In Search of Liquidity: The Time Is Now

After more than a year of investing in technology to comply with Reg NMS, firms need to demonstrate that their systems are up to the challenge of dealing with a shattered market and accessing 30 or more trading venues in the scramble for liquidity.

Why It's Important: While liquidity traditionally has been relegated to the biggest marketplaces -- namely the NYSE and Nasdaq -- Reg NMS represents a shift in power, with regional exchanges and alternative trading systems (ATSs) gaining considerable clout, and dark pools grabbing a yet-unknown amount of liquidity. Connectivity to the plethora of execution venues -- about 30 trading destinations by mid-year -- and the ability to accommodate the massive increase in orders will be paramount for sell-side firms.

Where the Industry Is Now: Because of the overwhelming technology requirements, compliance dates for Reg NMS Rules 610 and 611 -- the order-protection rule and access rule, respectively -- have been extended. Most bulge-bracket firms already have invested heavily in the endeavor, ranging from beefing up capacity and algorithms to building crossing networks to increase liquidity options. Small and midtier brokers are scrambling to build, buy or outsource smart order routing platforms to remain competitive. And, according to Michael Plunkett, president, North America, Instinet, the industry saw an unprecedented proliferation of dark pools in the U.S. in 2006. "We now have upwards of 40," he says. "For the buy side, this has become the proverbial double-edged sword; they have more opportunities than ever to execute anonymously with little to no market impact, but at the same time are faced with the logistical nightmare of accessing all of these dark pools."

Focus in 2007: Brokers realize that their relationships with marketplaces are vital and, as a result, many are investing in stock exchanges or ATSs. But no matter how proactive firms have been in preparing for Reg NMS, they still must react as the exchanges implement their order-routing processes in February. Consolidation also is likely, from exchanges to crossing networks to brokers. According to Plunkett, buy-side firms expect the sell side to provide access to as many dark pools as possible, and sell-side firms will need to put aside competitive and political differences to provide reciprocal access to each other's dark pools.

Industry Leaders: On the exchange side, smaller marketplaces have the potential to become major players. Regional exchanges will see more liquidity, as will electronic trading networks such as Liquidnet and ITG. On the Street, expect nonexecution-focused brokers to drop out of the trading game, while the bulge-bracket firms -- such as Credit Suisse, Goldman Sachs and Morgan Stanley -- rake in even more business. Most large sell-side firms already have announced the creation of internal dark pools. Instinet is attempting to bring together the various dark pools and provides access to nine dark pools through its Nighthawk algorithm. "We expect this to continue to be one of the biggest trends facing the industry in 2007," says Plunkett.

Technology Providers: Market data and storage are hot areas related to Reg NMS. Vendors that can address increased bandwidth, the Financial Information eXchange (FIX) protocol and data storage are poised to win big. In addition, intermarket connectivity is a necessity, creating opportunity for the handful of vendors in that space.

Price Tag: The SEC continues to estimate the industrywide implementation cost at $143.8 million, with additional annual costs at $21.9 million. Celent, however, believes the technology costs associated with Reg NMS for 2007 alone will hit $123 million. The total investment will not be known until the Street's self-regulatory organizations (SROs) nail down exactly what will be required as an audit trail.

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