Trading Nets Give Exchanges A Run for Their Money

Computerworld - Part of a continuing series on the impact of technology on Wall Street.

For decades, a select group of sentries has held captive some of the key information Wall Street traders need to make the most informed decisions on Buy and Sell orders. But the three-year rise of nine electronic communications networks (ECN) has forced the old guard to redesign its technology—and its business.

Yet the battle is far from over. While the New York Stock Exchange (NYSE) has rolled out the first phase of its ECN-like service, Network NYSE, Washington-based Nasdaq Stock Market Inc.'s ECN-like offering, has been stymied by complaints about the algorithm it uses, stalling the project before the Securities and Exchange Commission (SEC) for almost two years.

The winning model may eventually be a hybrid—one that combines the liquidity of a traditional stock exchange and the speed and direct access of an ECN, analysts said.

"This is a fascinating time," said Roger Berkhardt, senior vice president and chief technology officer of trading systems development at the NYSE. "It's all about choice—choice in access, execution and connectivity in [such] a way [that] the consumer can decide what suits them best. It's [also] about the commitment of technology and capital."

ECNs—simple order-matching networks such as those of Archipelago Holdings LLC in Chicago and The Island ECN Inc. in New York—make their money through transaction or access fees. They handle an estimated 34% of Nasdaq's volume in any given period, as well as a much smaller 3% to 4% of trading on the NYSE, according to Meridien Research Inc. in Newton, Mass.

Tightening the Profit Margin

On the NYSE and Nasdaq, all trades are conducted through middlemen who work on the trading floors; Nasdaq calls them "market makers," while the NYSE refers to them as "market specialists." When no buyer is immediately available, they put up their own capital—with the backing of securities firms like The Goldman Sachs Group Inc. and Merrill Lynch & Co., both in New York—to meet a Sell order. Then they find a buyer, sell those stocks at a higher price and pocket the difference. The wider this spread, the bigger the profit.

That difference in pricing policies is one point of contention between the ECNs and the exchanges. "Regulatory reasons have allowed ECNs to collect access fees when a broker dealer places a Buy order against an ECN offering to sell. That's an enormous regulatory subsidy that ECNs have had in the market," Berkhardt said.

But the real problem is that the ECN pricing model threatens those fat Wall Street spreads, said John Oddie, CEO of global equities business at top-trading ECN Instinet Corp. in New York. He said he sees nothing wrong with the ECN model; it's just different. "Our model is to charge commission when we execute a trade, while the market makers buy at one price and sell at another and make a commission," he said.