11/22/99 Fortune 251+ (Part I)
1999 WL 27633093
Fortune Magazine
Copyright 1999
Monday, November 22, 1999
Issue: November 22, 1999 Vol. 140 No. 10 Special Issue/ Businessman of the
Century
Features/Essays/Wall Street
Do We Need A Stock Exchange? People have predicted for 25 years that the
exchange will give way to some kind of electronic trading system. ECNs could
make that come true.
Carol Vinzant
American stock exchanges are now in one of those "In the future,
everyone will ride to work on monorails" phases. That's the stage
institutions pass through whenever a major shift in the business
environment leaves everyone uncertain how the future will work out
and scrambling to inject themselves into it somehow.
Today's stock market events certainly qualify as a major shift.
Electronic communications networks, or ECNs, are stealing market
share from the established exchanges; the exchanges, in turn, propose
to go public; Nasdaq and the ECNs threaten to become exchanges;
everyone wants to trade all night on the Internet; and while we're at
it, let's banish those funny fraction prices.
Behind all of this is a classic market share battle between a
group of technologically advanced upstarts (led by the ECNs) and
established brands like the New York Stock Exchange and Nasdaq. Think
of Amazon.com vs. Barnes & Noble three years ago, and you'll be close-
-although in this battle, regulation plays as big a part as
technology. The outcome is likely to be what it usually is whenever
competition intensifies: Profit margins will shrink (at least at
first), new alliances will be made, and customers will reap lower
prices and wider choice.
But there is also a more fundamental power struggle being played out here. The same forces that gave rise to ECNs--regulation, new
technology, and old-fashioned entrepreneurship--are slowly dragging
the center of the securities industry from the floor of the New York
Stock Exchange to an as-yet-unshaped electronic marketplace. That's
not going to happen tomorrow, it won't wipe out the NYSE, and it
probably won't make any perceptible difference in an ordinary order
for 100 shares of AT&T. But for those concerned about the long-term
fairness and stability of the market, this is the battleground.
To understand what turf is being contested here, let's review some
market basics. The stock exchange business, for all its jargon-
riddled, acronym-happy complexity, amounts to a simple matchmaking
enterprise. Trading is like dancing: You need to find yourself a
partner. To draw people in, the NYSE and Nasdaq have allowed
matchmakers to set up shop on their dance floors.
If these matchmakers can't set you up with another client, no
problem. They have the capital to hire a cadre of taxi dancers, and
they'll rent you one, earning a profit on the spread between the cost
of hiring the dancers and the rate at which they rent them out.
Taking part in the trade this way is much more profitable than
matching dancers directly. The prospectus for a recent IPO by
LaBranche & Co., a large NYSE matchmaker, revealed that the firm
partook in an aggressive 30% of the trades it handled, but those
trades accounted for 75% of its total revenue.
On the New York Stock Exchange, there's one matchmaker per stock--
the specialist. According to Salomon Smith Barney analyst Guy
Moszkowski, specialists enjoy an operating margin of an astounding
55%. On Nasdaq, competing firms known as dealers or market makers
cover each stock. (The average is 11 dealers per stock.) Lacking the
specialist's exclusive franchise, they have more modest margins of
25%. Both the market maker and the specialist agree to put up their
own money and maintain a buying (bid) and selling (ask) price for a
particular stock. That means investors can always count on being able
to trade--though they may not always like the price.
These matchmakers have two types of clients. Picture a guy walking
down the street yelling into his phone, "Buy Intel! Buy now!" He just
entered a "market order"--buy at the current price, whatever it may
be. This guy is the middleman's bread and butter. The other customer,
who places what's known as a "limit order," is a hassle. She'll only dance with guys with blue eyes and hairy chests, say, and she'll buy
Intel only at 70 or lower. These special requests go into the
matchmaker's "limit-order book," which used to be literally a paper
notebook. The ECNs that have so shaken the established exchanges are
nothing more than a cheap, fast, electronic version of that notebook.
