Of course, JBOH is NOWHERE to be found:"ECNs Duke It Out for Share of Growing Volume. Before electronic communication networks can challenge
market makers for Wall Street's heavyweight championship,
they'll have to endure several grueling elimination bouts.
Four ECNs started operating last year, bringing the number
of combatants to 10. But two big ECNs, Reuters Instinet
and Island, claimed 91% of trades executed on ECNs in the
fourth quarter, according to estimates by BancBoston
Robertson Stephens. The next-largest ECN mustered
barely 3% of the market. Yet, despite the new guys' small
splash, several more ECNs are looking to jump into the ring.
As a result, oddsmakers expect several ECNs to be
knocked out by more powerful competitors. Traders,
naturally, are likely to route orders where they can find
volume. Without the benefit of Island's captive order stream
from online broker Datek (owned by Island's parent) or
Instinet's 30 years of relationship-building, the new ECNs
may be in for a slugfest.
That's because order flow attracts more order flow, as Bill
Burnham, an online broker analyst at Credit Suisse First
Boston, postulated in a recent report.
"You're only as good as your volume, your orders," says
Matthew Andresen, Island's president. On the playground,
that might be called talking smack, but Island has some
impressive numbers. (Volume reporting by ECNs is widely
debated for accuracy, but no matter what numbers are used,
Island and Instinet are the industry's titans.) Island's most
powerful punch: Datek, the No. 4 online broker, routs its limit
orders through Island.
Captive volume is the strategy that other upstart ECNs are
pursuing. They're also trying to differentiate themselves with
pricing and technological innovation, hoping it's still early
enough to bulk up.
"This game is just starting," says Arthur Pacheco, president
and chief executive of Strike Technologies. Strike, which
received approval in November to operate an ECN, was the
No. 8 ECN in the fourth quarter, according to Robertson
Stephens.
Captive Audience
Strike is backed by a partnership of 19 firms, including Bear
Stearns (BSC:NYSE), Lehman Brothers (LEH:NYSE),
J.P. Morgan (JPM:NYSE) and Donaldson Lufkin &
Jenrette (DLJ:NYSE). Those relationships provide a built-in
critical mass of volume that other ECNs don't have, says
Pacheco. Only five partners use the system, but he says
volume will multiply as the rest of the owners come on the
system by month's end.
Other ECNs have Wall Street's backing, too, which they
hope will turn into order flow. Goldman Sachs and E*Trade
(EGRP:Nasdaq) recently took stakes of slightly less than
25% each in Archipelago, the No. 6 ECN in the fourth
quarter. Another ECN called Brut, ranked No. 5, has equity
partners including Merrill Lynch (MER:NYSE), Morgan
Stanley Dean Witter (MWD:NYSE), Goldman and market
maker Knight/Trimark (NITE:Nasdaq), all of which make up
about a quarter of Brut's volume, according to President
Brian Hyndman.
Brut, operated by Brass Utility, which is owned by
SunGard Data Systems (SDS:NYSE), is also pursuing
online brokers. Many brokers are considering a relationship
with an ECN, through which they could route a portion of
their limit orders. If brokers sign on, it would be another way
for ECNs to capture volume.
Tech and Pricing Perks
Technological innovation at Bloomberg's Tradebook gives
the network a competitive advantage over other ECNs, says
Bruce Garland, a principal at Tradebook, the No. 3 ECN. For
example, it introduced the reserve mechanism, where a
trader can display only part of the order to prevent tipping his
or her hand. It also introduced the ability to "sweep" the
market, sending orders to one or more market makers or
ECNs with the best prices. It aims to deliver other services
that help traders execute large orders without affecting the
stock price.
Strike touts its flexible technology and inexpensive rates,
says Pacheco. Strike uses Java-based technology that can
operate on any platform. (One of Strike's owners is Sun
Microsystems (SUNW:Nasdaq), which developed Java.) Brut
advertises the rebates it offers on orders sent its way,
something Island also does, which are an incentive for
brokers to send orders as rebates from market makers
decline.
The Volume Magnet
Yet despite all these apparent perks, traders still focus on
volume. "As a rule of thumb, the more volume an ECN
generates, the more likely it is to deliver better execution,"
says Darrin Spencer, a trader and OTC execution supervisor
at Scottsdale Securities, a discount broker that subscribes
to three ECNs.
"It comes down to the number of people looking at [the ECN]
and the number of shares you can get done in a short period
of time," says a trader at a New York discount brokerage,
who prefers Instinet for its liquidity, although his firm
subscribes to other ECNs.
However, one thing does buy the small ECNs some training
time. Every ECN offers representation in the broader market
because an ECN's best bid and offer prices are reflected in
the Nasdaq quote. ECNs and market makers are linked
through Nasdaq trading and quotation systems. And through
some ECNs, such as Tradebook, a trader can anonymously
access quotes at market makers and other ECNs. All that
doesn't stop many firms from subscribing to a handful of
ECNs, giving them direct access to separate pools of
liquidity.
But the competition is fierce and changes are swift. Some
ECNs are considering becoming or partnering with a
self-regulatory exchange. Traders' willingness to hedge their
bets won't keep puny ECNs in the ring for long."
JBOH is toast, the vultures are circling.
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