NEW YORK (CNNfn) - Island, Archipelago, Instinet and the other electronic communications networks have been exerting pressure on traditional stock markets lately, but just what is an ECN and how will it change the way individual investors trade?
ECNs are computerized trading systems that match buyers and sellers of stock. Instead of people executing trades over computers, which is how Nasdaq works, or through a specialist on an exchange floor, in the case of the New York Stock Exchange, ECNs basically operate like giant eBays for securities. A broker-dealer seeking a trade posts the asking price and a computer checks to find a match.
Competition forces change
ECNs, which operate with powerful computer servers and a handful of employees, are a cheap and quick kind of "alternative trading system." What online brokerages are to traditional brokers, ECNs are to conventional market makers, the Wall Street firms that for decades have matched buyers and sellers of securities.
There's been a proliferation of ECNs since the Securities and Exchange Commission first approved them in January 1997. There are now nine, and they accounted for 22 percent of the trading volume on Nasdaq in the first quarter of 1999, and 30 percent of the trades, figures show.
The most obvious effects ECNs are having are indirect. Both the New York Stock Exchange and Nasdaq are planning to extend their hours and go public. Both moves are widely attributed to competitive pressures from ECNs.
Because they're for-profit companies, ECNs are more nimble at adapting than traditional stock markets that have to answer to their members, market watchers say. It's easier for ECNs to offer extended trading hours, for instance, and many do, up to 5:15 in the afternoon or for an extra hour in the morning. Instinet, the biggest ECN, operates almost 24 hours a day.
These pressures are forcing the traditional markets and their members to adapt.
"The development of ECNs and the development of technology is really changing the structure of our markets," Mike Shokouhi, a Nasdaq spokesman, said.
For now, ECNs compete with Nasdaq's members, the market makers, more than the market itself, basically operating like nodes within Nasdaq.
Nasdaq makes much of its money from fees it receives from companies listed on the exchange, and will go toe-to-toe with the ECNs if they take off on their own as full-fledged exchanges. Island filed with the SEC to do exactly that in June and Archipelago followed suit Monday. ECNs running as full-fledged exchanges would be the first new real marketplaces to buy and sell stocks in almost three decades.
ECNs want more NYSE companies
Another reason they want to become exchanges is to get access to New York Stock Exchange-listed companies. Though technically ECNs can execute trades for most NYSE listings, access is limited. Only Instinet, the biggest ECN, really offers it, and volume isn't heavy. But stock exchanges are linked by an electronic quote system, and by tapping into that, the ECNs hope to offer broad trading in NYSE stocks.
Many issues still have to be sorted out before the ECNs can operate as independent exchanges, such as how they will guarantee a liquid market for stocks and how they'll be regulated. To answer the latter, the National Association of Securities Dealers Inc., Nasdaq's parent, is considering spinning off its regulatory unit. The theory is that on its own, the unit could better regulate Nasdaq and alternative exchanges.
Approving any new exchanges could take up to 18 months while those issues are hashed out, Archipelago CEO Gerald Putnam said. For now the ECNs offer institutions and brokerages a cheaper way to trade with each other, savings that eventually could be passed on to investors.
Tighter spreads, quicker trades
From a retail investor's perspective, it's tough to notice any direct change thanks to ECNs. Individual investors still have to deal with a broker to place their trades. The brokerage house then routes them to a market maker or an ECN, wherever they can get the best price.
That's where the ECNs say they can save investors money. By offering an electronic trade instead of a trade executed by people, ECNs say they cut down on error. The trades are also executed quickly by computer, reducing the chance of "slippage," or a price changing between when a trade is placed and when it is executed. Lastly, trades executed through low-overhead ECNs are cheap, a quarter of a penny via Island, for instance.
"When the customer went to a market maker, and the spread is an eighth, he's technically being charged 12 cents a share," said Chris Concannon, associate general counsel with Island. On an ECN, the brokerage places its own bid or ask price rather than relying on a market maker's best offer.
That increased competition has forced market makers to narrow their spreads, the difference between the bid and ask prices. If a Wall Street market maker doesn't offer a competitive ask price, for instance, it risks losing the trade because a brokerage could turn to an ECN.
"If you've got access to an ECN, you can create the inside market. It really is the ultimate opportunity for price improvement," Archipelago's Putnam said. "It's cheap, efficient, there's nobody goofing around with your order." By tightening spreads, Putnam says ECNs have saved investors $34 billion. Nasdaq reports the saving from ECNs is more like $1 billion.
Retail investors don't notice the change in spreads because they only see one side of the trade. But they benefit from a more efficient market. Think of ECNs as stock wholesalers, said SEC spokesman Duncan King.
ECNs like stock wholesalers
"If the grocery store you go shopping at suddenly has a number of different wholesalers for produce, then with the competition between the wholesalers you may end up with cheaper produce," King said. "But the individual shopper doesn't see the wholesaler."
Retail customers have seen limited direct effects from ECNs. In July online brokerage Datek Online, whose parent has a large stake in Island, started offering extended-hours trading until 5:15 p.m. ET via Island. E*Trade may well do the same when it hooks into Archipelago, which it bought into and also operates to 5:15, over the next month or so.
Many of the biggest Wall Street names are buying into ECNs, hoping to tap a future source of cheap trade executions. Analysts predict a shakeout in the ECN market that will leave only a couple standing, and it's guesswork where the future of alternative exchanges will lead. "Even the visionaries are groping a little bit," said Kevin O'Hara, general counsel at Archipelago.
But for now the quicker, cheaper quotes and the narrowing of spreads mean making markets in a stock is a much more competitive business. "The ECNs are good for investors - it brings another competitor into the market making system," Shokouhi at Nasdaq said.
Expect them to continue to force changes in the way market makers operate. If and when new virtual markets flourish, the whole nature of stock markets could change.
"Retail investors don't realize what a big deal this is," Putnam said. "This is a big deal."