instead of selecting a superior market.

The Amex disagrees. Michael Ryan, general counsel at the Amex, in a rebuttal sent to the SEC, said that the amendments would not result in "regulatory arbitrage or encourage issuers to choose an Amex listing."

"Further, the contention that SmallCap is a more transparent, liquid or better regulated market is without merit," Ryan stated.

And he added: "The Amex takes its regulatory responsibilities extremely seriously, and has, particularly over the past year, taken significant steps to substantially improve its regulatory program and oversight of the program."

Short sale restrictions reform could eventually be in place – permanently.

The Securities and Exchange Commission, deliberating on reforming the rules of short selling, has agreed to implement a pilot project. This will waive short-sale curbs for 1,000 Russell 3000 stocks.

One pro thinks the exemption could easily become permanent. "We already have this exemption in part because Nasdaq market makers are exempt today," said Jamie Selway, managing director of New York-based Whitecap Trading. He noted that Archipelago had been operating without a bid test "and everything worked just fine." Selway is a former economist at Archipelago.

The marathon demutualization of the Pacific Exchange (PCX) is finally completed. It took some five years with the recent approval of the California Department of Corporations concluding the last part of the review. PCX officials have said the demutalization structure makes sense because it will give them more flexibility. More importantly, the new structure will likely mean the PCX can raise more capital.

Todd Ehret has traded high-yield, value, tech and biotech stocks.

His latest focus is a volatile and challenging universe: small-cap and mid-cap technology stocks.

Ehret is the head technology trader in the hedge funds group at Robeco USA, a division of Robeco Group, one of the largest asset managers in Europe. Ehret trades for one market-neutral hedge fund and a long-biased hedge fund. He writes 50-75 tickets a day. Still, he often can't buy an entire position outright since the small-cap and mid-cap stocks he trades aren't liquid enough. "I may be buying or selling the same name day in and day out for weeks on end in order to build a position," he says.

Robeco Group, a subsidiary of Rabobank, manages $135 billion worldwide. The hedge fund unit that Ehret trades for in New York City, manages more than $1 billion. Before joining Robeco in June 2003, Ehret was at Eos Partners, another hedge fund based in the Big Apple. On the day of this interview, Ehret bought 25,000 shares of a stock that traded 31,000 shares for the session. Ehret essentially accounted for the volume. "I bought it carefully and at the price I wanted it at," he says. "I'm not going to chase a stock up because somebody buys it stupid or sloppily." Over the previous month, he had accumulated 300,000 shares of the stock. He still had more to buy.

The short positions held by Robeco's funds tend to be in larger, more liquid names and have a more short-term orientation. "The portfolio managers tend to look for a catalyst or event on the calendar near-term," Ehret says.

Ehret now trades less with the Street and more on ECNs. "I can probe the depth in Archipelago, Brut, INET – all the ECNs – almost at the same time," he says. "I do it virtually instantly without showing my hand. And I don't have to be on the phone with five different market makers worrying about whether a market maker is trying to pick me off, or whether somebody at a brokerage firm is showing my order to the world." Ehret says he gets 'pennied' on the machines, but that the price improvement has been dramatic. Before decimalization, he would sometimes pay up 3/8th of a point, or a stock would run up 5/8th of a point before he was done. "That's 38, or 62, cents," he says. "Now a stock moves 13 or 14 cents and you sometimes get frustrated. But in reality that's only an eighth of a point."

Robeco uses an order-routing system, ROX, designed by Lek Securities, to gain access to a number of marketplaces. In a typical trade, Ehret tries Archipelago Exchange first, since it has a "nice feature" that allows him to display a few hundred shares and put tens of thousands behind the order, he says. It also refreshes itself continuously. INET, however, is more active pre-market and after-market, Ehret notes. So on these occasions, he opts for INET.

Ehret uses brokers in limited situations. He will go to the sellside when he sees brokers advertising on AutEx, or on another system that they are a buyer or seller in a name. Ehret also uses brokers "in size situations." For instance, he will use the sellside, "when a broker calls and says they're a holder of a name, or that they're in touch with a size position."

A portfolio manager at Robeco, for example, may have heard from a company that a former director or a large shareholder is selling stock. He may have learned that there are, say, one million shares for sale through a broker. "I bought stock today that a company was selling for some employees," Ehret says. "It was option-related selling, about 180,000 shares. I ended up buying two-thirds of it." In those cases, he noted, he must go to a Street broker since the broker is representing the other side.