ECNs Adjust to a SuperMontage World

While SuperMontage isn't likely the death knell for electronic-communications networks, it will force them to visit the drawing board and come up with a better battle plan for competing in the new environment.

Just what that plan should entail, however, is not clear, as analysts are at odds on whether ECNs need to become exchanges or provide more broker/dealer-type solutions.

"I don't think the picture is as black and white or as bleak as many people would believe," says Damon Kovelsky, an analyst at Meridien Research in Newton, Mass.

What SuperMontage is forcing ECN vendors to do, he says, is "think a bit more about their business model. ECNs have to think about what they are actually doing." He says ECNs need to ask themselves, "Are we another execution platform, or are we an electronic broker/dealer? The success of ECNs depends on how they position themselves as electronic broker/dealers, and not just executioners."

ECNs must "show they are not only liquid enough to internally match trades or that they can route them to places that can, but that they can also provide greater value to a firm than a traditional broker/dealer," says Kovelsky.

Steve McKenna, a partner in the business-consulting-services practice at IBM in New York, says "I think (ECNs) need to team up and join forces. They need to become stronger entities and become exchanges."

While analysts might disagree on the direction ECN vendors need to go, what's clear is that ECNs can't stand still and rest on their laurels. "They need to become lean, mean fighting machines. They can't afford to be content," says Sang Lee, an analyst at Celent Communications, adding "ECNs as we know them in the past are more or less dead."

That's because SuperMontage, Nasdaq's new $100-million electronic-execution engine, has jump-started Nasdaq from an electronic-quotation-display service to a full-fledged electronic-communication network. It's now the base that the market will operate from and is designed to recapture order flow lost to ECNs.

However, ECN vendors won't be elbowed out any time soon. That's because only market makers and ECNs can represent orders on the system, explains Rob Hegarty, vice president of the securities and investments practice at the TowerGroup in Needham, Mass.

Moreover, Hegarty says, SuperMontage limitations will open the doors for ECN vendors. One area that ECNs are expected to exploit is anonymity. SuperMontage offers only pretrade anonymity. It doesn't extend post-trade, which provides ECNs with an opportunity to distinguish their services. As well, they will continue to hold an edge in speed and costs.

Hegarty says that SuperMontage will "have a negative impact on ECNs over time, but lots of variables still need to be fleshed out on whether SuperMontage can achieve what it's intended to do. It's making good progress and seems to be going smoothly, but time will tell."

He estimates that ECN market share will drop from around the 48-percent level today to 31 percent by the end of 2003.

Hegarty says the "key to the whole game hasn't changed. That key is liquidity." Who has it and who doesn't? Those ECNs that succeed, he says, will be the ones that "bolster their native liquidity" and "attract order flow. Connectivity and access will be less of an issue as time moves on."

When it comes to liquidity, SuperMontage has the advantage coming out of the chute and Celent's Lee expects it to "make huge gains by the end of the year."

However, he says, SuperMontage "still falls short of being the central-limit-order book that many envisioned initially."

Moreover, he notes, "Habits are really hard to break." ECN vendors have carved a market - accounting for 176 billion shares traded in 2001, according to Celent - and that will be hard to break. "You don't wake up one day and say SuperMontage is up, send our orders there. It's hard to break habits, especially those that involve making a living."

When it comes to vendors, the market is consolidating and there are really only a handful of players who count.

They include: Island/Instinet (the largest), Archipelago, which has broken from the pack by achieving exchange status, SunGard Brut and Bloomberg Tradebook. These four account for the bulk of the market share. After that, firms like TrackECN, and other smaller ECNs, barely account for a few percentage points of market share.

So how will the major ECNs compete moving forward and what are their strengths and challenges?

Here's a breakdown of the major players.

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Archipelago - www.archipelago.com

The ECN market has seen tremendous change in the past year and Archipelago has been at the forefront. It joined with RediBook and achieved exchange status, thanks to its merger with the Pacific Stock Exchange. In the summer it bought GlobeNet, which expanded Archipelago into over-the-counter bulletin-board stocks not listed or traded on Nasdaq. While it has joined SuperMontage, that's for the short-term and it's expected to pull out once it ramps up ArcaEx, its exchange.

