Article as reported in the NY Times
February 28, 1999
Sailing Into Murky Waters: Trading
Network Woos Wall Street
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By GRETCHEN MORGENSON
hrough the biggest bull market in history, Gerald D. Putnam
struggled as a stockbroker. Starting in 1981, he bounced around 7
firms in 12 years.
Then the Internet changed his fortune. Last month, Goldman, Sachs
and Etrade came calling, each putting up $25 million for a 24.5 percent
stake in his young stock trading network called Archipelago. The deal
also values Putnam's quarter of Archipelago Holdings at roughly $25
million.
Call it vision. Putnam, now 40, says he determined two years ago that
the future of investing was nothing but Net. With partners from a
Chicago software firm called Townsend Analytics, he created
Archipelago, an electronic network designed to provide investors in
NASDAQ shares with an alternative, lower-cost market in which they
could meet and trade stocks.
But even as he summons the respect and the resources that so long
eluded him, Putnam appears to have drifted into murky waters. The
brokerage firm he owns, Terra Nova Trading, which directs trades to
Archipelago, has skirted some industry regulations and engaged in
questionable practices.
Two of its 12 branch offices make payments to Internet chat rooms that
send paying customers to them, an arrangement that the firm calls
advertising but that may run afoul of Securities and Exchange
Commission rules. These two branches also arrange loans for customers
who need to raise money to satisfy margin requirements -- the rules
limiting how much borrowed money a stock purchaser can use in a
transaction.
Excessive borrowing puts an investor at risk when stocks fall; such
leverage is a growing concern among state securities regulators. In
addition, a man who Putnam said "runs the office" at one Terra Nova
branch is not registered with securities regulators, a requirement for
someone who solicits clients and deals heavily with customers. There
are also questions about Putnam's trading practices at Terra Nova's
headquarters in Chicago.
Putnam called the suggestions of impropriety nonsense. "I've been in
business 17 years, and there's not a mark on my record," he said. "It's
not my idea of starting a crime spree here. I've not risked anything
before, and I don't have to. I've got a great business."
While the brokerage firm is separate from the Archipelago network,
there are rumblings of dissatisfaction with Archipelago as well. Some
knowledgeable, frequent traders are complaining that they are not
getting the best possible prices by using the network. And one
professional trading firm says it has chosen not to offer Archipelago to
its clients.
The reports conflict with Archipelago's promise of a low-cost, instant
service for investors, while the Terra Nova practices are a reminder of
how treacherous the waters can be for online traders and companies
eager to stake Internet claims.
utnam was certainly prescient when he latched onto Internet
trading. Dirt-cheap commissions at online brokerage firms, and
sophisticated software systems that speed customers' orders to the
markets, have combined to make stock trading the best business on the
Internet.
Electronic trading is now used for one in four stock transactions made
by individual investors. Much of this trading is executed on electronic
communication networks like Archipelago.
There are eight such networks, known as ECNs; seven of them were
created within the last three years. Their goal is to cut out the
intermediaries between buyers and sellers in stock transactions.
NASDAQ stocks are their primary business. Unlike the New York Stock
Exchange, the NASDAQ market does not have a central trading floor;
this allows many dealers to "make markets," facilitating investors'
trades in its stocks, including today's sizzling technology offerings like
Excite, Ebay, Amazon.com and Yahoo.
The portion of NASDAQ stock trading executed by electronic
communications networks is estimated at more than 20 percent.
Trading volume now exceeds that of the American Stock Exchange and
all the nation's regional stock exchanges combined.
Archipelago, or Arca, as it is sometimes called, is by no means the
biggest. That prize goes to Instinet, a network begun in 1969 to allow
mutual funds and other institutional investors to post orders
anonymously at prices inside the wide spreads -- the difference between
the "bid" prices offered by buyers and the "asked" prices that sellers are
willing to accept -- on NASDAQ stocks.
Instinet, a subsidiary of Reuters, now trades in more than 40 stock
markets around the world, including the New York Stock Exchange,
which is looking for a way to set up its own network to trade NASDAQ
stocks.
Most of the newer ECNs are, like Instinet, for institutional customers
only. But Archipelago and The Island ECN, owned by Datek Holdings,
an online brokerage firm based in Iselin, N.J., accept trades from
smaller investors.
These networks grew out of changes in the NASDAQ market made after
an SEC investigation in the mid-1990s. The most significant new rule
requires NASDAQ trading firms, known as market makers, to provide
posting on their trading systems for customer orders that fall between
the bid and asked prices.
In its 1996 report, the SEC found that investor orders between the bid
and the ask were rarely, if ever, displayed. As a result, investors had a
tough time meeting one another without the interference of a market
maker and wound up paying excessively to trade NASDAQ stocks.
Meanwhile, investors in stocks listed on the New York Stock Exchange
were meeting other investors 90 percent of the time without the
intervention of traders.
Enter the ECNs, which allow individual investors to post their prices
electronically and meet other investors willing to take the opposite sides
of their trades. Among the networks serving small customers, Island has
by far the biggest volume: some 2.5 billion shares were traded there last
year; Archipelago reported 650 million shares traded.
