Is American cowboy capitalism causing unnecessary pain for the U.S. equity markets? Fragmentation of order flow is possibly the worst sign of strain.
A lance corporal of the U.S. equities markets is miffed the U.S. hasn't learned a valuable lesson from European centralized stock market trading. The newest American enemy is electronic communications networks.
"You don't see ECNs in Paris, Frankfurt, or Zurich or even in London, which is moving towards a much more efficient market," said Doug Atkin, the youthful chief executive of Instinet, at a recent press conference.
(Instinet, a subsidiary of Reuters Group, squirms at being labeled an ECN. That's even though it is technically an ECN, and the largest of the eight approved ECNs, as measured by single-counted share volume.)
A coming shoot-out at the OK Corral, therefore, might be a suitable metaphor for what is likely to occur in the years, if not the months ahead. Far-fetched? The suddenness may be as brutal on some participants as recent federal regulations have been for market makers.
"ECNs will be a short-lived pheno-menon," says a report on ECNs by Meridien Research in Newton, MA. "Eventually, fully electronic, order-driven stock exchanges will appear in the U.S. Nasdaq is clearly moving in this direction."
Though the Meridien report is unkind, with cutting cliches, regurgitating Securities and Exchange Commission handouts on how market makers allegedly engaged in price collusion, the picture it paints of the post order handling rules environment is not reassuring for traders.
(Yes, the academic evidence of ill-gotten gains on Nasdaq is overwhelming. A libertarian economist, however, might consider the subsequent federal order handling rules, installed to clean up Nasdaq, a form of insidious price control straight out of a socialist monetary textbook.)
The order handling rules, the report underscores, unleashed the whole sorry mess of ECNs that are fragmenting the marketplace today. The irony, of course, is that these rules, designed to speed up the centralization of the U.S. equity markets – and to prevent market makers from "shelving" unprofitable limit orders – are encouraging the opposite.
ECN Growth
Together, ECNs will attract and match an increasing proportion of Nasdaq order flow in the years ahead, according to Meridien. By 2001, the research outfit projects that ECNs will account for about 50 percent of Nasdaq trade volume. But the unification of disparate market centers may be looming.
"The number of ECNs will not remain at the current level," Meridien notes. "We expect to see significant consolidation because stock exchanges tend to be something economists refer to as "natural monopolies."
"Investors will naturally gravitate to the largest exchange, because that is where the greatest liquidity is, and where they are most likely to find a counter-party willing to trade at the best possible price. The same logic applies to ECNs – users will gravitate to the largest ECN."
The rationale is clear: a consolidating ECN industry will tussle with the New York Stock Exchange and Nasdaq and some marriages of convenience will occur. Instinet and other ECNs have all recently danced jigs with the Big Board and Nasdaq. The most publicized partnership talks centered on Instinet and the Big Board.
In the meantime, Nasdaq will tussle with its own members to finally implement a Nasdaq-operated central limit order book while the Big Board is likely to move in a similar direction. "Creating a central order book where orders are matched automatically based on price-time priority would mean that Nasdaq itself would operate like an ECN," Meridien states.
The loser is not Nasdaq but the Nasdaq market maker.
"A common misconception is that ECNs are taking liquidity away from Nasdaq," says Octavio Marenzi, senior analyst and author of the Meridien report. "In fact, ECNs are adding efficiency to the market."
"The pressure that ECNs bring to bear is squarely on the market makers, who can no longer control pricing. With some ECNs already filing for exchange status, it appears that the electronic network will take an increasingly greater role in the future of equity trading."
There is no certainty that the changes envisaged by Meridien will take place. But many trading experts, like Meridien, agree that the current patchquilt of ECNs and other market centers, could fail to survive in the next round of dynamic change on Wall Street.
That ECNs are clamoring to become full-fledged stock exchange brings the debate on the current state of the U.S. equity markets back to fragmentation.
Does allowing ECNs to register as stock exchanges make sense. Is there room for more "stock exchanges?" The American Stock Exchange, for example, has barely enough order flow to cover its embarrassingly dismal performance.
Will more exchanges just make it more difficult to accomplish the regulators' goal of best execution, never mind a national market system envisaged by Congress in 1975?
Virtual stock exchanges may be different. But as Meridien hints, the current crop of wannabe stock exchanges can promise but do not necessarily guarantee a best execution. The granddaddy Instinet has liquidity. The network handles 150 million shares daily and accounts for 20 percent of the volume in Nasdaq's 100 largest stocks. To be fair, it is a "super ECN" operating in 40 markets worldwide. Besides matching stock trades, it provides research and analytics, and has a strong edge in upstairs block trading. Instinet spends $100 million annually for technology.
But that does not mean the best prevailing prices on a stock are always available on Instinet. Bloomberg's Tradebook thinks it has the solution for traders having scruples about best execution. Its "bang" feature allows subscribers to access the markets broadcast by Nasdaq trading desks and ECNs via SelectNet.
Search Machine
Archipelago contends it is the first to implement a "best execution" system. If an order is not matched within Archipelago's internal book, the ECN will sweep Nasdaq market makers and rival ECNs for possible best execution. Another ECN, STRIKE, launched a web-based network that searches the best bid and offers outside its own limit order book
What this all suggests, of course, is that American cowboy capitalism came into its own soon after the order handling rules were unleashed. An astute investor should consider a search of most ECNs and market centers for the best possible prices.
With consolidation looming, many ECNs are likely to go down in battle. "Once Nasdaq and the NYSE move to fully electronic trading systems," Meridien states, "the niche that ECNs occupy will disappear."
