Credit Suisse First Boston,
Goldman Sachs Group LP, Merrill Lynch & Co. Inc., Morgan Stanley Dean Witter & Co. and Salomon Smith Barney Inc. all own stakes in at least two electronic trading systems. By some estimates, the top Wall Street firms have invested more than $200 million in ECNs.
It's now looking like most of that will be money down the drain. While the two largest ECNs, Island and Instinet, appear to have viable businesses, the seven others combined account for less than 6% of trades in Nasdaq stocks and virtually no volume in stocks on the Big Board. And recent developments suggest that the future won't be any brighter.
Earlier this month, Nasdaq agreed to sell itself in two private placements that will put much of its stock in the hands of Wall Street's biggest firms. This is likely to erode whatever incentive Goldman, Merrill and the others have to support the ECNs. Moreover, executives at Nasdaq's parent, the National Association of Securities Dealers, have expressed willingness to offer the same low prices and automated trade execution that made ECNs so appealing in the first place.
Scandal gave a push
While Instinet has been around for 30 years, mainly as an after-hours market for institutional investors, ECNs didn't emerge as a group until 1997. In the wake of Nasdaq's price-rigging scandal, the Securities and Exchange Commission forced Nasdaq dealers to give investors access to competing bid-and-offer prices that are better than the dealers'.
The ECNs have been able to offer better prices because they allow investors to trade directly with one another through fully computerized networks that are cheap to operate. Island, for instance, uses a $2,500, off-the-shelf Dell computer to match buyers and sellers for each of the 135 million shares it handles daily. Island charges a quarter of a cent a share for market orders, versus the roughly 6 cents a share institutional investors pay the big Wall Street firms.
Island, which is 85% owned by Datek Online Holding Corp., gets most of its business from Datek and 230 other retail brokerage firms, many of them discounters.
Most of the other ECNs are targeting the institutional marketplace. If they're going to succeed, these second-tier trading systems, like Archipelago, Brass Utility (Brut), MarketXT and Strike Technology, will need their Wall Street backers to provide them with more business.
But that's what the Goldmans and Morgan Stanleys have been least willing to provide. Directing too many orders to ECNs would undermine their own lucrative trading operations.
"Most people look at those investments in Archipelago, Strike and the others as an endorsement of the potential and promise of the ECNs," says James Marks, an e-commerce analyst at First Boston. "We see them largely as a defensive gesture."
In a new research report, Mr. Marks argues that ECNs are the rare
venture capital investments that the big firms don't want to see succeed. Buying into them has been merely a hedge. "This was quick money put on the table out of fear and ignorance," he says.
Goldman Sachs, for instance, worried what would happen if an ECN controlled by Morgan Stanley emerged as the dominant marketplace for important stocks. Therefore, its decision to invest in three electronic stock markets --Archipelago, Brut and Optimark -- was the equivalent of purchasing an option against its biggest competitor controlling a key segment of its business.
"If the ECN blossoms into something substantial, you've got the double payoff of a great return and control of a portion of the market," writes Mr. Marks, whose own firm has stakes in two ECNs. "If the ECN fails and the option expires worthless, you're actually happy and the investment was just the cost of insurance. The reality is that the options on most of the ECNs are going to expire worthless," he adds.
"People go where liquidity is greatest, and liquidity is greatest where people go," explains Lawrence Glosten, a professor of finance at Columbia University.
In order to create more liquidity, two of the second-tier ECNs, Brut and Strike, are merging. "The bottom line is liquidity, liquidity, liquidity, and right now, we don't have it," says Brut president Brian Hyndman.
But he acknowledges there's no guarantee that the duo's backers -- which include Goldman, Bear Stearns, Merrill Lynch, Morgan Stanley and Salomon -- will direct any more business to the merged system.
Nevertheless, he remains confident that the combined Brut/Strike will succeed. Brut's own trading volume has increased in six months to 40 million shares a day from 7 million, largely because its Wall Street backers have been directing more business its way, Mr. Hyndman says.
Whether that support will continue is debatable, largely because of the change in Nasdaq's ownership structure. As Nasdaq's future owners, the big firms have even less of an incentive to deliver business to ECNs.
