In our last issue we looked at how traditional exchanges are evolving to meet 21st century demands – automating trading, eliminating hands-on intermediaries, forming international partnerships, and strengthening their governance structures. Many of these changes have been accelerated by competition from new entrants to the world of equities trading. New exchanges, market makers and alternative trading systems (ATSs) have proliferated in recent years, each hoping to snatch a piece of the equities business and, in some cases, challenge the efficiency of the traditional exchanges. We now turn our focus to these new players.
In Europe, despite stock exchange alliances and consolidation, many diverse competitors have emerged, including alternative markets (Ji-way, Tradepoint and Atriax) and crossing networks (ITG Europe and E-Crossnet). In North America, competition has given rise to electronic communication networks (ECNs), such as Island, Instinet and RediBook, and other so-called third market makers (Knight Securities) which have introduced full automation as an alternative model for matching orders. Several of the new European contenders offer solutions to the high cost of cross-border transactions, while their North American counterparts have created open limit order books where bids and offers are publicly displayed.
Each of these players appeals to niche markets. They tend to be fast, cheap trading systems with powerful computers and very few employees. Take the Island ECN, for instance, which on a good day trades 350 mn shares, charging a fee of less than one-tenth of a penny per share. Island raised some eyebrows last year when word got out that its massive order-matching system was actually run on an ordinary, off-the-shelf Dell computer.
Technology is the driving force here. It has given diverse venues the ability to link with each other and share each others’ liquidity. The more participants, the more sum liquidity there is. This is a clear example of strength in numbers. Perhaps the most important consequence of this structure is disintermediation – it allows investors to deal with each other and bypass the traditional middlemen.
Nasdaq saga
It has already been 30 years since Nasdaq began operations as a venue to trade over-the-counter stocks and in the last ten years its operations have reached world-class maturity. Many consider Nasdaq as a predecessor of today’s alternative systems, with its network of geographically dispersed trading terminals. Unlike traditional exchanges whose transactions funneled through a single, physical trading floor, Nasdaq’s model is based on connectivity.
John Hilley, Nasdaq International’s chairman and CEO, believes this model is easily adaptable to a global environment. ‘In a phrase, it is an open architecture. And that draws on something very simple, which is network economics – the more people are plugged into the network, the more beneficial that is to the companies and to the investors.’ The NASD, Nasdaq’s parent, has launched Nasdaq Japan and Nasdaq Canada, and is hoping to build the European equivalent. The goal, Hilley says, is to create a 24-hour worldwide market (which will be discussed in detail in our next issue).
Nasdaq has been hit hard in the US by the emergence of ECNs. Since the release of the SEC’s new order handling rules in 1997, ECNs have taken nearly 40 percent of Nasdaq’s trading volume. ‘When ECNs came into the Nasdaq environment they got 32 percent very quickly and they narrowed the bid/ask spreads – investors saved billions,’ boasts Andrew Goldman, vice president of corporate communications at the Island ECN.
ECNs’ main success has been to provided a solution to what Nasdaq lacked – a central limit order book (Clob). According to Goldman, this gives investors improved transparency in stock trading activity. ‘The ECN business model is a completely transparent marketplace where you can see all the prices and all the quotes. It isn’t just an indication of interest that some market makers may get for a particular stock; it shows actual, live orders.’
Proliferation
About a dozen ECNs have emerged in North America since Reuters’ Instinet began in 1969. Investors interact through an automatic order-matching platform, and when a bid matches an offer – even if they sit on different networks – the trade is automatically executed.
ECNs offer fast, low-cost executions and it comes as no surprise that their main subscribers are retail brokers. The downside, however, is liquidity. On any given day, ECN activity for listed securities comprises a total pool of liquidity which, according to Howard Eisen, a director of NYSE specialist Spear Leeds & Kellogg, is not always that large. ‘Most stocks aren’t AOL or IBM which trade 10 mn shares a day. Most stocks trade something like 200,000-400,000. So when an investor wants to sell or buy 150,000 shares, that’s a half day’s volume to move. If they want to do that on an ECN or some other disintermediated market, they have no idea when the trade is going to be completed or at what prices.’
‘The way I see it, investors – particularly institutions – crave two things: anonymity and liquidity. They’d love to get both, but if they have to choose between the two, they’ll take liquidity wherever it exists,’ Eisen explains. This also explains why ECNs have not made significant in-roads to NYSE-listed stocks. They simply cannot compete with the Big Board’s concentrated pool of liquidity.
Are ECNs good for public companies? Sydney Kampschroeder, marketing director of the ECN Archipelago, certainly thinks so. She argues that ECNs allow the inside market to be set by individual investors rather than exchange members. ‘They provide an additional level of competition, which helps narrow the spreads and lower volatility. And when we make the transition to trading in decimals, the spreads will become even more narrow.’
