Electronic Networks Threaten Trading Desks on Wall Street
By REBECCA BUCKMAN and AARON LUCCHETTI
Staff Reporters of THE WALL STREET JOURNAL
12/23/98
NEW YORK -- Standing about 2 feet high and perched on the bottom rung of a
tall metal rack at 50 Broad St. in Manhattan, the Compaq computer server
called "Monster 101" doesn't look like a center of trading that handles
about 10% of Nasdaq Stock Market volume.
Looks can be deceiving. Monster 101 and its backup, a machine dubbed
Monster 102, are the unassuming "brains" of Island, a fast-growing
electronic-trading system run by Datek Online Holdings Corp., which has
become a major player in individual-investor stock trading during the past
18 months.
Previous installment of this series:
For Big Board, Many Challenges Loom From Electronics Trend (Dec. 22)
The low-budget Island and other "electronic-communications networks," or
ECNs, are proliferating in the screen-based Nasdaq market, a division of
the National Association of Securities Dealers. One analyst, James Marks of
Deutsche Bank Securities, figures the new networks -- pumped up by the
recent flood of orders from active investors trading over the Internet --
are now involved in as many as 35% of the trades on the Nasdaq, a
27-year-old market that has long been known for electronically connecting
trading desks across the country.
But is Nasdaq about to get even more electronic? Officials of the new ECNs,
which replace some of the human interaction of trading desks by matching
trade orders through a computer, say so. Many market observers say the
networks will capture more volume from Wall Street trading desks as the
ECNs lower costs for retail investors and, increasingly, for institutional
portfolio managers, who also like to buy and sell without affecting the
prices of the stocks they trade.
Many already do so now through Instinet, a division of Reuters Holdings PLC
that pioneered the electronic-trading movement.
Critics, though, say ECNs detract from market transparency and could add to
volatility and confusion in the markets, particularly on Nasdaq, which has
been transformed by new regulatory requirements instituted in the past two
years.
"All these ECNs aren't necessarily making it easier," says Leo Smith, head
of equity trading at Putnam Investments in Boston. With a multitude of ECNs
matching buyers and sellers at once, often without the same disclosure
requirements as market makers, "it's confusing matters rather than making
them simpler."
Despite the complaints, ECNs are booming. Much of the growth has been
fueled by U.S. Securities and Exchange Commission trading rules imposed two
years ago mandating the public display of customer limit orders. After the
rules were imposed, many market makers chose to send the limit orders to
electronic systems instead of integrating them into their own quotes, which
could have lowered trading profits in some cases.
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The Big Names in Electronic Trading Operating "electronic communications
networks" ranked by recent market share:
ECN Owner Estimated share
of ECN market-a
Instinet Reuters 69%
Island Datek Online Holdings 20
Tradebook Bloomberg 7
REDI Speer, Leeds & Kellogg 1
Archipelago (Tonto) Terra Nova Trading 3
Attain All-Tech Investment Group 0
BRUT-b Automated Securities Clearance 0
Strike-c Strike Technologies/
Bear Stearns 0
NexTrade PIM Global Equities/
Pro Trade 0
a-As of September 1998
b-Other owners include Merrill Lynch, Morgan Stanley, Goldman Sachs and
Knight/Trimark Group
c-Other owners include Donaldson, Lufkin & Jenrette; Salomon Smith Barney;
and Herzog Heine Geduld
Sources: Deutsche Bank Securities, BancBoston Robertson Stephens
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Already, the alternative systems are challenging Wall Street's lucrative
stock-trading desks by pitching their services directly to big
institutional clients. Now that the SEC, under recently passed rules, may
allow ECNs to become full-fledged stock exchanges, some observers are
predicting they will challenge Nasdaq and the New York Stock Exchange
themselves.
"We've been waiting now for two years for these rules to come into play,"
says Jeffrey Citron, chief executive of Dakek Online Holdings. Adds Island
President Matthew Andresen, who graduated from college five years ago: "For
us, the technology is the easy part."
Systems such as Island's, which function as a sort of hybrid
exchange/broker, "really are not and can never be real competitors for
Nasdaq and the NYSE," Mr. Marks says. But in a blistering research note
published earlier this month, he claims that electronic-trading systems
pose a "profound threat to the current structure of the institutional
equities business and the core profitability of major Wall Street firms."
To Mr. Marks and some other analysts, ECNs are to institutional trading
desks what deep-discount, online brokerage firms are to Merrill Lynch & Co.
and PaineWebber Group Inc.: a cheaper, faster way to execute some trades.
Four new ECNs -- Attain, Strike Technologies, NexTrade and BRUT, a unit of
Automated Securities Clearance Ltd. -- have started up just this year. As
they gain critical mass and force commission costs down, more hedge funds
and asset managers could start sending them smaller, "easy" trades, and
then perhaps bigger orders, analysts say. Currently, most institutional
brokerage firms charge between three and nine cents a share for trades, Mr.
Marks says, compared with a fraction of a penny for some ECNs.
Large funds and other wealthy investors have welcomed the tumbling
commissions created by competing ECNs. "We pay about 60% of what we were
paying in 1997" to trade stocks on ECNs, says Harold Bradley, a portfolio
manager at American Century Investment Management Inc., which uses ECNs for
more than 50% of its Nasdaq stock-trading business.
Analysts stress that despite the benefits of alternative systems,
securities-dealing firms will continue to play a major role in many larger,
more-complicated trades. But many Wall Street firms, including Merrill
Lynch, Morgan Stanley Dean Witter & Co. and Goldman, Sachs & Co., have
taken equity stakes in the new BRUT system and intend to send orders there
to get a piece of the growing business, as well as to trim the hefty bills
they are paying to competitors such as Instinet.
Other traders say ECNs have reached somewhat of a saturation point.
"It's a commodity business," notes Matt DeSalvo, head of Nasdaq trading at
Morgan Stanley.
They also say ECNs' influence could be curbed by new SEC rules that require
alternative trading systems, including ECNs, to publicly report their best
orders once they control 5% of the trading in a particular security. Under
that rule, "Instinet is the big potential loser," because it has the
highest ECN volume and because many of its customers like the netork's
anonymity, says David Whitcomb, a professor of finance at Rutgers
University in New Jersey.
A separate Nasdaq proposal recently sent to the SEC for approval may also
hurt by essentially allowing brokerage firms to have some ECN-like
capabilities.
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