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The future of ECNs
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September 1, 1999: 12:32 p.m. ET
A report finds they're headed for extinction. They'll fight to survive.
By Alex Frew McMillan
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NEW YORK (CNNfn) - Electronic communications networks, which are shaking up how the stock markets work, are a little shaken up themselves after a critical report Tuesday. It suggests ECNs, which let buyers and sellers of stock meet without the use of middlemen such as market makers and specialists, will ultimately head the way of the dodo.
ECNs say they're ready to fight for their survival. They feel they can compete long term with the established stock markets on the technology front and on the cost of executing trades. More immediately, talks are in progress for them both to pool their operations and to consolidate ownership.
Even if the nine ECNs ultimately are doomed, their rapid growth will continue over the next two years, according to Octavio Marenzi, who compiled the report for Meridien Research Inc. They already account for around 30 percent of Nasdaq's volume. Marenzi predicts that will rise to 50 percent of trading on the Nasdaq stock market sometime in 2001.
"But this is not a long-term template situation, where they're amassing this liquidity," Marenzi said. He foresees their eventual extinction over four or five years. "What's most likely to happen is that Nasdaq moves to an electronic trading system and really obliterates the ECNs."
What does the future hold for electronic communications networks? Executives at the ECNs themselves admit they don't know for sure. But the world of these alternative trading systems or quasi-exchanges is likely to change rapidly in a relatively short time, and to transform the way stock markets as we know them operate.
Consolidation the first step
Many observers expect large-scale consolidation of the nine ECN players, down to two or three. ECNs have been growing in market share because they allow big institutions to trade anonymously, meaning they can shift large blocks of stock without alerting the market and causing a dramatic shift in price. Increasingly, brokerages are hooking up to them to offer after-hours trading to retail customers.
ECNs also offer cheap execution. For instance, on Island, the second-largest ECN, the average commission for a 1,000 share block is 75 cents. That's because they run with very few employees -- Island has 38 -- and rely on computer technology to match orders. The computers that match orders on Island are basic Dell PCs.
The ECNs' biggest immediate challenge is their lack of liquidity, particularly in the extended-hours trading they offer. They're basically pools of limit-order trades that sit separate from each other. People involved in the talks say Instinet, Island, REDI, Archipelago and B-Trade, the five largest ECNs, are soon to declare their intention to link up and pool their after-hours trading.
During the day, if ECNs can't execute orders internally, they rely on Nasdaq's SelectNet system to link them with the other ECNs and market makers. ECNs have set up some links directly to each other, too.
If the ECNs do hook up, they could set up a system to compete with Nasdaq's SelectNet both after hours and during the day. Critics say SelectNet is expensive, and some ECN insiders think they can set up a faster system.
The majority of the ECNs are in merger talks already at a corporate level and "material discussions" are under way, according to a person familiar with the talks. A "substantial consolidation" is likely in the near term, he said.
Markets will become more like ECNs
In response, Nasdaq and the New York Stock Exchange will become more like ECNs. That's why Marenzi expects the ECNs to die out. He believes Nasdaq will become what he calls a "super ECN." It will evolve into a fully electronic system, with a central limit-order book.
Eventually he expects Nasdaq to phase out the market-maker brokerages that, until ECNs surfaced, carried out all the trades on Nasdaq. ECNs cut out the market makers -- middleman broker-dealer firms that make their profits on the spread between the bid and ask price on the stock, buying it at a slightly lower price than they sell at. "They're going to be the real losers in this, and really are already seeing the pain and the pinch from ECNs," Marenzi said.
The market makers have stayed afloat because the stock market's volume has also increased while ECNs have robbed them of trades, he said. But he and the ECNs envision a market that's entirely "transparent," where all the participants can see all the prices, and efficient, where buyers and sellers link without middlemen. "We're sort of seeing the death throes of the dealer-driven market," Marenzi explained.
Market maker traders thrive on inefficiency in the market, linking buyers and sellers at different prices. As electronic links get better and the buyer and seller are able to meet directly, "making money on the spread will become very difficult to do," he said. "It's just a bad place to be a middleman anywhere."
To survive, market maker brokerages would become more speculators than arbitrageurs, he said, making money from stocks rising or falling rather than price inequities. Specialists, who perform a similar function on the New York Stock Exchange, also are likely to see a substantial change in their role. The NYSE has seen less impact from ECNs, but observers expect it to make itself more ECN-like, more electronic, as well.
Philip Berber, CEO of CyberCorp, an Austin, Texas-based software company, envisions "one electronic hub, with no middlemen in the middle, within which buyer and seller orders will be electronically matched." His company is in talks with large Wall Street brokerages and the ECNs to provide the front-end software and back-end links to the participants, the "operating platform," on which that would run.
Exchange status might let them go it alone
Three of the ECNs have filed with the Securities and Exchange Commission looking to become independent exchanges. The SEC is unlikely to act on the requests until next year, after Year 2000 problems pass. How new, for-profit exchanges would be regulated also is very much up in the air.
But they ultimately could break away from Nasdaq, which at the moment they operate through rather than compete with. They also could seek their own listings, something Archipelago requested in its SEC filing. If and when ECNs become exchanges, they would have greater access to New York Stock Exchange listings.
Even if Nasdaq creates a central limit order pool and becomes an ECN-like exchange of its own, "you still need to compete on price, technology and liquidity," said Jack Vensel, vice president of sales at Island. Stock markets would become much more commoditized products, where the cheapest and fastest computer hookup gets the trade.
Berber, the CyberCorp CEO, sees that happening first in U.S. equity markets, with Nasdaq, the NYSE, and the ECNs. But the "electronic hub" he foresees would expand internationally, becoming global and 24 hours a day. Its scope would grow to incorporate bonds, futures and options, too.
How long will it take? Not long, he thinks, like most things computer-related. "What I've just described to you, the evolution in this space, will happen --" he paused to think -- "in a little over 18 months."
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