An initial public offering for Direct Edge Holdings LLC, whose two stock markets became registered exchanges this week, is a “possibility,” according to William O’Brien, its chief executive officer.
The venues, known as EDGX and EDGA, began their conversion to exchanges earlier this month and completed the shift on July 19, giving Direct Edge the same regulatory status as NYSE Euronext, Nasdaq OMX Group Inc. and Bats Global Markets. Jersey City, New Jersey-based Direct Edge is majority owned by International Securities Exchange, Goldman Sachs Group Inc., Citadel Investment Group LLC and Knight Capital Group Inc.
U.S. securities markets such as the New York Stock Exchange converted into for-profit companies over the last decade, with some becoming publicly held, as competition and rules encouraging electronic trading forced them to improve technology and lower costs. Both NYSE Euronext, owner of the Big Board, and Nasdaq OMX bought exchanges to boost market share and augment their offerings. The New York-based companies are now expanding their derivatives and technology businesses.
“We’re building a company that can endure,” O’Brien said. “An IPO could potentially be an important milestone. We’re looking very carefully at how the CBOE IPO went, both initially and in the after-IPO market.” He said Direct Edge has been profitable since the fourth quarter of 2007 and plans to “grow the core business and build out adjacent businesses.”
CBOE Holdings Inc., operator of the largest options venue and the last major U.S. securities exchange that was member- owned, began trading on June 15. The stock closed yesterday at $26.08, down from the IPO price of $29.
The Chicago Board Options Exchange traded 29.3 percent of the industry’s volume last month and has exclusive licenses to transact products on the Standard & Poor’s 500 Index and Dow Jones Industrial Average. Options on indexes represented 5.4 percentage points of the exchange’s share of trading in June, according to data from the Chicago-based Options Clearing Corp.
EDGX and EDGA accounted for between 9 percent and 11 percent of equities volume for most of this year, enabling Direct Edge to compete with Bats Global Markets in Kansas City, Missouri for the title of third-largest stock market operator, based on data from Macquarie Group Ltd. Bats, which converted its platform into an exchange in 2008, traded 10.8 percent of equities last month, compared with Direct Edge’s 9.8 percent.
“There isn’t anything about Direct Edge’s model that meaningfully differentiates it from the other players right now,” said Michael Vinciquerra, an analyst at BMO Capital Markets in Atlanta. “It’s difficult to tell how much demand there would be for shares in the company without it having some proprietary or exclusive products.”
The ISE, owned by Frankfurt-based Eurex, acquired a 31.5 percent stake in Direct Edge in December 2008. New York-based Goldman Sachs, Jersey City-based Knight and Citadel in Chicago each own 19.9 percent. An additional 8.8 percent belongs to a group of five brokers, including New York-based JPMorgan Chase & Co. Buying and selling by Direct Edge’s main broker-dealer owners helped the company grow and now represents less than 20 percent of its order flow, down from 30 percent in 2008, O’Brien said.
Direct Edge was formed in 2005 when Knight bought the trading platform from Domestic Securities Inc. O’Brien, the former chief operating officer of BRUT LLC, a venue Nasdaq acquired in 2004, joined the company in July 2007 after three years at Nasdaq. The company had 19 employees at the time and now has 84, O’Brien said. Knight spun off Direct Edge in 2007.
Operating exchanges will give Direct Edge revenue from market data it produces and sells to providers such as Thomson Reuters Corp. and Bloomberg LP, which owns Bloomberg News. In 2008, 11 exchanges received $464 million in revenue and paid $14.9 million in expenses relating to market data, according to the Securities and Exchange Commission. Direct Edge will also save money on clearing its trades.
As an exchange, Direct Edge controls the quotes it sends the systems that aggregate the best-priced orders from market centers. Previously, as an electronic communications network, it published its best quotes to another exchange or a system operated by the Financial Industry Regulatory Authority, adding another hop in the transmission of data and subjecting it to technology processes over which it had no control.
“It’s difficult for the four big venues to differentiate themselves,” Vinciquerra said. “Direct Edge was first with two venues that offered two different pricing models and others decided to copy them, but there’s only so much you can do.” As markets offered customers different pricing to win a bigger share of trading, competition over fees has grown, he said.
One innovation on Direct Edge’s EDGX platform is its Midpoint Match product, which the ISE Stock Exchange created to attract orders larger than the average trades on most equities venues, O’Brien said.
Midpoint Match allows participants to solicit the venue’s users publicly to trade a stock at the midpoint of the industry’s best bid and offer price. The ISE Stock Market, started by the International Securities Exchange in 2006, became a subsidiary of Direct Edge in December 2008 and ceased trading on July 16 as part of the deal that gave the options market a stake in Direct Edge.
Midpoint Match traded 34 million shares on July 19, compared to an average daily volume of about 5 million to 6 million when it operated on the ISE Stock Exchange, O’Brien said. He said the matching service is available only on EDGX, which accounts for about 60 percent of Direct Edge’s volume.
“It was the first example of deploying a new product on our exchange platform,” he said. “We’re pleased with the early results.”
Direct Edge is the only one of the largest American markets still offering flash orders, which the U.S. Securities and Exchange Commission proposed banning in September after criticism from Senator Charles Schumer and NYSE Euronext. Those orders enable investors, whose buy and sell requests can’t be matched on a particular venue, to seek out liquidity from some users instead of having their orders sent to another market.
The company’s market share for equities trading this month was 8 percent, down 1.8 percentage points from last month, according to a Macquarie report. Bats, which accounted for 11.2 percent so far this month, surpassed Direct Edge’s volume in May and June. Direct Edge’s share of trading outpaced Bats in the second half of last year.
The decrease in market share this month is “acceptable,” O’Brien said. “It’s because of the enormity of the transition,” he said. “What we did is something no stock exchange has done before -- completely migrating its technology to a new platform and moving into a new data center at the same time.” Direct Edge this month moved its systems to a data center in Secaucus, New Jersey operated by Equinix Inc.
“We’re excited by our ability, with the new platform and technology architecture, to deliver new products that are innovative,” O’Brien said. “That will help Direct Edge stand out.”