Gary, another interesting article on ECNs. From Red Herring.
A closer look at Island and
Archipelago
By Sarah Lai Stirland
Redherring.com
September 11, 1999
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.
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.
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