The changes now sweeping the equities marketplace got their start
in 1975, the year fixed commissions were abolished. Congress ordered
the Securities and Exchange Commission to push Wall Street toward a
"National Market System." In this ill-defined platonic ideal of a
marketplace, information would flow freely, markets would compete,
and investors could meet without a middleman. The easy stuff got
done. For example, after some wrangling, the Intermarket Trading
System was put in place to link the NYSE with competitors like the
regional exchanges. But things stalled when the SEC started talking
automatic execution on an electronic system, which would eventually
cut the middleman out of orders. New York greeted that idea as
enthusiastically as the NRA embraces One World Government. Like
another idealistic scheme Congress proposed that same year, the
metric system, the plan was mainly ignored. And like a mom who
forgets she meant to send her punk son to Sunday school, regulators
let the issue slide.
Until Mom caught her little boy stealing. In 1994 Nasdaq market
makers were taped harassing colleagues who dared to make the bid-ask
spread too narrow. (In other words, they were enforcing a price-
fixing scheme.) The securities industry was busted. The punishment: a
$1 billion antitrust civil settlement--the largest in history--and
the SEC's 1997 Order Handling Rules, which were designed to set the
industry back on the righteous path toward the National Market
System.
Before these new guidelines went into effect, a market maker who
got a limit order he didn't like--that is, one that would hurt
profits--could ignore it, pretending no match was available. The new
rules required him to post limit orders on Nasdaq or send them to an
electronic communications network that would post them where everyone
could see them.
Back then, the only ECN of any consequence was Instinet, a network
in which institutional investors could trade in secret with each
other and with market makers. Suspicious of this private party, the SEC effectively forced ECNs to post their quotes on Nasdaq's
comprehensive trading bulletin board, known as a Level II screen. It
displays all market makers' and ECNs' best prices and quantities.
Buyers line up on the left and sellers on the right, with the best
prices at the top.
Allowing ECNs onto this system was a crucial change. Previously,
an ECN could stay in business only if it could attract both partners
to its dance floor. Once it was allowed to advertise trades on
Nasdaq, however, it just needed to supply one party. The other side
could come from anywhere else in the Nasdaq system. By forcing
Instinet into the public marketplace, the SEC had inadvertently flung
open the public marketplace to ECNs.
Day-trading firms, which for years had sought greater market
access to Nasdaq, rushed to set up ECNs. Island ECN (largely owned by
the online brokerage Datek), Attain, Archipelago, and NexTrade, for
example, all started off handling day-trading orders. Not to be left
out, brokerage firms and other traditional players backed their own
stable. REDIBook was launched by the NYSE specialist Spear Leeds &
Kellogg. Strike was started by Bear Stearns.
Altogether, the nine ECNs that are hooked up to Nasdaq's trading
system have captured an estimated 20% of Nasdaq shares traded, with
most of the volume going to Instinet and Island (see chart). The
growth rate has been phenomenal. ECNs have been capturing an
additional 1% to 2% of share per quarter, and experts predict that
they could take 50% of Nasdaq's business within a few years.
The ECNs all have different clientele and pricing structures, but
the basic formula is the same: They internally post the size and
price of limit orders they get from their subscribers and
automatically execute when a match is found. When a Datek customer
places a bid for 1,000 Microsoft at 90, the order is sent
instantaneously to Island, which scans its outstanding offers for a
matching seller. If it finds one, Island automatically completes the
trade. If not, the order will post on Nasdaq as soon as it becomes
Island's best Microsoft bid. Once it is there, anyone with access to
a Nasdaq screen can take it. "What we are is your gateway to the
National Market System," says Kevin Foley, chief executive of
Bloomberg's ECN, Tradebook.
One of the great advantages of this model is privacy. Internally, ECNs list only the sizes and prices of orders, not the identity of
the trader. On Nasdaq, orders are identified only by the ECN's name.
