They were going to be the answer to investors' dreams: supercomputer-driven, instantaneously matched trades--and cheap. So, in 1996, when OptiMark Inc. launched an electronic system that promised to revolutionize markets by linking equity buyers directly with sellers, cutting out once-dominant market makers and specialists, Wall Street's best and brightest--Goldman Sachs, Softbank, and Merrill Lynch--signed up. Large brokerages and investment banks were "shaking in their boots to the core of their franchises," afraid to be rendered obsolete in a fast-paced technology age, says Lon Gorman, president of capital markets and trading at Charles Schwab & Co., which also got in the game with RediBook.
These days, though, it's the electronic communication networks (ECNs) such as OptiMark that are unsteady on their feet. In September, OptiMark suspended trading, fired 110 workers, and recast itself as a technology consultant. Other struggling ECNs have merged in order to survive: Tradescape.com bought MarketXT, and Brass Utility ("Brut") merged with Strike Technologies. Indeed, even the two largest--Instinet Corp. and Island ECN--pondered a merger in the spring, until the plan was scuttled by antitrust concerns.
GANGING UP. Traditional trading firms are also dwindling: Deutsche Bank bid $1 billion bid for National Discount Brokers Group Inc. on Sept. 10, on the heels of Goldman Sach's purchase of Spear, Leeds & Kellogg, and Merrill's of Herzog Heine Geduld. "The industry is definitely ripe for more consolidation," says Sang Lee, an analyst at Celent Communications, a Cambridge (Mass.) researcher. It's a climate that may be uncomfortable for three boutique ECNs that have just or are about to pile in: Nyfix Millennium, an affiliate of NYFIX Inc., Track Data Corp., and GlobeNet Capital Corp.
What went wrong? At base, the answer is simple: "Just being a matching engine behind buy and sell orders doesn't work," says Schwab's Gorman. Survival in the ECN industry now means differentiation: Instinet, the largest and oldest ECN, has a stronghold on the institutional market--its client firms manage over 90% of institutional equity funds--while Island cornered a big slice of day trading. But those without a niche find it hard to distinguish themselves from others as they fight to win business. "There's only a certain amount of order flow to go around," says Bernard L. Madoff of Bernard L. Madoff Investment Securities in New York.
The skittish stock market hasn't helped. After-hours trading volume, which averaged 50 million shares a day in September, has been slow to develop. And the fall-off in day trading has penalized the likes of All-Tech Direct Inc., which serves active traders. "You need a bull market," says Madoff.
Lack of liquidity and razor-thin margins are the bane of the industry. Since ECNs charge a fraction of a penny a share "you have to have massive volume to make any money," says Jason M.A. Lind, equities analyst with US Bancorp Piper Jaffray. It's not that ECNs haven't captured market share: They now handle more than a third of Nasdaq trades, up from 25% last year, and could execute over half of Nasdaq trades by 2003, reports Celent. Observers say that's because institutional investors have tended to hand off the most liquid tech-stock trades to the ECNs--leaving the more complicated trades in less liquid stocks to specialists.
The pressure on the smaller fry is growing because Instinet and Island have attracted the lion's share of business. Together, they account for over 80% of Nasdaq trades made through ECNs, and they are likely to get a bigger share still. Island, for instance, matched 178 million shares a day in August and 285 million by September. "It's not just a question of a great technology and a great price," says Island President Matthew Andresen "It's a question of liquidity."
BIGGER BATTLES. Not all ECNs, however, believe the battle over order flow will make or break them. Says Kevin Foley, president of Bloomberg Tradebook: "It's possible for a new guy to out-innovate and out-service a competitor, one client at a time." Further globalization of the financial markets and a higher level of comfort with after-hours trading will eventually allow competitors to grow into the market, argues Scott Appleby, an e-finance analyst at Robertson, Stephens & Co.
The biggest test for ECNs lies ahead: Nasdaq's so-called super montage system--a new electronic order system, awaiting the SEC's nod. Nasdaq says the system will not only enable trades, as ECNs do, but allow its member-dealers to trade ahead of pension and mutual fund managers. "From an investor's standpoint, you're better off having a more efficient system that will generate profits for 500 firms, rather than a half dozen [ECNs]," says Madoff, whose firm, along with Goldman Sachs and other big brokers, owns Primex Trading, an electronic facility that will provide an electronic auction in Big Board stocks to Nasdaq brokers.
The ECN revolution may not be unfolding as its instigators hoped. But, while they haven't dethroned traditional market makers, survivors of the ECN consolidation have a significant future.