The Changing Face of ECNs
The impending launch of Nasdaq's improved trading system, called SuperMontage, is driving electronic communications networks (ECNs) - platforms which transact up to 50% of Nasdaq's business - to consider alternative products, partnerships and ways of operating.
Already two of the largest ECNs - Archipelago and REDIBook - have merged and combined with a traditional stock market, the Pacific Exchange (PCX), to create a new stock exchange.
Both Island, another ECN, and Archipelago say they will list derivatives products soon; and rumours about further consolidation among ECNs, and merger talks between ECNs, such as Instinet, and traditional stock exchanges abound.
So, what do these developments say about the nature of the ECN business? Is the ECN model sustainable or merely a symptom of deeper problems in the US equity markets which might be resolved by traditional exchanges, taking away the need for ECNs altogether?
ECNs currently provide one of several ways to trade Nasdaq-listed shares. Firms can also trade through market makers, sometimes called specialists, and also via order entry firms which enter and execute orders through Nasdaq on behalf of clients.
There are around 500 market makers on Nasdaq and they buy and sell shares using their own funds. ECNs argue that market makers do not offer customers a neutral service since they also trade on their own account, so they can effectively trade against their customers. ECNs, on the other hand, do not trade for themselves. They operate electronic order books whereby clients can trade directly with one another rather than with a market maker. The idea is that since customers are trading directly, dealing is cheaper. ECNs are basically matching mechanisms.
Some ECNs feel their business will be threatened by the launch of SuperMontage because it will offer clients more ways to execute orders and potentially attract more to deal direct on Nasdaq, rather than through ECNs. However, Nasdaq seems to value the business ECNs bring to the markets, and it has been negotiating with the ECNs to convince them to link to the new system to guarantee liquidity from its launch, which is due at the end of July 2002.
But some firms have already opted effectively to get out of the ECN business altogether. Archipelago, for example, has recently started ArcaEx with the PCX. ArcaEx, an electronic stock exchange has replaced the PCX's 120-year old trading floor, and it began trading with 27 stocks listed in March 2002. The combined order books of Archipelago and REDIBook will gradually be phased out as more stocks are added to ArcaEx, and no stocks will be available on both ArcaEx and the ECNs at the same time. But the transition process will take time. The two ECNs do not expect to finish combining their order books before the third quarter of the year, and then they will migrate securities on to the exchange.
Nevertheless, Archipelago clearly sees becoming an exchange as the next step in ECN evolutions. "Becoming an exchange will offer Archipelago more revenue sources, including revenues from listing," says Sam Long, general manager of Archipelago, Europe.
Once ArcaEx has established liquidity in share trading, it plans to list more products, possibly including single stock futures, options, and futures and options on narrow-based indices. But the priority is generating liquidity in its listed stocks.
Meanwhile, Island, now the largest ECN on Nasdaq trading some 18% of Nasdaq volume in February 2002, compared with 11% for Instinet, the second largest ECN by volume, has more immediate derivatives plans. The platform's proposed derivatives exchange, the Island Futures Exchange, received regulatory clearance in February 2002, and it plans to begin trading by the end of June. The exchange will offer trading in single stock futures through the same matching and execution platform as its parent. Island, which developed the trading system in-house, says new products can be added to the platform quickly and easily. It has already arranged for clearing to be provided by the Options Clearing Corporation (OCC), which is used by all the major US options exchanges, and regulatory services for Island Futures will be provided by the National Futures Association.
"Opening a futures exchange seemed a natural step for Island, and the route to do so was opened with legislation passed last year which allowed us to become a contract market," explains an Island spokesman. Island is happy with the ECN side of its business and says it has no plans to merge with or become a traditional stock exchange. "We're really focused on increasing our Nasdaq business at the moment. Island trades up to 40% in the QQQ ETF [an exchange traded fund based on the Nasdaq stock index], and we want to emulate that success in other securities," the spokesman adds.
Island is not only increasing its share of Nasdaq business, it is also putting pressure on Nasdaq to change the way it deals with ECNs. In March this year, Island teamed up with the Cincinnati Stock Exchange in a so-called "market data revenue sharing plan", and this is apparently one of the reasons Nasdaq is reviewing how it handles revenues from data sales. At the moment, ECNs have to report their trades to a stock exchange, usually Nasdaq, so prices transacted on ECNs can be transmitted to the market as a whole. Nasdaq charges ECNs to report prices, and Nasdaq then sells the data to various vendors such as Bloomberg and Reuters, keeping the revenue from these sales for itself. Island says it gets nothing out of this arrangement at all, so it now reports some of its trades to Cincinnati instead. The Cincinnati Stock Exchange shares the revenue it gets from data sales with Island, and Island passes on a third of this revenue to the securities buyers, a third to the sellers, and keeps a third for itself.
Meanwhile, the Brut ECN plans to make the most from the introduction of SuperMontage by linking to as many markets makers and other ECNs as it can. "Fragmentation will be the main issue surrounding SuperMontage so we want to provide our users with a one stop shop - a single platform linked to as many liquidity pools as possible," says Stuart Adams, director for institutional sales for Brut in London. Brut opened its London office in March 2002 to market its US share dealing to European traders. Once the ECN has established its London presence and dealt with the launch of SuperMontage, Adams says Brut may well consider listing futures and options.
As well as facing pressure from SuperMontage, competition is also hotting up between ECNs. Instinet, which was for a long time the largest ECN on Nasdaq, lost its top spot to Island early this year as Island cut its prices. In addition, Instinet has also recently lost its president and chief executive Douglas Atkin, who is leaving the company "to pursue other business interests," and Kenneth Marshall, the firm's chief operating officer, has also decided to retire. Mark Nienstedt, previously Instinet's chief financial officer, has been appointed acting president and chief executive, and Marshall will be replaced by Jean-Marc Bouhelier, executive vice president in charge of Instinet's US institutional and professional business.
Instinet made an initial public offering in May 2001, selling around 15% of its ownership, Reuters owns the remaining 85%. But Instinet's share price has since nose-dived to around $7 by mid-April 2002, from $14.50 at the IPO. Indeed, the firm does look a little stodgy with 2,210 employees, compared with just 80 at Brut for example. With ECNs trying hard to differentiate themselves from both other ECNs and what may be a new, improved Nasdaq, unless Instinet can provide a clear and positive indication of how it plans to develop its business, it may be left behind by the more nimble competition.
The situation for Instinet seems to parallel that of its parent Reuters. Once competition from Bloomberg shook up the data vendors, Reuters looked vulnerable. Similarly, Instinet - and indeed all the other "pure play" platforms - needs to consider how they can create a long-term valuation model. Those ECNs which morph into exchanges seem to be on a sensible route, although success is far from assured. The long-term need for execution platforms as an adjunct to traditional exchanges (and genuine new players in the entire exchange business) seems less clear. Nevertheless, it looks like an interesting period, although ECNs still look more plausibly likely to fit into a footnote of digital market history. |
