Slotman Brought this to my attention. It was written up on Raging Bulls Home Page.
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N E W E C O N O M Y : 1 0 1
The Floorless Exchange of the
Future
December 8, 1998 - 4:15 PM
By Claude P. d'Hermillon, Jr.
Chat with Claude on the New Economy message board.
If you get a rush from trading stocks online today, wait until
you see what's in store for tomorrow's screen-based investor.
Last week's decision by the Securities and Exchange
Commission to essentially deregulate the way equities are
bought and sold is going to accelerate the development of
online stock markets, while eliminating the price advantage
institutional investors have long had over retail investors.
The regulatory body unanimously approved new rules governing
so-called alternative trading systems, those private computer
networks used to match buyers and sellers of stock without
the aid of intermediaries like NYSE specialists or Nasdaq
Market Makers. The net effect of this new system will be a
drastic reduction in order execution time along with a
contraction in stock spreads, the difference between a share's
bid and ask price, which middlemen have traditionally taken as
their cut for facilitating a transaction.
What's Ahead
The new system will also allow electronic networks to register
with the SEC as full-fledged exchanges. At the same time,
though, they'll be required to publish their stock quotes for all
to see, which is why analysts expect spreads to shrink. In the
past, when a customer has instructed a broker to buy a
particular stock, that broker has turned to a market maker,
which in turn sold shares to the broker for slightly more than he
or she paid for them. That difference, or the spread, has long
been a principal source of revenue for market makers across
exchanges.
Under the new regulations, though, alternative trading systems,
also known as Electronic Communications Networks, will
allow buyers and sellers to transact directly with one another,
bypassing market makers altogether. Eliminate the
middleman's cut, and you've got a system where sellers can
maximize their take while buyers can reap pennies-per-share
savings from not having to pay for a market maker's service. In
short, ECN's will level the playing field, allowing individual
investors to execute their own trades based on pricing
information previously available only to giant institutional
investors like pension and mutual funds.
Early Leaders
Right now, Reuters-owned Instinet is the reigning electronic
network, allowing institutional clients to trade literally around
the clock on 16 exchanges, including Nasdaq and the NYSE.
Then there's Datek Online's Island trading system, a
six-year-old network that lets individuals place orders directly
into the Nasdaq order system. In all, some 50 ECNs now
operate in the U.S., processing about four percent of all trades
made on U.S. exchanges. On the Nasdaq alone, roughly 20
percent of all transactions are processed through alternative
trading systems. Those figures, according to SEC projections,
are expected to triple during the next three years.
Instinet, meanwhile, has expressed an interest in following
Island's lead, offering retail investors the same service it now
provides to institutional clients alone. Though a myriad of
procedural obstacles would have to be surmounted for that to
happen, most industry watchers agree that an Instinet retail
product would not only threaten market makers' bottom line,
but also discount and online brokers as well. That's because
most brokerages today rely on order flow -- bounty-like fees
that market makers pay trading houses to send transactions
their way -- as a major stream of revenue.
Resistance is Futile
Traditional stock exchanges, too, fear the proliferation of
electronic networks because ECN orders are processed
outside of the established exchange systems. That allows
ECN's to avoid paying the exchanges their standard per-trade
fees. Especially galling to the exchanges of old, is the fact that
ECN orders will continue to be posted on traditional exchange
order boards.
Indeed, as these digital markets begin to take root, the
entrenched infrastructure will have to adapt. Certainly, jobs will
be lost. Like it or not, full-service brokers, for example, will be
forced to face the fact that their once value-added services are
fast becoming commodities, subject to cutthroat pricing
tactics. In other words, they'll have little choice but to follow
their revenue base as it migrates away from transaction fees
toward advice and guidance.
Meanwhile, average-Joe investors appear to have the most to
gain from this new order. In fact, one idealistic scenario
portrays retail investors, particularly trigger-happy day traders,
using highly advanced software to locate those stocks best
suited to their portfolios, then firing their orders off to whichever
exchange offers the cheapest execution.
Still, there is some concern that because market makers use
their own capital to ensure liquidity in particular stocks -- that
is, they buy specific issues to guarantee availability -- their
collective disappearance or marginalization could impact
liquidity across the market as a whole. Their role, some argue,
is especially crucial during market downturns. If a market
maker is not there to buy or sell a particular stock as they are
now required to do, how many investors will be left holding
devalued issues that nobody, short of a market maker, wants
to buy?
Chat with Claude on the New Economy message board.
- About Claude P. d'Hermillon, Jr.
- Past Issues
The Raging BullTM aims to provide a forum for investment ideas. Our articles and
columns should not be construed as investment advice, nor does their
appearance imply an endorsement by Raging Bull, Inc. of any specific security or
trading strategy. An investor's best course of action must be based on individual
circumstances. This material is for personal use only.
Copyright 1998, RagingBull.Com
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