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A Bigger Stepping Stone for Archipelago

By Darnell Little From his office in a downtown Chicago high-rise, Archipelago CEO Gerald D. Putnam is planning to change the way the U.S. stock markets operate. He has applied to partner his electronic communications network (ECN) that connects stock traders via high-speed private connections or the Internet, with the Pacific Exchange. The result, which he plans to call the Archipelago Exchange, would be the first ECN-spawned national stock exchange.

ECNs are popular among institutional investors and online brokerages because of their low trading costs, speed, and technical impartiality. Now, Putnam wants to bring those key advantages to a larger market. "Investors can trade on Archipelago from their Windows-based computer at home or in the office," Putnam says. "It consistently executes their orders using the same set of rules, the same algorithm, every time. It's consistent, it's fair, you know what the rules are."

"ANTICOMPETITIVE?" It looks like the old guard views Putnam's efforts to turn Archipelago into a full-blown exchange as a threat. Nasdaq has protested Archipelago's proposal to the Securities & Exchange Commission, calling it "anticompetitive," and claiming that Archipelago could monopolize the brokering of deals on the exchange.

But Putnam has such big financial backers as Merrill Lynch, Goldman Sachs, and J.P. Morgan Chase behind him, making him a force to be dealt with. "The quasi-monopoly the existing exchanges have is fading, and a competitive framework for completing an order will only benefit investors," says Gregory W. Smith, a senior analyst with J.P. Morgan Chase.

Putnam is waiting for final clearance for the deal from the SEC, but he's confident that he'll get his answer this summer. "It's definitely going to happen," he says. "There's just a lot of administrative things to clear up first." Meanwhile, two other ECNs, Island ECN and NexTrade Holdings, are following Archipelago's lead and are vying for clearance to become exchanges.

But by the time ECN-based exchanges start becoming commonplace, Putnam plans on moving toward the next big thing -- whatever that may be. He has spent his career adapting the latest technology to the field of trading, and he intends to keep at it. "That's always been a big interest of mine -- seeing how technology can improve and change the way we do business with the markets."

RULES CHANGE. Indeed, it was by spotting SEC rule changes and advances in computer technology that Putnam gave birth to Archipelago. In late 1996, the SEC announced new order-handling rules for Nasdaq securities, which created the opportunity for electronic networks to communicate with the Nasdaq National Market System directly. Putnam was at home, sick in bed, when he read the proposed rule set and saw the opening for ECNs. He called friend and business partner Stuart Townsend, a software developer, and together they developed the idea.

ECNs basically replace pit brokers with computers by electronically matching investors' buy and sell orders. By December, 1996, Archipelago became one of the first four ECNs approved by the SEC. Archipelago now handles more than 100 million shares daily -- mostly of Nasdaq stocks -- making it the nation's fourth-largest ECN.

Not bad, especially considering Putnam was an economics major and has no formal technology background. The 43-year-old Philadelphia native and University of Pennsylvania graduate worked his way through the ground floors of several New York brokerage firms during the early '80s before landing at Walsh, Greenwood & Co., an options-trading boutique. That job brought him to Chicago and gave him his first taste of computer technology for the trading field. Walsh Greenwood was using a PC-based real-time quotation system called The Shark, which allowed users to perform calculations and analysis unheard of with traditional mainframe-based systems.

SOLID FORESIGHT. Customer interest in The Shark led Walsh Greenwood to develop it into a commercial product. "I watched this small company develop this enormous piece of business by converting technology into dollars," Putnam recalls. "It stuck with me."

By 1994, Putnam had struck out on his own. He founded Terra Nova, an agency broker for institutional investors. He also met Townsend, who was running Townsend Analytics, a financial-software development company. Townsend was impressed by Putnam's enthusiasm for technology and his ability to see opportunities for new applications. "We were working with other day traders then, but no one could see the opportunities that changes in SEC rules would bring like he could," Townsend says.

Putnam got the chance to see one of Townsend's most advanced products, a Windows-based quotation system called RealTick. Microsoft's graphics-based operating system was just beginning to dominate the PC market, and Putnam saw RealTick as a potential blockbuster, like The Shark. Terra Nova quickly became a reseller of Townsend's computer systems, sometimes offering the software to clients in exchange for trading business.

PARTNER OR GET CRUSHED. When the opportunity to jump into the electronic trading business came along, Putnam naturally called Townsend. Putnam, Townsend, and Townsend's wife, MarrGwen, founded Archipelago. At first, the three had fun running the small business themselves and watching the technology behind the ECN develop. But Putnam grew worried about potential emerging players in the ECN field. If Morgan Stanley, Goldman Sachs, or other major players decide to get into the business, small, privately held Archipelago could get squashed. "As soon as these guys start choosing sides, we're out of business," Putnam says.

Putnam decided it was time to get some big partners. He lured E*Trade Group into investing into Archipelago. Goldman Sachs, Merrill Lynch, and J.P. Morgan Chase followed. Putnam used the extra money to build the company's sales and management teams. Another rules announcement from the SEC gave ECNs an opening to apply for exchange status. The advantages of being an exchange jumped out at Putnam because SEC rules regarding ECNs basically limited them to trading Nasdaq stocks.

Being an exchange would give Archipelago the opportunity to trade New York Stock Exchange- and American Stock Exchange-listed stocks as well as Nasdaq shares, and the ability to connect with other exchanges through the Intermarket Trading System. It would also give Putnam a chance to leapfrog larger competitors, such as Island ECN and Instinet. Putnam chose to go for it. "An exchange is just a higher life form than a marketplace," he says.

CONFIDENT. Archipelago filed with the SEC for exchange status in August, 1999. The application languished for months with no action. To kick-start the SEC process, Putnam forged a link with San Francisco-based trading marketplace Pacific Exchange, and in March, 2000, he announced a partnership to create a fully electronic stock exchange.

He's confident that Archipelago Exchange will revolutionize the industry, because it's always the new players that give established veterans the push they need to be innovative. "There's no reason for all exchanges not to be electronic," Putnam says, "and in the end, I think they all will be." He's probably right. But when that day comes, he'll most likely be trying to bring even newer technology to the markets. Little covers technology from Business Week's Chicago bureau

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