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ECN Portals Serve Up A Menu of Appetizing Choices

Borrowing a recipe from the day trading industry, Wall Street firms are eyeing a couple of software companies that have married the Internet with direct,electronic access to ECNs.

Day trading-that brand of rapid, electronic scalping that attracts Generation Xers, former Wall Street market makers, teachers, lawyers and people from all walks of life-has had direct access to electronic trading systems for the past two years.

That's why the top five Wall Street sell-side brokerage firms and at least two private trading networks are chasing a trio of little-known software companies that supply automatic execution and order routing technology to the controversial day trading industry. Negotiations with Wall Street firms and ECNs can either mean making an investment, forming a strategic alliance or acquiring the companies outright.

But going a step further, CyBerCorp and Tradescape claim they can scan the liquidity of the major ECNs and determine which one can execute an order at the best price at a given moment in time. Tradescape and CyBerCorp license their technology to day trading firms and active traders through the Internet, but now believe that the direct electronic execution technology will migrate to the institutional space.

"Around five of the largest Wall Street sell-side brokerage firms are actively and at the most senior level engaged in discussions with technology firms like ours who have developed direct access, electronic execution technology," reveals Philip Berber, founder and CEO of CyBerCorp. Inc. However, he declined to specify the firms by name.

Among the firms holding discussions are Merrill Lynch and Lehman Brothers, as well as Instinet Corp. and Optimark Technologies, according to a source with knowledge of the talks. Other possible suitors/investors could include D.E. Shaw and Vulcan Ventures, the venture capital firm owned by Paul Alan, a co-founder of Microsoft. Vulcan recently pulled out of a deal with Datek Online Holdings Inc., majority owner of the Island ECN, reportedly because Datek Online, the brokerage unit, was under investigation by the SEC. Merrill, Instinet and Optimark declined to comment. Calls to Lehman, D.E. Shaw and Vulcan were not returned.

Without commenting on the market rumors, Rob Laible, senior vice president, equity derivatives at Lehman Brothers, who is global program trading product manager, agreed that some of the services and tools would apply to institutions. "You've got links to nine ECNs, plus 100 market makers. Who do you go to?," he asks. Maybe in the old days you checked Autex, and you looked at who had the most volume in a particular security and then you called them up ... Now it's much more of a real-time environment where portfolios can be segregated by sectors and then there might be a particular ECN or broker that has an edge in that sector. You may just want to be able to move that to that particular pool of liquidity but not have to give your entire portfolio," he says.

The potential deals underscore the demand for online trading and the growing importance of the ECNs which currently account for 30% of Nasdaq's trading volume. It also suggests that sell-side firms are lagging in this type of integrated execution technology.

Wall Street firms were "blindsighted by the evolution of innovative technology in this space," and are now looking to bring e-commerce into the institutional business," says Berber, citing the Internet, intranet and frame relay technologies. Berber says that sell-side firms want to use the direct access technology to build an e-commerce business-to-business model and to provide that to their buy side fund managers, institutional traders, and hedge fund clients. "A sell-side institutional broker will want the client or buy side fund manager to use their Web site and use their Internet application as opposed to the next guy's," he says.

The key issue for them is time to market, says Berber. Sell-side firms need to make up a two-to-three year development time gap and the millions of dollars they'd have to spend to catch up. "Everybody's looking to buy technology," confirms a consultant with a Big Five technology practice, noting that Merrill Lynch paid $20 to $30 million for D.E. Shaw's DeSoft's e-commerce business-a bargain for all the programming talent and patents.

Also, more of the order flow is coming in electronically-one in four equity trades is executed online, yet Wall Street is still mired in the phone and the old boy network or relationships, says Berber, noting that they need this technology to capture the order flow electronically. That trend is expected to continue. A recent report on ECNs by Meridien Research predicts that ECN volume will account for half of Nasdaq volume by 2001.

Day Trading Origins

Why would Wall Street firms want to buy these companies?

Once reviled as "SOES bandits," because they used Nasdaq's small order execution system to scalp professional market makers, today, day trading firms and their technology suppliers are emerging as key sources for the next generation of Wall Street's electronic trading technology. "The irony is that some of the same firms that are looking to buy day trading firms' technology are the very firms that vilified them," notes Omar Amanat, 27, CEO of Tradescape.com, whose software firm is merging with Momentum Securities, the largest day trading operation.

Another reason why Wall Street firms might want to buy day trading technology is that "it's the most robust out there," says Amanat, who adds that the combined firms process 100,000 trades a day.

So while the technology has been developed outside of Wall Street, says Berber, it's been tested on large volumes in the day trading industry, he points out. Day trading has exploded in the past two years fueled by the Internet, faster and cheaper bandwidth via cable modems, pervasive access to Nasdaq Level II quotes and the ability to send stock orders to an electronic trading system, such as Island ECN, in seconds.

The concept, known as Electronic Direct Access Trading (or EDAT), was coined by Mark Nassar, author of the book "How to Get Started in Electronic Day Trading."

