Consolidation is cutting into the ranks of institutional ECNs, but the ones left are gaining a greater share of overall trading activity.
Three years ago, more than a dozen institutional electronic communications networks were fighting for order flow in an increasingly automated equity trading environment; now, there are four viable ones. And traders and market experts anticipate even more consolidation since Nasdaq has launched its own order display and execution network, SuperMontage.
Executives at the surviving ECNs are looking to expand from their traditional role as trading conduits for Nasdaq stocks to include NYSE-listed shares and exchange-traded funds. They also are considering enhanced automated trading strategies, or are seeking to establish themselves as electronic exchanges, rather than just matching customer buy and sell orders.
ECN industry consolidation accelerated last year. Chicago-based Archipelago Holdings LLC, one of the first ECNs approved by the Securities and Exchange Commission in 1997, merged with REDIBook ECN LLC and acquired GlobeNet Capital Corp. ECN. Archipelago then formed Archipelago Exchange, the first all-electronic national stock exchange.
Also in 2002, BRUT LLC was acquired by SunGard Data Systems Inc., and Instinet Group Inc. merged with ECN competitor Island Holding Co.
While ECNs are consolidating, trade volume has grown as buyside traders and government regulators push for better quality trade execution.
"The rise of ECNs was an interesting story itself," said Sang Lee, electronic trading analyst and manager of the securities and investment group at Celent Communications, a Boston-based consulting and research firm. "Originally the goal was to match limit orders on Nasdaq stocks. Now, the ECN market is moving to consolidation. ... I think the key event which caused that (consolidation) is the creation of SuperMontage."
About 90% of the market share now is concentrated in the top ECN tier - Archipelago, Instinet, Bloomberg Tradebook and Brut, Mr. Lee said.
SuperMontage was billed as the next generation electronic trading system for Nasdaq securities when it went live in October. Although it was designed to recapture some trading volume lost to ECNs during the previous five years, it has not done so "in any significant way," he said.
Now, Mr. Lee said, the remaining ECNs are trying to diversify to help them bypass Nasdaq and to move into the listed share market and exchange-traded funds. He said he's heard rumors that Nasdaq will acquire an ECN.
Mr. Lee, who wrote a report on trends in the electronic marketplace, released March 25, said equity market fragmentation "is creating complexity in the marketplace, and electronic platforms are needed to help sort out the mess."
It is also possible that more ECNs will seek to become exchanges, rather than remain electronic trading platforms.
Archipelago spokeswoman Sydnie Kampschroeder said the primary benefits of becoming an exchange are economic. That's because clearing costs are eliminated and tape revenue (from selling transaction records of trading data to broker-dealers) is increased. As an ECN, trades were cleared using a broker-dealer; now, all exchange trades are cleared through the National Securities Clearing Corp. and the Depository Trust and Clearing Corp., she said.
In addition, being an exchange transforms an ECN into a "higher life form," separating the firm from the ECN pack and providing more competitive punch. "It puts you in a whole new realm," she said.
Instinet spokeswoman Alicia Curran said Island applied to the SEC for exchange status prior to the acquisition, and that the application is still pending. She declined to elaborate.
ECNs were designed to provide low-cost trade execution in Nasdaq-listed and over-the-counter stocks. Traders believe that ECNs and electronic alternative trading venues remain the most efficient venues for reducing transaction costs, with commissions averaging about 2 cents per share.
"We firmly believe that the fewer human beings that touch the trade, the better," said John Wheeler, head of equity trading at American Century Investments, Kansas City, Mo., one of the first institutions to make significant use of ECNs. "We also believe that market fragmentation is not bad as long as you have (electronic) connectivity. Connectivity is so good now that you can have a market maker in Istanbul and can compete shoulder-to-shoulder with a market maker in New York."
Mr. Wheeler echoed Mr. Lee and other industry experts who said the consolidation in the ECN industry was hastened by Nasdaq's launch of SuperMontage.
"The feeling by ECNs is that bigger is better. The rush to consolidation is happening because they felt the need to be bigger in order to compete and that you have to be huge in order to enjoy economies of scale in today's market environment," said Mr. Wheeler. In effect, he said, Nasdaq "opened its own ECN" to compete with existing ECNs. He said SuperMontage was a "technological success," but it has not dented ECN market share.
As trading volume on SuperMontage, ECNs and alternative trading systems grows among institutional investors, another mini-industry has started to spring up around the electronic trading community.
Connectivity is crucial in an electronic trading environment as trades are routed among the various trading venues. While it is possible to be connected directly to each venue, the use of ECN aggregators is rising.
ECN aggregators such as Lava Trading Inc., New York, and Sonic Trading Management LLC, New York, provide institutions with a single point of access to ECNs, exchanges and alternative trading systems. Richard Korhammer, Lava co-founder, chairman and chief executive officer, said traders at 16 of the largest 20 Wall Street brokers are using technology developed by Lava.
"We have built technology that allows traders to access everything as though there was only one marketplace," said Mr. Korhammer.