ECN Evolution

Throughout their history, ECNs have been linked directly with Nasdaq. Increasingly, however, the likes of Archipelago, Brut and Instinet are becoming more diverse. In fact, they have already made inroads into the listed and exchange-traded-fund markets and are looking to expand further.

Electronic-communications networks will forever be linked with Nasdaq. From the time of their collective rise in 1997 through present day, ECNs - trade-matching engines that cross buy and sell orders for stocks - have used Nasdaq as their proving ground. In fact, Instinet, Island and Archipelago, the three largest ECNs, currently account for close to 40 percent of Nasdaq's trade volume.

However, ECNs have also recognized that their opportunities for growth in the Nasdaq market are limited - partly due to their already sizable market share and partly due to the recent launch of Nasdaq's SuperMontage order-display and execution network. Consequently, the likes of Instinet, Island, Archipelago and SunGard Data Systems' Brut ECN are working diligently to expand their presence in different markets, including traditional listed equities and exchange-traded funds.

In fact, over the last two years, Island has evolved into the ETF kingpin - establishing a dominant market share in the trading of the American Stock Exchange-listed QQQ, an extremely liquid ETF that tracks the Nasdaq-100 stock index.

What's more, Instinet, Island's former arch-rival and current parent, is currently the largest ECN for the trading of New York Stock Exchange- and American Stock Exchange-listed stocks - accounting for between 4 and 5 percent of total exchange-listed volume in any given month.

Meanwhile, in its quest to penetrate deeper into the listed and ETF markets, Archipelago has employed a unique strategy: migrating from an ECN to an all-electronic, regional stock exchange. Archipelago transitioned the full complement of NYSE- and Amex-listed securities it trades - including roughly 3,200 stocks and 130 ETFs - to the Archipelago Exchange (ArcaEx) during a six-month period last year.

Thanks in part to its metamorphosis, Archipelago has been able to boost its collective market share for QQQs, Diamonds and Spiders - the most actively traded ETFs - from 4 to 10.2 percent over the past 12 months, says Archipelago Chief Economist Jamie Selway. Moreover, during that same period, Archipelago was able to double its very modest share of the single-stock-listed market, from 1 percent to 2 percent.

Brut, as Archipelago did in its pre-exchange days, now trades in the listed and ETF markets via Nasdaq's Computer-Assisted-Execution-System interface to the Intermarket Trading System - an outdated routing platform that electronically links together the NYSE, Amex, Nasdaq and six other regional equity markets.

Through its participation in the ITS, Brut - which started trading listed and ETF securities in the second quarter of last year - can post quotes in the National Consolidated Quote System. And via NCQS, a real-time market-data platform that displays bids and offers to every ITS participant, Brut can effectively advertise its listed and ETF prices to a huge audience of traders.

Though Brut has yet to generate any significant volume outside of Nasdaq, the ECN remains confident in its potential to grow its listed and ETF businesses. William O'Brien, Brut's senior vice president and general counsel, says that in 2003, Brut should be able to build its listed business in an environment of ECN-friendly trends - such as the industry's move towards sector trading.

The Listed Chase
Sang Lee, an analyst covering e-trading at Celent Communications, says that the strategies of ECNs in the listed market have been devised, in part, with SuperMontage in mind.

Nasdaq, which launched SuperMontage on Oct. 14, rolled out its new network with the intention of trying to recapture some of the order flow it had lost to ECNs over the previous five years. Thus far, ECNs have held their ground against SuperMontage, but the threat of Nasdaq's network eating into their over-the-counter businesses still remains.

"Even before SuperMontage, ECNs were trying to move aggressively into the listed side ... . But with the introduction of SuperMontage, there probably is even greater pressure on ECNs to try to diversify," says Lee.

Selway retorts that Archipelago decided to pursue the listed market, via ArcaEx, primarily because it saw an excellent opportunity for growth, but also because it wanted to get out from under the thumb of Nasdaq.

"Nasdaq was an incredibly costly (regulatory-service) provider. They sucked down all that tape revenue, and their equipment was old and clunky," he says. "So (Archipelago's decision) to become an exchange was (driven) by a combination of Nasdaq being kind of a competitive threat ... (and) not being a very cost-effective regulatory-service provider."

The barriers for entry in the traditional listed-equities arena are daunting, mainly due to the fact that 85 percent of listed orders are still executed on the floor of the NYSE. But Selway says Archipelago's exchange status, combined with a securities-industry trend towards combining Nasdaq and listed-trading desks, should help ArcaEx lure significant liquidity away from the Big Board.

ArcaEx, he says, also thinks it will receive more listed business as a result of a recent securities-industry trend towards sector trading - a strategy that calls for firms to divide up stock trading by sector, rather than by exchange affiliation. Historically, says Selway, firms have traded Nasdaq stocks via their Nasdaq desk and NYSE stocks via their listed desk. But increasingly, he says, ArcaEx's buy-side and sell-side clients are scrapping that approach in favor of trading stocks according to their sector, such as semiconductors or telecommunications.

"This means that some of the younger guys who are used to electronic trading - guys who cut their teeth trading Cisco and Yahoo - will be trading listed stocks more often," says Selway. "They know what a reserve order is, they know what a discretionary order is - they know how to use all the goodies that are available in the OTC marketplace ... . (And) if they can trade IBM on an ECN, they will."

Expecting Growth
Brut's O'Brien is also pleased with the industry's move towards sector trading. Brut, he says, currently only trades about 1 million shares of listed and ETF securities on a daily basis. But the ECN expects that figure to grow quickly, facilitated in part by the convergence of Nasdaq and NYSE trading.

Brut, he says, believes that it can become "one of the principal ECNs that trade ETFs" in 2003, and is also very optimistic about its chance to grow its single-stock-listed business "exponentially." However, while acknowledging that ECNs have already made significant inroads in the ETF space, Celent's Lee says that it is highly unlikely that Brut or Archipelago - or any other ECN - will achieve success in the listed arena.

"I don't really see ECNs succeeding on the listed side ... . The NYSE has done away with a couple of anti-competitive rules, including Rule 390, which prohibited the trading of (a group of) NYSE-listed stocks away from the NYSE floor. But ECNs still haven't made a dent in the NYSE's volume," he says. "And it will be difficult to convince investors to execute trades via a smaller pool of liquidity when 85 percent of all liquidity resides in one specific place."

But ArcaEx fully expects to prove Lee wrong. Selway says that ArcaEx believes it can grab a 10 percent market share in listed equities by the end of 2003, and grow to 20 percent by the close of 2004. Since ArcaEx currently accounts for roughly 2 percent of the total listed volume, those projections seem very ambitious. Selway, however, says those numbers are achievable, especially since more and more firms are looking for ways to cut costs and consolidate NYSE and Nasdaq trading.

Instinet and Island, like Archipelago and Brut, have expanded outside of Nasdaq. Instinet, via Island, has already built a very large ETF business and has also made some progress in the listed realm. But Instinet also has a lot on its plate, and is currently very busy trying to integrate all of its technology with Island's systems. Instinet officials were unavailable at press time.

Celent's Lee, however, says that out of all the ECNs, one has the best chance to take liquidity away from the NYSE. "If anyone has a pretty decent shot at it, it's probably Instinet," he says.