Jay Beee Ohhhh (baby) Haych is toast: "Electronic-Trading Firms Generate Buzz, Few Bucks
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
When Track Data Corp. announced a month ago it was joining the
electronic-trading fad and building an "electronic communications
network," or ECN, its stock jumped 35%.
So just how much does the Brooklyn, N.Y.-based concern, better known
for options data and online brokerage, expect to make off its ECN?
"I have no idea," says Chief Executive Officer Barry Hertz. "I really haven't
given it any thought." But it certainly won't put his money-losing company
in the black any time soon.
ECNs are clearly changing the landscape on Wall Street, grabbing a 33%
share of Nasdaq Stock Market and a smaller, but growing, share of New
York Stock Exchange volume with their innovative technology and low
costs. The excitement has enabled some to earn enormous valuations from
investors.
The problem is, most aren't generating a lot of revenue, never mind profit.
ECNs are relatively simple devices. They electronically match buyers and
sellers of stock, a job historically done by stock exchanges, but ECNs
have no dealers to intervene.
But matching orders just isn't where the money is on Wall Street. While
ECNs claim to match orders more efficiently than the traditional players,
most analysts believe it's still a commodity business with limited earnings
potential.
The oldest and by far biggest trading system, Instinet Corp., a unit of
Reuters Group PLC, had revenue of $634 million in the first nine months of
this year, comparable to that of a midsize brokerage firm. And while
Instinet boasts pretax profit margins of 31%, they are slipping in the face of
competition from cheaper ECNs, a factor that has helped batter parent
Reuters's stock since September.
Hugely successful Island ECN Inc., majority-owned by Datek Online
Holdings Corp., executes as many as 100 million shares a day. But
transacting such staggering volumes generated revenue of just $14 million
in the first nine months of the year, based on its typical net commission of
$1.50 per 1,000 shares (a fraction of Instinet's).
In spite of that, Island was valued at $200 million in a private placement
earlier this year. President Matthew Andresen says Island will lose money
this year due to expanding payroll and marketing expenses, but expects it
to be profitable within 18 months.
Then there's Chicago-based Archipelago Holdings LLC, which only has an
estimated one-third of Island's volume. But, based on a round of private
placements with investment dealers and General Electric Co.'s CNBC unit,
it has a valuation of about $400 million, estimates Sanford C. Bernstein &
Co. analyst Steve Galbraith. That's more than 10 times current revenues,
he says. Archipelago, which plans to go public, says it's roughly breaking
even now.
"No one is making a lot of money now," says Mr. Galbraith. "They all say
when we get to scale we'll make more money," but they can't all get to
scale. Since buyers and sellers ultimately need just one big market on
which to meet, "It is inconceivable ... that the current environment of nine
or 10 ECNs is tenable," Mr. Galbraith says in a report, predicting the total
will quickly fall to one, "maybe two."
Bill Burnham, a partner at venture capital fund Softbank Capital Partners
LP, figures that for Archipelago to justify its valuation, it would have to
vanquish most of the other ECNs and take a sizable chunk of the Big
Board's and Nasdaq dealers' market share.
But that hasn't stopped new ECNs from popping up. Two of the nine
existing ECNs -- Brass Utility LLC, majority-owned by Sungard Data
Systems Inc., and Strike Technologies LLC, owned by a group of
brokerage firms -- did say a month ago they would merge. But within
weeks, three new ECNs were proposed.
Certainly, all think they have something to offer. The backers of Nyfix
Millennium LLC, an ECN launching next year that is jointly owned by
Nyfix Inc. and a group of securities brokers, say it can take a chunk out of
the Big Board's volume because Nyfix Inc. already operates the wires that
connect many trading desks to the floor.
Meanwhile, in Winter Park, Fla., Bob Semones, head of GlobeNet Corp.,
is planning a niche strategy by starting an ECN early next year dedicated to
small, thinly traded companies. Current ECNs mostly trade "high-volume
Nasdaq stocks." His system will provide investors with as much
information as possible about small companies.
But others, like Mr. Hertz of Track Data, concede there isn't much to
differentiate ECNs. "I don't feel we can offer a lot more than other
people," he acknowledges, but then says, "we don't think putting this ECN
together is extremely expensive."
If matching orders isn't so lucrative, why are so many savvy Wall Street
firms pouring money into them?
"I don't think any of the firms that have invested in ECNs are doing it
because they think they're going to make a lot of money," says William
Harts, a managing director at Citigroup Inc.'s Salomon Smith Barney unit,
which has invested in several trading systems. "Rather, we're trying to
influence the direction that the equity market structure will take in the
future."
REDIBook ECN LLC has assembled an impressive array of backers,
including Charles Schwab Corp. and Donaldson, Lufkin & Jenrette Inc.
But to them, says acting CEO Larry Leibowitz, REDIBook is just "a utility,
a way to cut their costs. This is not a venture-capital investment."
Greg Smith, an analyst at Hambrecht & Quist, says it's too narrow to think
the value of an ECN is only in matching stocks. "There are other potential
revenue sources: market-data fees, analytics, and products outside of
equities." Instinet, he notes, has been transforming itself from an ECN to a
"global agency broker" that charges higher fees in return for more
sophisticated trading services. Archipelago, which like Island has filed to
become a stock exchange, hopes to one day list companies. Listing fees
are a major source of revenue for the New York Stock Exchange and
Nasdaq.
But then, there may be ultimate limits on how much business they can
garner. Last year, the Big Board and National Association of Securities
Dealers, Nasdaq's parent, had combined revenue of $1.5 billion, and most
of that came from listing, regulatory and data fees. Most of the fees
associated with trading on the Big Board and Nasdaq are charged not by
the exchanges but by their member dealers.
Both are watching the ECN threat; the Big Board is building its own ECN
for small orders and is slashing the commissions its floor specialists charge
to execute orders, while Nasdaq is building a centralized trading system to
do what ECNs do.
Indeed, notes Bernstein's Mr. Galbraith, ECN investors seem to think the
Big Board and Nasdaq won't have a competitive response, "and I think
that's a little naive, frankly." |
