Instinet, Datek Recently Held Serious Merger Discussions
By GREG IP and RANDALL SMITH
Staff Reporters of THE WALL STREET JOURNAL
Imagine a giant electronic marketplace that handles as much as one-quarter of all trading in Nasdaq stocks.
That is what Instinet and Datek Online Holdings have been pondering. The Reuters Group unit and Datek, who together boast the two largest electronic trading systems, recently held serious merger discussions that have since been dropped, according to people familiar with the talks.
Together, New York-based Instinet and Iselin, N.J.-based Datek's 85%-owned Island ECN account for two-thirds of the volume of stocks traded on electronic-communications networks. Indeed, the principle reason the talks didn't proceed further was antitrust concerns, according to people with knowledge of the negotiations.
It isn't clear if the discussions will be resumed. What is obvious: The talks underscore the pressure for consolidation as U.S. securities markets move increasingly toward electronic trading. Indeed, some senior Wall Street executives envision the day when all marketplaces, traditional and electronic, are joined in a megatrading arena.
Negotiations had advanced enough over several months for the two sides to agree to a "term sheet," say people familiar with the matter. Billed as a merger of equals, Instinet would have owned slightly more than half the unit, which would later have an initial public offering.
Representatives for Reuters, Instinet and Datek declined to comment.
ECNs are screen-based trading systems that automatically match buyers and sellers without market makers or stock-exchange specialists as intermediaries. Although regulated as brokers, they act more as stock exchanges and indeed pose a growing threat to the established markets. They handle a third of Nasdaq volume and a small portion of New York Stock Exchange volume. Four years ago, Instinet was the only ECN. Today, there are about a dozen, many with ownership stakes by major Wall Street brokerage firms.
Some of those firms' chiefs now believe the proliferation of ECNs have contributed to the fragmentation of trading among multiple venues, making it harder and costlier for buyers and sellers to meet. They have called for reforms to centralize more of stock trading.
Ironically, an Instinet-Datek deal would have been a big step in that direction with no effort at all from regulators. A recent report by Chase H&Q indicates that as of the fourth quarter, Instinet handled 43.8% of ECN volume and Island 19.5%, for a combined total of more than 63%. That amounted to a quarter of all Nasdaq volume. The combination would have been even more potent than these numbers suggest, since the pooling of so much "liquidity," that is availability of buyers and sellers, would have been a magnet for additional liquidity. By gaining critical mass, they could have been a serious challenger both to Nasdaq and the Big Board.
The merger would also have helped both Instinet and Datek plug their respective strategic holes. Instinet has long been the primary ECN to which institutional investors and brokers send orders, but it has been losing part of that market to others. Its chief executive, Doug Atkin, has been repositioning Instinet from an ECN to a global agency brokerage, while making strategic investments in complementary businesses, such as online underwriter W.R. Hambrecht & Co. He has also set up a retail brokerage, but because it lacks a natural customer base, has turned to partnerships, such as with E*Trade Group to acquire order flow. By joining with Datek, Instinet at a stroke would have acquired one of the largest online broker's retail-customer base, infused its ECN with Island's enormous small-order liquidity, and gained access to Island's highly regarded Internet-based technology.
For its part, Datek has been looking for a way to give Island a presence with institutions and brokers. Last year it had conversations about a combination with Brass Utility, an ECN in which Morgan Stanley Dean Witter, Merrill Lynch, Goldman Sachs Group and Knight/Trimark Group all have small stakes, although the talks never became serious, according to people familiar with those talks. Instinet would have given Island access to a sales force, a global presence and valuable real estate on traders' desks that it will now have to acquire on its own. It is in the process of setting up an institutional service.
Joining with Instinet might also have enabled Datek to finally put its history of run-ins with regulators behind it, a history which has helped derail previous deals.
Datek's old Datek Securities unit, which specialized in rapid-fire trading through the Nasdaq Stock Market's small-order execution system, was censured and fined several times during the 1990s by the National Association of Securities Dealers for infractions ranging from trading-rule violations to excessive cursing. The old securities unit since has been sold.
Datek Online scrapped plans for an initial public stock offering last year amid publicity over investigations by the Securities and Exchange Commission and the U.S. attorney in Manhattan. Authorities were examining trading and lending practices at the old Datek Securities unit, Datek officials say. After the aborted IPO, Datek efforts to sell itself to rival E*Trade Group collapsed after off-and-on talks broke down, people familiar with the matter say.
In June 1999, Vulcan Ventures, a venture-capital fund run by Microsoft cofounder Paul Allen, pulled out of a planned $50 million investment in Datek; a Datek spokesman conceded at the time that the firm's history of regulatory troubles may have contributed to Vulcan's decision.
Despite their different pedigrees, the current management at Instinet and Datek share the same philosophy about the future of the markets. Both believe investors are best served trading directly with each other in a transparent, electronic market rather than through a market maker or exchange specialist. Datek is the only major online broker that doesn't sell its customers' Nasdaq orders to market makers.
Despite the apparent setback to Instinet and Datek, many on Wall Street believe ECNs are poised to take an increasing role in the nation's stock trading.
In a January report on Island, Sanford C. Bernstein analyst Steve Galbraith said: "As retail investors continue to wag the trading dog and technology enables rapid market-share gains by completely new participants, we believe previously entrenched competitors in the trading chain [specialists, market makers and even exchanges] are now at risk" of being replaced.
Write to Greg Ip at gregory.ip@wsj.com and Randall Smith at randall.smith@wsj.com |