Archipelago is one of three ECNs (along with Island and NexTrade) to apply to the SEC for exchange status. If approved, they aim to compete on equal ground against the NYSE and the Amex. In the meantime, Archipelago has found a quicker way to achieve that goal. It plans to merge with the Pacific Exchange (PCX).
Dale Carlson, the Pacific Exchange’s vice president of corporate affairs, says Archipelago and the PCX are a natural match. ‘Ninety-eight percent of our trades on the equities side are handled electronically today. And in fact when we got to that level of automation several years ago, it begged the question, Why do we continue to pay for the floors? As far as we’re concerned, real estate adds zero value to the process of executing a stock trade. Our customers shouldn’t have to bear that expense.’
The joint entity, to be called the Archipelago Exchange, will employ the ECN’s trading system and the PCX’s regulatory body. While Carlson predicts the exchange will lower its overhead by closing its trading floors in Los Angeles and San Francisco, not everyone is convinced the SEC should grant exchange status to every ECN that applies. There is one controversial reason: more exchanges may lead to more market fragmentation.
Across the pond
Although US-based ECNs offer European institutional clients cross-border electronic executions, they haven’t been able to secure a strong toehold in Europe. Some sources say this is because most European exchanges already have a Clob. Europe has also been very proactive in linking its various trading platforms, such as Frankfurt’s system, Xetra, and London’s Sets.
Gregor Pozniak, deputy secretary general of the Federation of European Stock Exchanges (FESE), says American electronic communications networks have not had success in Europe because most European exchanges themselves are, in essence, ECNs. ‘If you leave out the legal aspect of the ECN definition under SEC rules, in functionality European exchanges are the same: they are fully electronic and, in most cases, order-driven trading systems for stocks.’
Pozniak explains that unlike their US counterparts, most European exchanges have a minimal self-regulatory function. ‘This means being branded an exchange instead of an ATS or ECN doesn’t necessarily make too much of a difference.’
Semantics aside, European exchanges have their own weaknesses. The European alliances have so far helped to inter-link foreign trading systems, though they haven’t cut the costs of foreign trades. Cross-border clearing and settling continue to be problematic and expensive. Once international transactions are agreed upon, several middlemen are required to ensure the shares actually get paid for, change hands and travel to their safekeeping.
Several alternative networks have taken a swipe at this problem. Both Tradepoint Financial Networks and Ji-way, two cross-border, all-electronic European equities markets, are trying to attract customers based on their all-inclusive services. They offer order execution, clearing and settling in one neat package. Ji-way even offers custody services. Likewise, Goldman Sachs recently unveiled PrimeAccess for low-cost trading, clearing and settling of US and European stocks for its brokerage clients.
Another model is the crossing network – a periodic system that matches buy and sell orders at the midpoint of a stock’s bid/ask spread. The two main crossing networks, ITG Europe and E-Crossnet, each conduct four crossing sessions per day for thousands of European stocks. The Arizona Stock Exchange uses a similar model for NYSE, Amex and Nasdaq stocks.
Pros and cons
So is the emergence of all these new trading systems a good thing for issuers? Some experts see it contributing to market fragmentation. Conversely, some say it is a good and necessary middle step to a truly global trading network.
The FESE’s Pozniak believes electronically linked exchanges indirectly benefit listed companies. ‘Running a fully electronic trading system makes it possible to link up remote members. It helps to get a higher number of brokers interested in your stock. Wider accessibility to your stock certainly contributes to liquidity and, hopefully, reduces your costs at the end of the day.’
Bob Forney, president and CEO of the Chicago Exchange, believes stock exchanges need to have different strategies for different types of stock. ‘This industry is full of the one-size-fits-all mentality. Most exchanges have the same systems and rules supporting the most liquid, high-trade volume stock as they do for the little stocks. That just doesn’t make any sense.’ Forney argues exchanges must be nimble enough to efficiently handle different niches. ‘If you don’t have the diversity, you can’t sustain high growth.’
Many alternative trading systems around the world have emerged as a result of open competition, and competition will help sort them out. The traditional exchanges, which have long been symbols of national identity, are facing competition more fierce than ever before and are being forced to adapt. Those that can effectively service their customers’ needs will thrive. More and more, they will have to widen their customer group to include not only exchange members but retail brokers and the issuers themselves.
The arguments continue about how the exchange of the future will execute trades – through pure automation or manually-aided automation. What is new and innovative now may become antiquated in a few short years. While the new, alternative systems have exploited the weaknesses of traditional exchanges, their survival will not depend on savvy marketing; it will depend on their ability to continue providing the services their competitors don’t.
As Forney analogizes, ‘If you discovered a formula for walking on water, all it would take is about two dollars of marketing for it to take off.’ Translation: there’s always a market for solutions.
Next month this trilogy on global markets will conclude with a discussion of global exchanges, after-hours trading and cross-border listing.