Though there are differences in the ways ECNs tally volume,
Archipelago is clearly much smaller. But it is expected to grow smartly
in the coming months, with the firepower of Goldman, Sachs and
Etrade. At the time of the deal, Goldman, Sachs said investing in
Archipelago was part of meeting its commitment to a broad array of
trade execution systems for its customers, while Etrade said it would
aggressively market the ECN to its customers.
Archipelago was a natural offshoot of Putnam's brokerage firm. He
founded Terra Nova in 1994 as a day-trading firm that used NASDAQ's
Small Order Execution System, or SOES, to capitalize on small
discrepancies between market makers' bid prices and asked prices in
various stocks. Then it grew into a cyberbroker, handling online trades
for individual investors through branch offices in White Plains and in
El Segundo and San Jose, Calif., among others.
Some of these offices also house what Putnam calls day-trading salons,
rooms that seat as many as 40 people who bring in their own capital and
trade furiously on line each day.
With a stream of orders from these brokerage operations, Putnam
seized on the NASDAQ changes to create an electronic network for
executing trades. "Our business plan was to provide immediate direct
access to the marketplace," he said.
With the brokerage firm and the electronic network, Putnam and his
partners do well. When two customers' orders are matched, Archipelago
earns a commission of one-half cent to 2.5 cents a share. If it matches 75
million shares a month, as it did in January, those commissions run
somewhere between $375,000 and $1.8 million a month.
Even bigger money comes from the charges levied on Internet customers
and day traders. Terra Nova receives about $7 a trade. Putnam says it
has 6,000 clients, who average 70 trades each a month; that pace would
produce almost $3 million a month in revenues.
The day after Archipelago's deal with Goldman, Sachs and Etrade was
announced, Putnam resigned as president of Terra Nova Trading to
focus full time on Archipelago. But he still owns Terra Nova.
He lives in the affluent Chicago suburb of Kenilworth and has a
vacation house in Wisconsin. Not bad for someone who describes his
career in the securities industry as "rocky" and says he was asked to
leave his brokerage job at Prudential Securities in 1993.
Terra Nova's biggest branch office is MB Trading in El Segundo. Ross
Ditlove runs the office, according to Putnam, and he answers
customers' questions about MB Trading on the Internet. He also
promotes the company to potential clients. He is not, however,
registered with securities regulators, a requirement for any individual
who deals closely with brokerage customers.
"We don't solicit customers," Putnam said when asked about the rule.
"There's no rule you have to be registered," he said, if you're not
soliciting customers.
Rules about who must be registered in the securities industry leave
some room for interpretation. The National Association of Securities
Dealers is fairly explicit. It says people soliciting on behalf of member
firms must be registered. Employees are exempt if they are strictly
clerical employees, if they are inviting customers to firm-sponsored
seminars, if they are asking customers whether they want to discuss
investments with a registered person, or if they are offering to send
sales literature.
nvestors who use Internet sites for advice may be surprised to
discover who gets a portion of their trades. MB Trading and
another Terra Nova branch office, the Executioner in White Plains,
have made financial payments to two Internet sites devoted to stock
investing, without disclosure, according to a person close to Terra Nova
who spoke on the condition of anonymity. The two sites are
Trading-places.net, which has a link with MB Trading, and
Pristine.com, which is linked to the Executioner.
In exchange for referring customers to MB Trading, the Internet site
receives $1 to $2 a trade from the branch office, the person close to
Terra Nova said, adding that the Executioner makes similar payments.
Trading-places.net states in a disclaimer: "We do not recommend any
particular broker(s)" or "brokerage firm." But in a section of its site
about software providers, a page pops up with this headline in bold type:
"Trading Places Recommends MB Trading." The recommendation is
technically for MB Trading's software.
Pristine.com is more subtle. In a question and answer section, Pristine
"strongly suggests" that active traders start at the Executioner. It
recommends the Terra Nova branch office several times. Only one other
firm is mentioned.
Neither Trading-places.net nor Pristine.com is registered with
securities regulators. While it does not comment on specific cases, the
SEC has stated in the past that registration would be required of any
person receiving a percentage of commissions or other transaction-based
compensation.
Putnam said any fees are part of an advertising arrangement.
"Per-trade payments are against policy here," he said. He went on to
describe the payments as advertising fees for putting a branch office's
banner on the Internet site. But advertising fees are typically flat rates,
not variable payments based on trading volume.
Chris Rea, who is the owner of Trading-places.net, denied that he
received payments for customers sent to MB Trading. Executives at
Pristine did not return a telephone call.
Some Terra Nova branches also arrange loans for their customers to
help them meet margin calls. These calls are triggered when a customer
has borrowed money to buy a stock and the shares drop substantially,
requiring the customer to deposit more money to make up for the
depleted value of the stock held in the account.
