Turning the Tide

As ECNs and other alternative trading systems have emerged, fragmentation in the capital markets has increased. But with the acquisitions of Archipelago by the New York Stock Exchange and of the Brut and INET ECNs by Nasdaq, the tide may be turning.

Why It's Important: Investors' desires to trade at the best price with zero market impact reflects the dichotomy between fragmentation and consolidation. While the rise of alternative execution venues allows investors to place block orders with less market impact, fragmentation can lead to wider bid-ask spreads and increased price volatility; however, too much consolidation runs the risk of less competition among exchange service providers and, thus, higher fees and less innovation.

Where the Industry Is Now: Nasdaq acquired INET, Instinet Group's ECN subsidiary, on Dec. 8, two days after NYSE members voted to merge with Archipelago. As a result, the NYSE and Nasdaq again are the main players; however, the four regional exchanges -- Boston, Chicago, Philadelphia and the National Stock Exchanges -- are striking alliances with leading broker-dealers to attract order flow and/or are ramping up their electronic trading capabilities. Meanwhile, crossing networks are targeting institutional block orders, with Liquidnet, Investment Technology Group's POSIT and Pipeline Trading Systems seeing increased volumes.

Focus in 2006: Reg NMS (most of which is scheduled for implementation in June, but delays are expected) will have a profound impact. Under the trade-through rule, market centers must route trades to wherever the best quote is posted, giving smaller exchanges and ECNs opportunities to attract order flow. In addition, the market data component -- which distributes revenue to centers offering the most aggressive and meaningful quotes -- potentially lowers entry barriers for execution venues, since a new system can generate revenue and compensate firms posting liquidity. On the flip side, under Reg NMS market participants must connect to each venue, and, if there is more fragmentation, the cost of setting up a trading system is greater.

Industry Leaders: With average trade size continuing to shrink (it is now less than 350 on the NYSE), Liquidnet, POSIT, Pipeline and NYFIX Millennium have attracted some block trading volume, but still account for only a fraction of the total market. Similarly, agency broker Instinet, which sees 100 million shares a day of institutions' trading, is seeking alliances with competitors to form linked liquidity pools to better enable clients to find the natural other side to orders.

The NYSE and Nasdaq remain the biggest venues, with the regional exchanges battling it out for the third spot. Although the Big Board's market share has fallen, it is seeking to reinvigorate its standing through the Archipelago deal and potential future acquisitions. Nasdaq also strengthened its position with the ECN acquisitions and will launch an intraday crossing system early this year to compete directly with the crossing venues.

Technology Providers: Tools that quickly sweep execution venues for the best prices, such as Lava Trading, Portware and FlexTrade, are well positioned for the post-Reg NMS world. Barclays Global Investors, Rosenblatt Securities and Sanford C. Bernstein, for example, use FlexTrade's algorithmic platform. Order management system vendors, such as SunGard's BRASS, NYFIX and LatentZero (which recently struck a deal to integrate access to Liquidnet), are also well placed. Connectivity providers such as BT Radianz, SAVVIS and Transaction Network Services will be increasingly important.

The Price Tag: According to an Aite Group report, industry spending on Reg NMS-related IT projects will total $544 million from 2005 to 2008, with more than half dedicated to compliance-related systems and a third on routing and execution. The sell side as a whole is estimated to spend approximately $800 million per year on electronic trading technology. <<<