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Making Markets Move

The race to become a fast market may lead exchanges to join forces with ECNs.

In March, INET, the largest electronic communications network (ECN) in the United States, told the world in Instinet Group's 10-K filing that it was considering becoming a national stock exchange. And, in late April, Ed Nicoll, chief executive officer of Instinet Group - the parent company of both INET and Instinet, the institutional broker - told analysts that INET was in talks with the Securities and Exchange Commission about becoming an exchange. "It's just a question of whether we believe we want to pull that trigger or not, and whether that's in the interest of our shareholders," Nicoll told analysts.

According to a company spokesman, the process is already in motion. "We are in the early stages of a discussion with the commission staff about exchange registration," he tells Wall Street & Technology in early July. Though no formal application has yet been filed, the spokesman says, Instinet submitted a draft document for discussion with the SEC in late spring. A previous draft filing by Island, an ECN that INET acquired in the second half of 2002, "was withdrawn upon the filing of INET's draft application," he adds.

"Instinet is the most logical candidate for exchange status," says Damon Kovelsky, senior analyst, capital markets, at Framingham, Mass.-based research firm Financial Insights. "That would not be a stupid move on their part," he adds. Kovelsky cites the Chicago Stock Exchange, the National Stock Exchange (NSX; formerly the Cincinnati Stock Exchange), the Boston Stock Exchange and the Philadelphia Stock Exchange as possible candidates to join forces with the ECN.

Fast Market Frenzy

At a time when stock exchanges are under tremendous pressure to become fast markets due to Reg NMS - the SEC's proposal to reform the U.S. market structure - the idea of an exchange joining forces with an ECN could be an attractive strategy. While the proposed rule is at least several months away from being finalized by the commission, every exchange is jockeying to position itself as a fast market in the meantime. As it stands now, Reg NMS will require all securities markets to provide an automatically executable quote - something that many stock exchanges with manual floor-based auction models do not provide.

Clearly, INET could offer an exchange the automatic-execution technology it would need to qualify as a fast market. INET consolidates order flow from the former Instinet and Island ECN and accounts for 25 percent of the trading activity in Nasdaq stocks. And, in addition to matching orders within its own book, Island features a smart router, which can route orders to other exchanges' markets.

"Everyone will eventually have to become a fast market," says Bernard Madoff, chairman of Madoff Investment Securities, a New York-based market-making firm. "Everybody will have to meet that standard if the New York [Stock Exchange] feels compelled to meet it."

Jodi Burns, senior analyst with Celent Communications, agrees. "If the NYSE is a fast market, and Boston, Philadelphia and the National Stock Exchange are all slow markets, they become insignificant," because under the proposed regulation, fast markets ignore the prices of slow markets, Burns explains. The NYSE has said it plans to eliminate size and timing restrictions on its Direct+ automatic-execution system, which will provide an immediate execution at the National Best Bid and Offer (NBBO). "If [the NYSE] succeeds, then the regionals are on an un-level playing field with the NYSE," because the NYSE will have automatically executable quotes, Burns says, unless the regional exchanges can "reinvent themselves as automated markets," she adds.

Reg NMS is going to hurt the regional business models for a number of different reasons, according to the head of a sell-side trading firm who requested anonymity. "First, it's going to make a lot of the volume electronically come out of the crowd where people are going to access that liquidity via ECNs that have far better functionality and speed," he says. Second, traders are going to program their algorithms to take liquidity from the most efficient markets - so they'll go to ECNs, Nasdaq and the NYSE first, and then the regionals will be last, he continues. Third, the regional exchanges depend on the Intermarket Trading System - a much maligned order-routing network linking the regionals to the NYSE, Amex and Nasdaq. But, under Reg NMS, brokers are going to want to use "direct connects" to reach pools of liquidity, the sell-side trader explains, adding that ECNs have access to the front-end desktops on the buy and sell side, which could help a regional exchange to reinvent itself.

On the other hand, Reg NMS may also provide motivation for ECNs to seek exchange status. Some of the provisions within Reg NMS - namely the provision to cap ECN access fees and a new formula for market-data revenue-sharing allocation - could have an adverse impact on the economics of ECNs.

"I think Reg NMS does put the ECN model in jeopardy," Celent's Burns says. "The question is, how else will you make money? The answer is, maybe I become an exchange because it's more profitable to become an exchange right now in the world that the SEC is proposing," she continues.

Though INET's president, Alex Goor, declines to comment on whether INET is in discussions with any specific exchanges or how it will go about attaining exchange status, he does confirm that becoming an exchange is an attractive option. "There are economic advantages to being an exchange at the moment, and we would like to partake in those, as have our competitors," he says, referring to Nasdaq and Archipelago. There are three major revenue sources for exchanges: listing fees, transaction fees and market-data fees - all revenue sources that an ECN cannot tap. An exchange can also avoid clearing costs from the National Securities Clearing Corp., Goor says, because it can step out of the trade. This means that when an exchange reports a trade, it reports the two parties to the trade, not itself, so it doesn't get a bill.

"If we were to do it, it could give us more control over our own regulatory destiny," Goor explains. "I think we could add something to the world of exchanges," he says, noting that INET's primary advantage - technology - could "extend to the maintenance of an exchange and surveillance operation of an exchange platform."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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