As Nassar explains, a direct access trading system "aggregates a number of tools to make those trades to systems like SOES, SelectNet, ECNs, of all sorts by pooling all those resources under one system."

The true pioneer in EDAT is Joshua Levine who created the Watcher System used by Datek Online. Day trading firms like Broadway Trading, use The Watcher System to preference orders to the Island ECN, which is majority owned by Datek Holdings. But Wall Street firms don't have the technology to integrate the ECNs into a centralized pool of liquidity.

Dealing with ECN's

Fragmented liquidity rumors of the deals come at a time when Wall Street brokers are making multiple investments in ECNs to hedge their bets on the future direction of trading. For instance, on Sept. 9, Merrill Lynch announced that it had invested in Archipelago Holdings LLC, buying 14.3% of the ECN. Merrill also owns stakes in Brass Utility's Brut, another ECN, as well as Primex, a venture with Goldman Sachs and Bernard L. Madoff Investment Securities to build an electronic auction market for NYSE-listed stocks, as well as Optimark. "For firms that are placing bets in three or four ECNs, the most logical choice would be to place a bet in the technology that aggregates all of the ECNs and gives you access from one terminal," says Amanat of Tradescape.com whose firm has developed an Electronic Communications Network Portal, called ECP. "In 17 milliseconds it'll actually go out and scan all nine ECNs for the best price available," because it gets all the direct feeds from the ECNs, he says.

Amanat is positioning his company as an "aggregator or consolidator" that has direct connectivity to all nine ECNs. And that number will soon be 12, Amanat says, because he is working on linking to Optimark, Lattice and ITG's Posit-various types of matching systems that could route orders to the ECNs.

Amanat contends that since many of the ECNs Wall Street has invested in-naming Strike, Brut and Bloomberg's Tradebook-have not lived up to expectations in terms of volumes, order flow or revenue, technology linking the ECNs may be a better investment.

Meanwhile, rival CyBerCorp has developed an intelligent order routing algorithm dubbed CyBerExchange, which can search for the best price among Nasdaq market makers as well as ECNs. "We hunt and seek amongst every ECN and every market maker and then we forwardthe order to which ever market maker or ECN is offering the best price at that moment," explains Berber who adapted techniques he learned from the military and aerospace industries in the 1980s.

One reason the so-called Super ECN technology is valuable right now is that ECNs are fragmenting the liquidity in the stock market.

"The real value of this thing is to be able to almost one-stop shop and this thing will figure out the best place to tradesomething. You don't have to waste time trying different markets," says George Kledarus, president of Javelin Technologies, a New York-based developer of applications using the FIX protocol who works with all the major ECNs.

"A lot of the firms are having problems connecting to these ECNs," says Larry Tabb director of the securities and investment practice at The Tower Group. "Having somebody consolidating all these quotes helps them figure out where the liquidity is in the marketplace," says Tabb.

Covering the major ECNs is what's important, according to Tradecast's CEO Bobby Earthman, which markets Go Direct. "We've got a server that connects up to Instinet, firms can just use that one. Major ECNs are covered with Island, Archipelago. Our Brut server--that's almost done. We just sort of base it off of what people are looking for," says Earthman, adding, that the vendor has also developed a server for the NYSE's Superdot and to Chicago Corp., Spear, Leeds & Kellogg and Southwest Securities-clearing firms that handle listed stocks.

Currently, CyBerExchange links to Archipelago, Island, Brut and Redibook, while an interface to Strike is in the works, says Mark Stryker, CEO of CyBerBroker, the firm's online broker, which provides two trading front ends: CyBerTrader and CyBerX. Both utilize the CyBerExchange order routing technology, which is the portal that looks at the activity and decides where to send an order, explains Striker. A customer can override it or let the system make the decision, he says.

One problem was that some of the ECNs resisted giving the software firms a direct connection. For instance, CyBerExchange has an indirect link to Instinet and Bloomberg TradeBook through SelectNet, whereas the other four ECNs, allow for a direct link.

"CyBerTrader found its genesis in the day trading industry," Stryker explains. "Many of the established firms did not want to have links with anything that it has its roots in day trading," he says. "That freeze in the relationship is thawing," he says.

But according to David Nassar, who also owns Market Wise Trading, a trading school, as well as a brokerage firm by the same name, these liquidity scanners are overselling their capabilities. "What's important to know is their technology is really not a major breakthrough. In my opinion, the real value comes through the ECNs themselves, and the systems that were created by Nasdaq SOES and SelectNet," says Nassar. "What their tools give you is a way of looking at the data, a front end-almost what I call a paint job, ... in comparison to others. And they've linked that front-end to execution."

Nassar says, "that an illusion is being presented to the market that this software has got this intelligent, artificial, fuzzy logic built into it, that it can find you the best liquidity. That's just not true ... That only comes through intuition and experience of trading," says Nassar. "And if you rely on software to find you the best markets, then you're giving yourself, false hope."

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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