Nasdaq Plays Rough With Rivals
Peter Chapman
Nasdaq needs technology and scale to turn itself around. Will its acquisition of the Brut ECN do the trick?
The embattled market's $190 million all-cash acquisition of Brut from SunGard, completed in September, gives it both outbound routing and greater liquidity. And with its price cuts from earlier this year, Nasdaq believes it now has the three elements to stand up to its more fortified competitors: the Archipelago Exchange and the INET ECN.
"Now we have everything lined up," says Chris Concannon, the executive vice president in charge of Nasdaq transaction services. "We've built our product to the level, if not greater, of the services of Arca and INET."
For the time being, the Brut system will operate separately from the Nasdaq Market Center, formerly known as SuperMontage. The creation of a single trading platform will not take place for another 12 to 18 months, according to Nasdaq. Brut runs on Sun Microsystem's Solaris technology, which has the capacity to process 11 million orders per day. Nasdaq runs on Tandem's Himalaya servers and can handle 50 million orders per day.
For complete integration, Nasdaq has yet to settle on one of these platforms or something completely different. Nasdaq spent some $100 million to develop SuperMontage. Although it has yet to merge the two trading systems, Nasdaq has brought them closer. The full depth of Brut's book will now be visible in Nasdaq Market Center. Previously, Brut only published its top of book in Market Center.
"An order coming in to take liquidity on the Nasdaq Market Center will sweep its natural liquidity as well as the Brut liquidity," explains Concannon. "That creates a much better pricing environment or liquidity experience."
Full depth may not be such a big deal though. Market Center subscribers only get full depth if they pay for Nasdaq's expensive TotalView data feed. Not many do. If they don't, they only get participants' best quotes. And, typically the shops that subscribe to TotalView also subscribe to Brut. As for orders coming into Brut, those that don't immediately fill can use Brut's order routing technology to automatically check Nasdaq Market Center. Brut was routing out unfilled client orders prior to the acquisition, but "on a limited scale," according to Concannon.
Finally, the speed of interaction between the Brut book and Nasdaq's book is slated to improve, says Concannon. "When you move the Brut match system into the Nasdaq data center, the two books are just closer together and the interaction happens quicker," the exec says.
The construction of this virtual book,' as Nasdaq is calling its two-platform offering, gives Nasdaq parity with INET and Arca. Each of the three major market centers now controls roughly 20 to 25 percent of all executions in Nasdaq stocks. Nasdaq does not like to dwell
on those numbers, though, preferring instead to highlight its share of prints. That figure was 53.5 percent on a recent day in September, according to data from the Wall Street Journal.
The National Stock Exchange - to which INET reports - has a 25.1 percent share while ArcaEX handles 20.7 percent. (Brut, which used to print on the Boston Stock Exchange, accounts for 11 percent to 12 percent of the Nasdaq total.)
Nasdaq is able to claim a larger share of prints over executions because most trades conducted internally by Nasdaq market makers get reported to Nasdaq. After Nasdaq, Arca and INET, most orders are filled internally by Nasdaq market makers.
Nasdaq emphasizes its share of prints rather than executions when pitching to potential issuers, but most of the money is made in trades. In 2003, the last year for which such data is available, Nasdaq recorded $78 million in transaction revenues versus $47 million in trade reporting fees.
The addition of Brut will automatically goose those numbers. The addition of Brut's liquidity could drive even more executions if traders rate their chances of execution higher on a bigger Nasdaq. Concannon notes one of the reasons traders opted to trade elsewhere was Nasdaq's smaller book.
An industry observer and Nasdaq customer sees a boost. "This deal will definitely help Nasdaq shore up its market share," says Jeff Brown, director of product development at electronic brokerage UNX. "They had been losing to INET and Arca."
Black Box
Of the customers Nasdaq won with its acquisition of Brut, most were already customers of Market Center. Brut, originally an ECN for market makers, had, in recent years, found success with the electronic brokerage and black box segment.
Driving the black boxers into Brut's arms, sources say, was the merger of Instinet and Island. Black box traders fare better in a fragmented market, specifically one with four venues. They therefore found it in their interest to support another system.
Ironically, history may be repeating itself. The ECN NOCI, owned by Domestic Securities, once an also-ran, has seen a spurt in volume since the Nasdaq-Brut deal was announced.
