For the past couple of years, equity trading technology staffers at many broker-dealers have been gnashing their teeth and tearing their hair out over the myriad technical challenges presented by Regulation NMS. But in Princeton, N.J., at the headquarters of Order Execution Services Holdings, the only frustration has been over the delay in the implementation of the Securities and Exchange Commission's sweeping new rule.
The centerpiece of the new regulation, the order protection and the fair access rules, is like a gift from the gods for the small, specialty broker.
OES, which operates an extensive network used by broker-dealers to send orders to exchanges, suddenly finds itself at the center of the NMS whirlwind. Literally.
"With Reg NMS," says Michael Barth, an OES senior vice president responsible for exchanges and market centers, "we've positioned ourselves to be the premier private linkage provider for the exchanges as the alternative to the ITS."
The ITS, or Intermarket Trading System, is the network operated by the Securities Industry Automation Corporation that transports orders between exchanges. The technology and governance of the 30-year-old ITS are supported by all of the nation's stock exchanges. With the coming of Reg NMS, though, ITS is scheduled to be phased out.
In its place, exchanges intend to handle their own outbound routing, relying on internal resources or contracting with specialty broker-dealers and/or vendors.
Under Reg NMS, exchanges are required to make sure they have the capability to route out orders that do not execute on their trading platforms.
To do so, they need an affiliation with a broker-dealer and an outbound routing mechanism. Some exchanges are setting up the broker-dealer internally and outsourcing the routing. Others are outsourcing both services.
The Prize
At stake are tens, if not hundreds, of millions of shares per day flowing through the intermarket system. OES would take a fee for every share delivered.
However, the profitability of all that flow is a question mark. Some predict a price war once Reg NMS is fully implemented and a dozen or so exchanges and ECNs are competing for flow. The less they get per share, one exchange official argues, the less available for the outbound routers.
OES is one of only three firms under consideration by the country's 10 stock exchanges to provide the broker-dealer services, the routing or both. Lava Trading and Selero, formerly IBSN, are also being considered, sources say.
The firm is positioning itself to act as both a broker-dealer-with representation on all stock exchanges-and a routing provider.
OES has landed five exchanges so far. It will function as the facility broker-dealer and routing supplier to both the Philadelphia Stock Exchange and the ISE Stock Exchange. It will function only as the routing supplier for Nasdaq and the two exchange subsidiaries of NYSE Group.
For them, OES will not act as a facility broker. Nasdaq will use Brut for this purpose. The NYSE exchanges will both use Archipelago Securities.
Lava has two wins: the Boston Equities Exchange and the National Stock Exchange. Still in contention are the American, the Chicago and the CBOE stock exchanges.
"We won't get everybody," says OES chief executive Dave Scheckel, "but we'll get the lion's share."
OTC Roots
Scheckel and some of his top lieutenants at OES have been in the order routing game since the late 1980s. As a part of SG Cowen in the 1980s and 1990s, his team supplied order routing facilities to regional specialists and options market makers looking to lay off equities positions, largely on the NYSE.
In 1996, the group joined trading house Herzog Heine Geduld, where it serviced Herzog's broker-dealer correspondents as well as the regional specialists and options market makers. While most Herzog staffers were engaged in trading Nasdaq names, Scheckel and his team handled the listed flow.
In 2000, Merrill Lynch bought Herzog for about $1 billion. The subsequent market rout left the venerable wholesaler in tatters, and Merrill eventually disgorged what became OES in 2002.
Since March 2002, OES has been a private company based in Princeton. It now has about 35 employees and a couple hundred broker-dealer customers. Prominent investors in the firm include trading technology pioneer Bill Lupien, founder of OptiMark.
The first few years of OES' independence witnessed a clamor by electronic players to reform the U.S. stock market, specifically calling for the elimination of the ITS trade-through rule. OES began to see a bright future for itself. So when the SEC finally threw Reg NMS on the table, OES pounced.
Commenting on Reg NMS' "fair access" provision, OES told the SEC in spring 2005 that it was "the sole service provider that has already built and currently operates a functional linkage that provides linkage for ECNs, exchanges, third market firms and broker-dealers. OES provides private linkages that can act as hubs to all market centers for any broker-dealer."
Outbound Traffic
Much of that experience, according to OES executives, came from providing the outbound routing for the ECN-turned-stock exchange Archipelago.
The ECN's attraction for traders in its early days was its policy of sending unexecuted orders to other market centers, something the dominant ECNs at the time, Island and Instinet, did not do.
"We took that model that Dave [Scheckel] built for Arca and leveraged that as an ITS replacement," Barth says. "We spent a good deal of time with the exchanges and the regulators to formulate this idea and convince them our model was the appropriate one."
Under Reg NMS, exchanges are required to do everything in their power to ensure that an order hitting their system does not trade through a better-priced order elsewhere. If they receive such an order, they must ship it out.
OES claims to have the compliance and smart routing technology necessary to accomplish that. In the case of the Philly, for example, such an order will be handed off to the OES broker-dealer, called PRO Securities, which will act as the agent for handling PHLX routing decisions.