This is vital to institutional investors, who are frequently burned
by trading desks that "front run" the institution. To return to the
dancing metaphor, if an institution has a busload of dancers who want
red-headed partners, a matchmaker might run onto the floor and hire
all the redheads first, then offer them to the fund at a higher
charge. "Fear of front running and information leakage is the entire
electronic trading business," says Foley. In addition to anonymity,
ECNs automate some of the services that middlemen provide
institutions. For example, ECN software can let funds post large,
potentially market-moving orders in reserve. Charged with a 100,000-
share bid, it might coyly post a bid for 1,000 shares that will
automatically refresh itself or accept larger offers until all
100,000 have been accumulated.
What is confusing about ECNs is that they behave like a broker--
by taking orders and disguising trades--but they make money like an
exchange. When they take orders, ECNs charge a razor-thin commission
ranging from 0.0015 of a cent to 4 cents per share. Market makers, on
the other hand, rely on the spread, which is typically between 1/16
and 1/4 of a point (or 6.25 cents and 25 cents). When prices switch
to decimals next spring, the spread (and with it, market makers'
profit margins) will shrink.
ECNs are at the forefront of the highly publicized push toward
after-hours trading. Up to 40% of online trades are placed after the
market closes, when investors get home from work. But for now, these
nocturnal orders only pile up at trading desks for the following
morning. The result is an increasingly chaotic open that strains the
capacity of the current system and may not give investors good
prices. (So you should confine your own market orders to daylight.)
For the thinly staffed ECNs, however, extending hours is relatively
easy, and the prospect of building volume by absorbing some of the
nighttime overhang is hard to resist. The ECNs have formed a
consortium to share after-hours trade data so they can keep making
money after the established exchanges go to bed. Some ECNs already
operate after dark. Island, for example, trades from 8 A.M. to 8 P.M.
weekdays, and NexTrade never closes.
Building volume remains the critical job. According to Moszkowski,
most ECNs orders internally.
It takes volume to build volume: The best way to draw dancers to
your dance floor is to have plenty of other dancers. So, like new
Websites trying to attract eyeballs, ECNs will do anything to get
"liquidity," that is, limit orders in their book. Many have sold
equity to partners who can send them more orders. Archipelago now
counts Goldman Sachs, E*Trade, and American Century among its owners.
BRUT and Bloomberg's Tradebook get clients from brokers they have
already wired for their trading and information systems. BRUT also
announced plans to merge with Strike. Other ECNs pay for liquidity.
Island, for example, rebates 0.10 cent of its 0.25-cent-per-share fee
to anyone who places an order.
So far, ECNs have taken only about 4% of the Big Board's volume.
The chief reason: The exchange dominates trading in listed
securities, controlling some 84% of the share volume in those stocks.
The pool of liquidity is so deep that in 75% of the orders, buyers
meet sellers without the specialist taking a position as a principal.
On the Big Board, as in an ECN, volume begets volume. The NYSE's
volume also allows it to charge transaction fees that will be hard
for ECNs to undercut. In many trades, the exchange's and specialist's
fees come to less than 0.4 cent per share. So why go anywhere else to
trade NYSE-listed stocks?
Institutions have a good reason to look elsewhere--front running.
But a trusted specialist can provide unique insight. If you're a big
institution, a shrewd floor broker can judiciously parcel out your
trade to avoid moving the price against you. Their judgment and savvy
are something that no ECN computer can ever fully emulate.
Moreover, New York has shown in the past that it can adapt to
competition. In the 1970s broker Bernie Madoff popularized the third
market--in which nonmembers trade listed stocks off the floor--by
undercutting the exchange's then-thick margins on retail orders. The
NYSE responded by lowering fees. To compete, Madoff now pays half a
cent for trades sent his way. The usual estimate is that the third
market's share is about 10% of the volume in listed stocks.only generate enough traffic to match 5% to 10% of their |
