A closer look at Island and Archipelago
By Sarah Lai Stirland
Redherring.com
September 11, 1999
herring.com
For the first time details of future electronic competitors of the New York Stock Exchange and Nasdaq were revealed, when two electronic communications networks (ECNs) filed documents with the U.S. Securities and Exchange Commission.
Archipelago Holdings and Datek Online's Island ECN have filed to gain full-fledged stock-exchange status. (Professional Investment Management's NexTrade ECN has also filed for exchange status, but its documents were not available at publication time.)
PALTRY NUMBERS
A first public glimpse at the numbers shows that the ECNs pose little threat. Compared to the major exchanges such as the NYSE and Nasdaq, the figures are paltry.
The NYSE rolls with the times and says it may go public.
Rival brokerages teamed up to form an ECN.
Island ECN bids to become an independent stock exchange.
For the calendar year ended in 1998, for example, Island ECN earned a net profit of $388,759 on $8.4 million in total revenues; total assets were $12.3 million. Island's resources have rapidly grown in 1999; it received $25 million this May from the discount brokerage TD Waterhouse Investor Services (NYSE: TWE) and an additional $30 million this July from the venture capital firms TA Associates and Group Arnault.
The existing stock exchanges have diversified revenue streams coming from membership, listing, and real-time stock quote fees, in addition to transaction fees. In contrast, it appears that Island's main source of revenue comes from transaction fees only. The most costly item on Island's expense list was its back office: in 1998, Island paid $3 million for clearing and brokerage fees, according to its filing. Next on the list was information technology: in the same year Island spent $1.7 million on communications and data processing.
The New York Stock Exchange, on the other hand, earned $101.3 million in profit on revenues of $729 million for this same period. Total assets of the NYSE added up to $1.3 billion; Nasdaq made $47 million on revenues of $740 million.
Data for Archipelago covers a different period, but the information provides a snapshot of the firm's operations, as well as insights into TD Waterhouse's investments into the trading network.
Detailed figures on Archipelago ECN's business do not appear to have been filed. Instead, the firm filed financial information for the overall holding company, its day-trading software subsidiary Archipelago Services, and its investment in the British electronic stock exchange, the Tradepoint Stock Exchange. For the period between January and July 31 this year, Archipelago was running at a loss of $43,000.
According to the filing, capital contributions from all of Archipelago's outside investors amount to $95 million (with Merrill Lynch's [NYSE: MER] contribution yesterday, that number would presumably add up to $120 million.) Each of the investors, with a few exceptions, sank $25 million into Archipelago Holdings. The exceptions are J.P. Morgan Investment Management (NYSE: JPM) at $33 million, Goldman Sachs (NYSE: GS) at $10 million, and Southwest Securities (NYSE: SWS) with almost $2 million. The other investors are Instinet, the ETrade Group (Nasdaq: EGRP), and Gerald Putnam himself and his affiliated software company, Virago Enterprises. Yesterday, Merrill Lynch joined this group, contributing $25 million.
Each of the investors, except for Southwest Securities, now holds a 14.2 percent stake in the firm. In exchange for the investments, Archipelago has agreed to give Goldman Sachs first dibs on the right to be the lead underwriter of future transactions such as an IPO, a merger, or an acquisition. J.P. Morgan, ETrade, and a broker-dealer affiliated with Instinet (probably W.R. Hambrecht) will also have rights to be part of the underwriting syndicate, according to the filing.
THE HEAT IS ON
Wayne Wagner, founder of the Plexus Group, a company that measures transaction costs and broker performance for asset-management firms, says that apart from the leading ECN -- Reuters's (Nasdaq: RTRSY) Instinet -- most of the action on the smaller ECNs is better suited to the individual investor than to large buy-side financial institutions such as mutual funds.
"All the old barriers are falling and we're getting a whole lot of competition that should benefit the investor," Mr. Wagner says. But on the part of institutions so far, "access to these things has been pretty minimal."
ECNs have gained much attention in recent months for their potential competition with the major stock markets, since they handle a fair amount of trading volume from many of the online brokerages. With the NYSE management decision this year to convert itself into a for-profit corporation, Dick Grasso, the NYSE's chairman and chief executive officer, announced that he was taking such competition to heart. Last week in a press conference, Mr. Grasso said that the growth of competition in all its amorphous forms "led to us to look at the exchange very differently," in order to prepare for the future.
Trading on the ECNs is currently limited to Nasdaq stocks, but exchange registration should provide the ECNs the ability to open up their trading to NYSE-listed stocks and would allow their systems to be plugged into quote consolidation and transaction mechanisms.
ISLAND IN THE STREAM
As Chris Concannon, Island's associate general counsel points out, there's still a long way to go before the ECNs become full-fledged exchanges.
For starters, the fact that SEC Chairman Arthur Levitt has questioned the ability of the NYSE and Nasdaq to act as self-regulatory organizations at the same time they become for-profit corporations has muddied the regulatory waters. Under new SEC rules on exchanges and alternative trading systems that went into effect earlier this year, market centers were given the option of either registering with the SEC as exchanges or broker-dealers. If they registered as exchanges, they were theoretically allowed to regulate themselves, just as the NYSE and Nasdaq's parent company, the National Association of Securities Dealers (NASD), do. "Our filing represents exactly that: a self-regulatory, for-profit exchange," says Mr. Concannon. But now that the SEC has tossed the rules up in the air, further deliberations on the topic may wait until after a Senate Banking Committee hearing on the topic of exchange demutualization, scheduled for sometime in the last week of September.
After SEC approval of the exchange applications, the ECNs will still have to gain approval from various exchange committees for access to the national market system -- a process that could be halted by a single veto from any one exchange on any of the committees. Optimark was the last company to try to gain access. Mr. Concannon points out that it took the company two years to overcome the NYSE's objections.
With the limited historical financial information in the SEC filings, and unreliable Nasdaq trading statistics, it's hard to determine how fast the networks are growing and how much of a challenge they will pose to the NYSE and Nasdaq. But experts conclude these organizations have a ways to go before they threaten the major exchanges. |