The Philly decided to outsource the operation for two reasons, according to Bob Miller, an advisor to the exchange.
"We saw a potential for a conflict of interest between operating a broker-dealer and an exchange," Miller says, "and we don't operate a private routing network."
The issues involved with exchange outbound routing are complex and OES has not been shy about pointing out the perceived flaws in certain exchanges' routing programs.
OES has sent two letters to the SEC criticizing the proposed set-ups of the Chicago and the National stock exchanges.
In July, it told the SEC that some aspects of the National's outbound routing program were "inconsistent with the definition of an exchange" as described in the Exchange Act.
Specifically, OES stated, the NSX's proposal placed the routing decision with the exchange and not its special purpose routing broker, NSX Securities. The SEC approved the proposal anyway and Lava won the business.
In August, OES informed the SEC that the Chicago's routing set-up did not incorporate the use of an exchange facility. The order routing services of the CHX's "specified third-party broker-dealer should be a facility of the CHX," OES stated. At presstime, the SEC had not approved the Chicago's proposal.
Broker-Dealers
OES isn't stopping with the exchanges. Although broker-dealers are not required by Reg NMS to prevent trade-throughs, many are taking the position they must shoulder the burden to comply with their best execution obligations.
Seeking to capitalize on that sentiment, OES has stepped up its marketing to broker-dealers. Its pitch is four-fold: (a) connectivity to all the exchanges, (b) smart-order routing, (c) a compliance service called Order Trail Recall (OTR) that captures quote and trading information and retains it for seven years and (d) membership on all 10 stock exchanges.
"Under Reg NMS," Barth says, "there is no excuse not to directly go and get the execution. The SEC is going to be putting a lot of pressure on broker-dealers that aren't connected everywhere. They will be put on the spot to defend why they are routing to one exchange or the other."
Typically, OES execs say, a broker-dealer may have connectivity to some exchanges, but not all. "It is very rare that most firms have all the market centers on a consolidated basis."
Even within the largest firms, Barth says, connectivity to market centers may be dispersed among various divisions.
DMA Trail
Order Trail Recall was developed by OES in partnership with John Paul De Vito, the head of a small direct market access brokerage called Bon Trade Solutions. The firm has been an OES customer for four years. "Under Reg NMS," De Vito says, "no DMA firm is going to be in business without something like this."
OES is not the only shop pushing a compliance snapshot. Routing vendor Selero markets a service called "Reg NMS Compliant Routing" in conjunction with a firm called Aleri Labs. Other DMA shops such as Lava Trading say they will have it as well.
OES competes against three different types of routing providers in its quest for broker-dealer business: niche shops like itself, including firms such as Belzberg Technologies and GL Trade; large clearing brokers; and telecom-like organizations such as TNS and BT Radianz.
In contrast to the rosy scenario of millions of shares passing out of stock exchanges and through OES' pipes, there is a "dark" cloud on the horizon: The number and popularity of blind crossing networks, or dark pools, is surging. Traditional "public" systems such as Posit and Pipeline are seeing healthy volume growth while many large broker-dealers are building their own platforms.
Buyside traders, frustrated by their inability to get large blocks done on the exchanges without adverse price impact, are demanding alternatives. The so-called dark pools that match orders out of sight of the broader marketplace are considered possible solutions.
There are now close to 10 public crossing systems in operation, including two new ones from Nasdaq and the International Securities Exchange. An equal number are in development at large shops such as Merrill Lynch and Lehman Brothers.
By and large, the systems are operating on the front lines of the trading landscape, capturing order flow before it reaches the exchanges. The phenomenon may not be good news for exchanges or the routers that serve them.
No one knows how successful these nascent systems are likely to be, but most industry experts agree that more flow is likely to pass into them.
For OES, there is a silver lining: Crossing systems traditionally have very low matching rates. Perhaps 90 to 95 percent of the inflow never crosses and flows right back out of these systems.
Integrating the Dark
Many of the owners of these systems are in discussions with their competitors and connectivity providers to link their systems.
Thus, an order that does not match in one system could find a contra-party elsewhere. OES hopes to act as a linkage between dark pools and the broader marketplace. "We are positioning ourselves to provide a dark book integration model into the national market system," Barth says, referring to the country's stock exchanges.
"The dark books are going to be a key component of the marketplace going forward, because there will be a lot of internalization," he adds.
Thus, the stock market of the future could manifest itself as a network of open and closed trading centers. The open marketplaces would be the exchanges with their displayed quotes. The closed centers would be the blind crossing networks.
Connecting these disparate pools is the goal of OES. "No one has yet to emerge to integrate dark books under Reg NMS," Scheckel says. "I think we can."
OES into Options
With its plan to link the nation's stock exchanges to each other and to the broker-dealer community well under way, OES is setting its sights on the options market. Earlier this year the firm hired Corey Zimmerman, formerly a specialist at options house Botta Capital Management, to spearhead the new venture. The plan first offers broker-dealers connectivity to the six options exchanges. Then, OES execs say, they will look to link the exchanges to one another.
