A Second Wind for E-Finance Startups

Despite the success already achieved by online financial-services companies, a crop of newcomers aimed at special niches is thriving

Electronic trading may not be the first place you would expect to find a lot of innovation. After all, haven't online brokerages such as E*Trade (ET ) and electronic exchanges such as Instinet (INGP ), which Nasdaq plans to buy for $1.88 billion, done it all?

Not quite. The past five years have seen a renaissance in financial-services startups, most of which are targeting specialized markets that established players ignore or barely address. Several of them have recently gone public or are on the road to an initial public offering.

Sweeping changes in the financial markets have created opportunities for these companies. "You're dealing with more volatile capital markets than before," says Joel Gomberg, an analyst at William Blair. The Federal Reserve's interest rate hikes (see BW Online, 4/26/05, "The Fed: No More 'Measured'?"), soaring oil prices, terrorism, and the weakening U.S. dollar have injected risk into the markets. That has boosted the popularity of derivatives -- securities whose value depends on the performance of underlying securities -- as tools for hedging risk. Trading volume of options, a common derivative, grew 30% last year, to 1.2 billion trades, according to the clearinghouse Options Clearing Corp.


  Many investors often use these options to offset risk in their portfolios. For example, if you own shares of Microsoft (MSFT ) but can't decide how they'll perform, you can hold them and buy put options on Microsoft stock, which gain value as the price of the stock falls. Though you'll diminish the gains realized if the stock soars, you'll also mitigate the risk of a big loss if it tanks.

Individual investors often rely on options-trading specialists such as online brokerage OptionsXpress Holdings (OXPS ), which was founded in 2000 to bring options trading to the masses. "My partners and I came together with a common vision that the online investor using options was treated like a second-class citizen at other online brokerages," says David Kalt, CEO and co-founder.

The Chicago-based company offers tools like Strategy Scan, which turns an opinion about a stock or stock index into an easy-to-understand options strategy. Its Virtual Trading feature lets investors run simulations of strategies before they invest real money, which they can do on OptionsXpress. The company went public in January at $16.50 a share on strong 2004 results. Net income grew 91% last year, to $31 million, on revenue of $93 million.


  Brokerages need exchanges to execute their orders. Not surprisingly, the first all-electronic options exchange, International Securities Exchange (ISE ) in New York, was founded the same year as OptionsXpress. Before ISE, options trading was conducted in the time-honored manner still used at exchanges like the Chicago Board Options Exchange, where traders shout out bids and offers on a floor.

ISE co-founder Bill Porter, who previously founded E*Trade, sought to bring the efficiency of electronic trading to the options market. "As a result of options trading electronically, the markets have improved," says CEO David Krell, who explains that options can now be traded faster and with narrower gaps between bid and offer prices than before.

In just five years, ISE has grown into the largest equity-options exchange in the U.S. as measured by volume. Last year, customers traded an average of 1.4 million options contracts a day, and ISE commanded 33.3% of the U.S. equity options market. Net income grew 30% in 2004, to $26 million, on revenue of $125 million. ISE went public in March at $18 a share, and the stock closed at $30 on its first day of trading.


  Like options trading, corporate bond trading has historically been a manual process. To place an order, institutional investors phone multiple dealers and then wait for responses -- a process that can take hours. Enter New York-based MarketAxess Holdings (MKTX ), a five-year-old company that automates corporate bond trading through an electronic marketplace.

An investor can submit one inquiry for multiple bonds through an electronic form, which goes to multiple dealers. Then he or she quickly gets responses, ranked by price. Investors can see prices in dealers' inventory, get real-time price quotes, and use tools to compare and analyze prices. Revenues at MarketAxess grew 30% last year, to $75 million. It went public last November at $11 a share.

Some of the most interesting up-and-comers in financial services aren't public yet. Consider LiquidNet Holdings, a six-year-old online marketplace that lets institutional investors trade large blocks of stock without revealing their activity to the entire stock market. Traditionally, an institution places a large buy or sell order for a stock with brokers, who broadcast the order to all market participants.


  As news of the order disseminates, the stock price falls if the institution is selling or rises if it's buying. With LiquidNet, institutions trade with each other directly and anonymously over the Internet, preventing the stock price from moving against them. "We cut out the day traders, the hedge funds," says founder and CEO Seth Merrin.

LiquidNet is one of the fastest growing private companies in the U.S. It says revenues have doubled every year since 2001. Last year, it was profitable on $107 million in revenue. In February, LiquidNet's founders and early investors sold 13% of the company to private-equity investors in a $250 million transaction that valued LiquidNet at $1.8 billion.

With revenues expected to double again this year, LiquidNet won't even consider a distracting IPO for at least two years, Merrin says. Note to IPO investors: Mark your 2007 calendars.

By Justin Hibbard in Silicon Valley

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