To customers who are overextended during the course of the trading
day, the Executioner offers access to what is called an overnight bank,
according to a customer who expressed surprise at the practice. The
firm, which is not a chartered bank, charges $100 daily to arrange the
loans, which help customers leverage their accounts. MB Trading
provides a similar service.
"I don't know what an overnight bank is," Putnam said when asked
about the practice. "Now I know customers lend one another money. If a
customer wants to loan money to another, we require signatures and
customer authorization. There is no facility here for lending customers
money that we orchestrate." Putnam likened the situation to a
customer borrowing money from a relative: "There's nothing wrong with
that."
ut excessive borrowing by investors, especially at day-trading
firms, is a concern among securities regulators, who worry about
how much money overextended investors stand to lose if their stocks
plunge.
Frank Zarb, chairman of the NASD, expressed concern early this month
that some firms were "extending credit inappropriately," by pooling
customers' capital. "It is not within the spirit of what should be our
mutual goal of protecting investors," Zarb said.
Another troubling issue involves Putnam's own trading practices at
Terra Nova's headquarters in Chicago. The firm uses a system called
Retail Auto Execution System, meant for retail customers only, to
capitalize on small discrepancies in prices of equity options from
exchange to exchange.
The system was intended to assure that small trades would be executed
promptly at fair prices. The Chicago Board Options Exchange, which
created RAES, and the Pacific Stock Exchange recently instituted
measures intended to prevent the price discrepancies.
An options account at Terra Nova belonging to Putnam's wife, Sharon,
has generated enormous profits using the retail execution system.
Putnam said the trading was not a problem because it was done for a
customer, his wife. "Only if you trade a firm's proprietary capital, you're
not supposed to use RAES," he said.
But a spokeswoman at the Chicago options exchange said that while
Putnam may be technically correct, he is "violating the spirit of the
rule," which forbids any broker-dealer from using the retail execution
system for the benefit of its accounts.
Putnam's crowning achievement remains Archipelago. It was designed
to have certain advantages over Island, the bigger but older system.
Instead of simply letting investors post their prices on the network in
the hope that another investor will come along who is interested in
buying or selling at the same price, Putnam's system allows an order to
leave the Archipelago network once it has been determined that nobody
is willing to take the other side of the trade. "We built Arca with a
best-execution model in mind," Putnam said. "We'll go out and get your
order filled."
But the system doesn't always work that way. According to several
veteran traders who were doing business with Terra Nova and had their
trades routed to Arca, market orders -- an eternity, in volatile NASDAQ
stocks. The veteran traders say they were then forced to take inferior
prices on their trades as the market moved away from the prices they
had originally sought.
Part of the problem with Arca is that it does not have the volume of
orders that a larger network like Island does. In January, Arca matched
75.6 million shares to Island's 864 million. So the chances of meeting an
investor interested in buying the stock you are selling, or the reverse, is
much greater on Island than it is on Arca.
Putnam said: "We weren't focused like other ECNs on generating lots
of orders on the system. We were concerned with execution." Of course,
orders could flood the system if ETrade or Goldman, Sachs begin
funneling customers' orders to Arca. But for now, trading on Arca
amounts to choosing a small, sparsely populated trading room instead of
a big, crowded one.
Garth F. Lansaw, a financial planner in Pennsylvania, says using Arca
impaired his investing results. Until last month, he had executed his
personal trades through Terra Nova and Archipelago. But he has quit
doing business with the firm.
Over six months, Lansaw said, many of his trades were not executed
when they were sent to Archipelago, even though they were placed at
the prevailing market price. Like many active investors, Lansaw has an
advanced computerized system, which allowed him to see the different
prices offered on stocks by trading firms like Merrill Lynch or Knight
Securities.
He cites several problems that came up when he was trying to sell 2,000
shares of Fore Systems last fall at the current asked price. "I'd see
15,000 or 20,000 shares go by without getting hit," he said. "In some
cases I was the only one sitting there" -- even though he had the best
price posted on the screen. After 30 seconds or a minute went by, the
price would change, he said. So to sell the stock, he had to lower his
price.
Even though Putnam assures customers that their orders will be
instantly routed elsewhere if they are not filled within the Archipelago
system, Lansaw says this did not happen. Other investors sounding off
on the Silicon Investor's site on the Internet tell similar tales.
utnam concedes that much of his time is spent educating
customers about how Archipelago works. "A lot of time these
people complain they're trying to buy some Yahoo at the current offer
and the thing's on fire," he said. "And we're sending it to a market
maker, and it doesn't get done. That's because somebody else beat them
to the punch."
Steven Goldman, a principal at Yamner & Co., a brokerage in Fairlawn,
N.J., executes trades for his firm's institutional and wealthy individual
customers. To make sure these clients get the best prices for their
trades, Yamner has links to 16 trading systems -- but not Archipelago.
"I found their pricing structure was prohibitive," Goldman said. "I didn't
like the technology, as to how it would link in."
Ever the entrepreneur, Putnam is not standing still. "We're going to
continue to expand our business," he said. "I want to start offering
products and services to the more traditional investors. There's still
room in that online space for more competitors."
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