Nasdaq started to court this fast-draw crowd when it added FIX connectivity and post-trade anonymity to SuperMontage last year. Although its customer list overlapped with Brut's, the ECN was by far the more popular. "The client lists were identical," says Concannon. "The most active list was not. They've done well in some accounts we haven't."
A bigger book was not the only reason Nasdaq bought Brut. Both of Nasdaq's chief competitors offer their customers outbound routing if their orders fail to fill on their books. Nasdaq never incorporated smart order routing technology into SuperMontage because SuperMontage was intended to be the great aggregator. All electronic books would display there.
The error of that strategy was made plain when INET and Arca abandoned SuperMontage shortly after it was launched. Both organizations pledged to send their customers' unfilled orders elsewhere while Nasdaq could make no such promises.
Trading shops, especially smaller ones without book aggregation software, snubbed Nasdaq for Arca or INET. "They had a gap in outbound routing," says Brown.
Concannon adds: "A number of customers who were using Arca's or INET's router said they needed a routing offering in order to put any orders on our system."
Despite the prevalence of book aggregation and routing software such as Lava or FutureTrade, many trading houses prefer to connect directly to a book and let it do the routing. Connecting to all the different market centers is simply too costly. And cost is not just an issue with small firms. "Even some of the largest," says Concannon, "who have a variety of different technology needs may not want to spend money connecting to all the different destinations."
Nasdaq has been mulling smart routing technology for at least a year. Last year, it struck a deal with Instinet for the use of its smart routing technology. The plan was never implemented and is now unnecessary. Nasdaq will incorporate Brut's routing technology into Market Center.
Technology is not the only issue. Nasdaq is a self-regulatory organization. SROs are not allowed to route orders to one another. Only broker dealers can route to SROs. Therefore, even with Instinet's technology, Nasdaq could not legally route to ArcaEx.
ArcaEx got around the same problem by creating a broker dealer called Archipelago Securities. The subsidiary is a member of Nasdaq as well as the New York Stock Exchange. In other words, until now Arca could access Nasdaq's liquidity, but Nasdaq could not access Arca's. In Brut, however, Nasdaq gains a broker dealer. Brut is a member of ArcaEx. It is also a subscriber to INET. And soon, Nasdaq will use Brut to join the New York Stock Exchange!
In conjunction with the acquisition, Nasdaq will contract with SunGard for the clearing and settlement of all of Brut's trades. As Brut remains a broker dealer it must clear and settle its trades. Brut uses SunGard's Phase3 system to do so. "The clearing contract has a limited lifespan," says Concannon. "Over time, when we move to a single platform, we won't need to clear."
Pricing and Profits
Now that the Nasdaq market has shrunk from four to three major books, will prices go up? Nasdaq cut its pricing sharply earlier this year, but is mum on future plans. "Our intention is to be the price leader," Concannon says, "but you can never know what will happen in the future."
Brown of UNX sees price increases as unlikely. In fact, a look at history suggests just the opposite. "Consolidation has been a reality in this space for years now," Brown says. "And we've seen prices go down, not up. As people get scale, they tend to follow with a price cut as a way to attract volume."
Concannon does not appear overly worried about the current level of "price compression," noting that with the proper scale even a commodity business can be profitable. "The cost of delivering the match technology gets cheaper over time," Concannon says. "Once you've met your fixed costs everything is profitable."
Everything is relative though. Brut, an aggressive price-cutter, was probably not profitable enough for SunGard, some observers say. Bryan Keane, an analyst with Prudential Equity Group, considers the sale of Brut a "modest positive" for SunGard as the divestiture should improve SunGard's margins. "Brut has structurally thin margins that are compressing SunGard's overall Investment Support Systems margins," the analyst wrote in a report earlier this year.
Nasdaq badly needs profitability. The market lost $105 million last year on significantly lower revenues. Nasdaq has shed businesses and employees furiously in the past year in an attempt to concentrate on its core executions business.
Revenues in 2004 are running at $500 million on an annualized basis. That's down from $850 million in 2001. Revenues from transactions, access and trade reporting are also sharply lower this year. In the first six months of 2003, they came in at $134 million. In the same period in 2004, they were $95.6 million. Expenses have also declined. It had 870 employees at mid-year, down from 1,290 in March 2003. Brut adds about 60 staffers to Nasdaq, although there has been at least one casualty on the Nasdaq side. Steve Blatney, Nasdaq's head of sales, was replaced by Brut president Brian Hyndman.
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