ATS Epidemic

Ivy Schmerken, Wall Street & Technology

I was surprised to learn that the sell-side community is funding yet another round of ATSs after investing in regional exchanges and turning their own internalization engines into SEC-registered crossing networks.

In case you haven't heard, this week Wall Street firms unveiled plans to launch two different electronic matching initiatives - begging the question, do we need another ATS?On Wednesday, six global securities firms - Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS - said they plan to launch Block Interest Discovery Services (BIDS), a new electronic trading service for block trading. Trading is expected to begin in early 2007.

This followed Monday's announcement that five global securities firms, including Citigroup, Fidelity Brokerage Company, Lehman Brothers and Merrill Lynch, plan to launch LeveL, an order-matching engine that will cross their own order flow as well as execute contra-party trading.

LeveL- which is scheduled to commence trading on October16 - is being launched by EBX, a joint venture formed by the five investment banks, which are also investors in the Boston Stock Exchange. Orders not matched in LeveL can be routed to the Boston Equity Exchange (BeX).

Interestingly, three of the investors - Citigroup, Lehman Brothers and Merrill Lynch - are participating in both of the new initiatives, suggesting that brokers are rapidly placing their bets in advance of the new market structure rules taking effect under Regulation NMS. Two weeks ago, Lehman announced an equity stake in BATS Trading Inc., the ECN. This week Lime Brokerage revealed it has acquired a minority stake in BATS as well.

The question is how many broker-operated crossing networks, third-party ATSs and dark liquidity pools can the market absorb without fragmenting the liquidity further? Is the industry again setting itself up for another wave of consolidation? And how many trading venues can buy-side institutions realistically monitor or go fishing in - especially if many of them are dark liquidity pools that don't publish quotes.

"There're way to many players out there," says Sang Lee, managing partner at Aite Group in Boston. While on the surface there appears to be massive fragmentation, Lee contends nearly 80 percent of the equity trading volume is still centralized in two destinations - Nasdaq and the NYSE - so there is market share to lose.

But just because brokers are piling into these investments and creating more than 20 ATSs (if you count every internal and external crossing network) doesn't mean that they will all succeed. Lee predicts there will be three to five ATSs and ECNs surviving.

This reminds me of the late '90s when we had a dozen or more ECNs fighting for market share; and then a shake-out and consolidation ensued that left Island, Instinet and Archipelago with 90 percent of the market.

Now all three former ECNs have been acquired by exchanges with Nasdaq gobbling up Island and Instinet, and the New York Stock Exchange buying Archipelago.

The same thing happened in fixed income where the Internet boom gave rise to 70 or 80 e-bond trading platforms, and the only two survivors are TradeWeb and MarketAxess, says Lee.

"The lesson there is just because you have a bunch of high-flying dealers in there doesn't mean it's going to survive," says Lee.

But the dealers that formed BIDS in the spring of 2006 contend they are trying to solve an industry problem and their goal is not necessarily to make a lot of money or go public.

According to Larry Leibowitz, managing director and COO for Americas Equities at UBS, the BIDS consortium was formed to solve a problem. "We in the brokerage community have heard our clients say for years, particularly because of the rise of algorithmic trading, that spot liquidity for large blocks has become harder and harder to find," says Leibowitz."

Alberta Market Solutions, Ltd., in Calgary, Canada, developed the technology and concept for BIDS and approached the brokers in 2003. "We basically solved the classic block trading paradox: I don't want to tell you what I'm doing because I'll use it against you. But if I don't tell you I can't find you at the other side to trade," says Paul Hanson, a director at Alberta Market Solutions (AMS).

BIDS also is being run as an industry utility, where the brokers own and control it. "There will be no differentiation between owners and nonowners," emphasizes Leibowitz from UBS.

Third-party broker-dealers can use BIDs. Institutions need broker sponsorship to use the system, will probably have multiple broker sponsors and would pay fees to each broker. But BIDS will not take a big bite out of these fees, says AMS' Hanson.

Leibowitz maintains that BIDS is different than other initiatives that brokers have invested in, such as regional exchanges and alternative trading systems or dark pools, because they are not geared to block trading and lack a negotiating feature, he says.

While Liquidnet only lets in the buy side to preserve anonymity and prevent information leakage, BIDS will unite buy side and sell side, gaining access to sell-side liquidity, a feature that helped Pipeline Systems pick up momentum recently.

"We felt that this was the best chance to solve the problem," Leibowitz adds. "Otherwise why would we build a public utility system where we're clearly not going to make a lot of money or get an IPO if we didn't think we had a problem to solve," says Leibowitz.

Meanwhile, we haven't heard from the exchanges. Nasdaq plans to launch Nasdaq Block Crossing Network before year-end, and NYSE Group recently purchased MatchPoint Technologies, a designer of crossing networks.

"To a certain degree, one can argue block trading has already left the NYSE because the average trade size is around 400 shares," notes Aite Group's Lee.

Lee sees the BIDS initiative as a more of response to the perceived threat of the Liquidnet-type players. Altogether, Liquidnet, ITG POSIT, Pipeline and NYFIX Millennium account for 3 percent of the daily average volume in U.S. equities, which means this can be a much larger market.

Even so, does the market need another block trading service? Alberta's Hanson says that in all the discussions BIDS had with senior traders, dominant on the buy side and some on the sell side, "We have yet to hear everybody say they are, in fact, satisfied with the services and structure of the market."

Clearly, no one expects all of these ATSs to survive - though it is neat to see all of this experimentation with market structure and automated trading going on. Some are bound to stick and others will fall by the wayside.

"Like all evolving marketplaces, there will be some winners and losers," predicts Leibowitz. "Some good models will win, and some bad models will fail. The buy side is good at figuring out which models will work and those that won't, and voting with their order flow," he says. 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