Jamie Selway, chief economist at Archipelago, says that since the launch of SuperMontage, "Our business has not changed one iota." He says that ArcaEx will launch sometime in the first quarter of 2003. Selway says the key for Archipelago, moving forward, is convincing users that ArcaEx is more than a regional exchange and has something to offer. "It's all about the brand," he says, noting that, "People don't think of a regional exchange as a place to do serious trading."

Archipelago hopes to change that attitude and has undertaken an advertising campaign to build its name. It currently controls about 10 percent of Nasdaq trades and targets institutional investors, proprietary-trading firms, hedge funds and broker/dealers.

Strengths: Hegarty says that the combination of Archipelago's technology with Redi's provides "two very good platforms" and the fact that it's an exchange will help its business grow. It has also had significant liquidity since the launch of SuperMontage, he says.

Question mark: Can it get beyond the shadows of a regional exchange?

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TrackECN - www.trackecn.com

One of the newest kids on the block, Track ECN has less than 1 percent market share, compared to other ECNs. Part of Track Data Corporation, it trades Nasdaq and OTCBB stocks and targets institutional investors, broker/dealers and hedge funds.

Rod Colvin, executive vice president at Track ECN, notes that Track started on SuperSOES so, "SuperMontage is not that much of a change for us in terms of the way we operate." Rather, it levels the playing field for smaller ECNs by providing access to greater liquidity.

For Track, pricing is the name of the game and it's distinguishing itself as a "low-cost provider." It features two pricing options - a rebate pricing model and a limited-free pricing model.

Colvin is blunt in his assessment of the market. "I don't think there's any ECN that can offer anything that another ECN can't offer. If one of the ECNs goes out Monday with a great idea and starts offering a new service to customers, we can have it Tuesday."

The firm's proTrack direct-access-trading platform integrates with its market data and provides unbiased trade routing, allowing clients control over where their orders are sent. Track internalizes less than 10 percent of its order flow.

Colvin plays it close to the vest when it comes to new services he is planning, but says if a customer "wants a particular service, we're quick to accommodate." He says there are no major upgrades in the cards for the platform, but it will add some new features. Track ECN has no plans to become an exchange.

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Brut - www.ebrut.com

Recently acquired by SunGard, one of its part owners, Brut is participating in SuperMontage and got off to a good start with a rise in its market share to about 6 percent. The SunGard acquisition came with a $3 million investment that Brut is using to upgrade its hardware and migrate its software to Sun Microsystem's Solaris 2.8, 64-bit system. As well, Brut will become part of the SunGard transaction network.

Bill O'Brien, senior vice president and general counsel at Brut, says it's committed to staying in SuperMontage, unlike a number of its competitors that plan to pull out at some point. O'Brien says it's important to provide access to all liquidity pools. "No one trading environment can be all things to all people."

About 60 percent of its order flow is book to book, while 20 percent are inbound orders, leaving 20 percent of trades routed to outbound destinations. He agrees that functionality will be the key to moving forward, but O'Brien questions how far ECNs will be able to go in offering new services and trading solutions. "ECNs have tried that historically and not done well."

He cites Brut's sponsorship program - which allows institutions trading on Brut to direct commissions to the broker/dealer of their choice - as the type of value-added service ECNs will bring to the table.

For now, O'Brien thinks that ECN consolidation has "run its course in the short term" and he says Brut has "no plans to become an exchange at this time." However, he adds, there "may be some economic advantages to being an exchange."

Strengths: Lee says Brut has "great position on the broker/dealer side because of Brass," its front-end system. Hegarty adds that it has a "good technological system" with a "captive client base."

Question mark: Hegarty says the perception is that it's a "closed system."

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Instinet/Island www.instinet.com - www.island.com

The combined entity is the 800-lb. gorilla of the ECN world. The Island/Instinet combination is a formidable player, accounting for as much as 32 percent of the Nasdaq volume since the launch of SuperMontage. The combined entity targets everyone from institutional investors to broker/dealers, day-trading firms, retail brokerages and proprietary-trading desks.

It recently announced $100 million in cuts, including 300 layoffs. Andrew Goldman, executive vice president at Instinet, says the reductions "were proportional. Island certainly took its fair share of reductions across the board as did Instinet." However, he says, the cost reduction plan will result in a "leaner, more efficient company" that is "better positioned to serve customers."

Goldman says it's "premature to draw any conclusions" about what impact SuperMontage has had on the business, but he notes that the two ECNs are "demonstrating some strong market-share numbers" and "robust growth across the board," maintaining 30 percent of the market.

He says the firm's strength is that "We offer broad and comprehensive access to diverse pools of liquidity." The large liquidity pool means that it's the starting point for professional traders looking for "best-execution opportunities" and maintains that liquidity will be key to keeping the business viable.

In order to maintain and grow that liquidity pool, Goldman says combined entities must continue to "offer superior products and services," such as the recently launched Newport - Instinet's next-generation portfolio-trading system for portfolio managers and traders executing baskets of global equities.

It also has introduced the Instinet Trading Portal, designed to improve trading performance, and has FIX connectivity and smart order routing. Instinet has also provided clients with seamless access to Island's book and, in the fall, introduced a flat rate for broker/dealers routing OTC orders to external destinations.

From a technology standpoint, Goldman says the focus in 2003 will be continuing to integrate the two liquidity pools. "That's arguably the most important value-added proposition," he says, noting that that "vast majority of trades are matched internally."

Instinet has elected not to post its Nasdaq quotes in SuperMontage, opting instead to use the National Association of Securities Dealers' Alternative Display Facility. Island is showing its quotes through the Cincinnati Exchange and has an application for exchange status pending. Goldman says, "We'll see how the two strategies play out over time," and how customers react.

Strengths: Hegarty says the firm is playing a "wait-and-see game. It's a smart move before you dive into the water to test the temperature." Established client base, global reach and "innovative technology makes for a nice combination," he says. Recent cost reductions are a "smart move." Kovelsky adds that Instinet/Island "can give SuperMontage a run for its money easily."

Question mark: Will owner Reuters take advantage of Island's know-how? Its "hands-on approach" to Instinet eventually led to a "massive brain drain," Kovelsky says. "If it gets too hands on with Island, people might decide it's not what they want to do." Hegarty adds that "getting the cultures (of the two firms) to work together presents a bit of a challenge."

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Bloomberg Tradebook

www.bloombergtradebook.com

At Bloomberg Tradebook, the ECN game is not about buying liquidity.

"We're not pursuing volume and market share for its own sake," explains Kevin Foley, chief executive at Tradebook. It's about trading tools and customer service. "Our clients don't measure the quality of service they get by the number of other clients using it. It's the quality of execution they receive."

"Other people in the marketplace are aggressively buying market share, which we think competes with one's ability to provide high-quality service to clients."

He says the new world of Nasdaq means different liquidity pools. "The real focus is bringing 100 percent of liquidity to clients, not tying up the biggest percentage of the market. The focus is on quality, rather than quantity. That's our strategy. We see the market continuing to move in that direction."

Tradebook, which is participating in SuperMontage, sees itself as a global electronic-agency broker, offering state-of-the-art trading technology and expertise, along with straight-through-processing tools, news, data and analytics in an integrated solution through its Bloomberg terminal. It targets institutional investors, agency brokers and market makers.

Foley says the firm's strength is that it takes "that complicated environment and consolidates it on our client's desktop, using smart algorithms to "help traders disguise large orders" with "great speed and precision."

Tradebook matches less than 10 percent of its trades internally, a reflection of its belief that the goal is to match buyers and sellers, irrespective of where the liquidity lies.

"Our SuperMontage solution is working for (clients)," he says, adding, "They are voting with their orders." The firm will continue to enhance its algorithms and add more markets. It will also post quotes to the Alternative Display Facility. It currently provides 28 markets in 24 countries on one platform.

"If you know how to trade one, you know how to trade them all," says Foley. Like other ECNs, it is eyeing the listed market for growth. It has also been growing its basket-trading business thanks to its List Manager application and is aggressively connecting to a number of order-management systems.

The firm has no intention of seeking exchange status. "Our clients are very demanding. They want service and they want innovation and they want to be treated individually. You don't get that from an exchange."

Strengths: Celent's Lee says penetration of the Bloomberg terminal puts Tradebook in a "very good position when trading anything."

Question mark: Lack of liquidity and closed system presents a challenge.