So Much for Fragmentation

With the merger of Archipelago and the NYSE and the acquisition of Instinet (Inet) by Nasdaq, the over-crowded ECN field of five years ago suddenly looks smaller. Much smaller. With the disappearance of Inet and Arca, the field of seven to 10 ECNs circa 1999 is down to only Bloomberg's TradeBook and a number of much smaller entities (e.g., Track, Attain, Nextrade, etc.) that today have little impact. So much for fragmentation.

But what will this mean for the markets? And is the era of intermarket competition dead?

There are two schools of market theory: order competition versus intermarket competition. Order competition assumes a centralized exchange predicated on orders meeting in a centralized environment aggressively competing for best price. The intermarket competition theory assumes multiple exchanges competing with each other and offering order flow incentives to attract liquidity.

Order competition traditionally has dominated discussions, as a centralized structure enables more efficient price discovery, less arbitrage and, generally, the ability to obtain better price.

However, with connectivity advancements, the ubiquity of FIX and the development of direct-market-access and aggregation technology, we now can have a centralized virtual market in which fragmented liquidity can be easily consolidated across decentralized liquidity pools.

Intermarket competition also has facilitated easier and more open access to the markets, a lowering of exchange fees, development of sophisticated order types, enhanced efficiency and a spurring of new trading technology investment by both firms and the exchanges that was previously unimaginable.

Open market access also has provided a level of access and transparency that has enabled easier surveillance, the development of automated trading tools and greater understanding into the trading process at the most micro-level, in turn facilitating a new wave of more active traders and investors.

But what will happen now that there are only two liquidity pools?

In some ways, competition will be more fierce than ever. Nasdaq's move to provide free order routing to the NYSE but float the orders by Nasdaq's transaction engines will look to take listed flow from the NYSE. Simultaneously, the NYSE's acquisition of Archipelago gives the NYSE Group an automatic 22 percent-plus market share in over-the-counter order flow. This battle over order flow and the ensuing poaching will keep both players in check until parity is reached or both competitors wave the white flag and surrender.

This, however, may be more difficult for the NYSE as it goes public. While going public gives the NYSE greater operating flexibility, it also puts the exchange on the earnings treadmill, as it will need to show earnings growth to satisfy both equity analysts and investors.

But where will these entities find earnings growth? Will earnings growth come from the traditional sources of listed equity transaction, market data and listing fees, or will they need to mount an all-out assault on each other to capture market share?

U.S. exchange revenues, especially given the intense intermarket competition of the past seven years, has not grown for a while, which may force both exchanges to look outward for growth. Will growth come from the more direct sale of market data, expanding into other products (such as options or other derivatives), or from vertically integrating like the European exchanges, which offer depository, clearing and custodial services? We should probably expect all of the above.

While fragmentation may be dead for now, I would not count it out. In the short term, both order flow and intermarket competition will be alive and well - the big question is for how long? Will new ECNs develop; will the Hybrid succeed; and will the exchanges continue to push innovation?

Only time, leadership, the SEC's final NMS rulings and, maybe, the Department of Justice will tell for sure.

Larry Tabb is founder and CEO of Westborough, Mass.-based The Tabb Group, a financial-markets strategic-advisory firm. [email protected]

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio