Commentary: Behind Nasdaq's Hissy Fit

At first blush, it would seem like a $1.2 billion-revenue gorilla swatting at a pesky $70 million flea. After all, the Nasdaq Stock Market handles 2 billion shares daily compared with Chicago-based Archipelago LLC's paltry 100 million shares. So why is Nasdaq wringing its hands? It even fired off a letter on Jan. 22 to the Securities & Exchange Commission lambasting Archipelago's proposal to become a stock exchange as "anticompetitive," and questioned the upstart's ability to guarantee liquidity.

Turns out this little flea may have a pretty big bite. It's among a number of electronic communications networks (ECNs) that have plans to become real exchanges and mount what could be the biggest challenge to Nasdaq since it was itself the feisty upstart 30 years ago. Widely used by online brokerages and some institutions for their speed and low transactional costs, ECNs are electronic engines that match buyers and sellers of stock. Archipelago, which could be the first to get SEC clearance to become an exchange as early as March, has the wherewithal to pull it off, being backed by such heavy-hitters as Goldman Sachs, Merrill Lynch, J.P. Morgan Chase, E*Trade Group, and Instinet. "If Morgan and Goldman push trades to this exchange to save costs and exchange fees, it will be a force to be reckoned with," says Stephen McKenna, a partner at PriceWaterhouseCoopers LLP.

Already, Archipelago and a clutch of fellow ECNs have grown over the past four years to now equal 35% of Nasdaq's volume. Along with Archipelago, the others--Island ECN Inc. and NexTrade Holdings Inc.--are quickly moving to get regulatory clearance to start exchanges. As exchanges, ECNs will have faster, direct access to the National Market System that links all the stock exchanges, and their quotations will be displayed nationwide alongside those of other exchanges, including the Big Board. They will also be able to profit from selling stock price data and collecting listing fees, and won't be regulated by the NASD, Nasdaq's parent. No question, they could draw away a hefty share from Nasdaq, the New York Stock Exchange, and even futures and options markets.

BUYING TIME. If the ECNs achieve exchange status, it will force down trading costs even more--a boon for investors. And hot competition will bring better service and more innovation. "We'll offer many more products in the pipeline--single-stock futures, options, convertibles, you name it," says Archipelago CEO Gerald D. Putnam, noting that they will initially offer NYSE, Nasdaq, and AMEX securities.

The regulators need to brush aside Nasdaq's carping and move quickly to clear these new exchanges. ECNs have revolutionized trading by bringing down costs from as much as 7 cents a share to as little as a half-cent and by helping to reduce bid-ask spreads.

Nasdaq's complaint against ECNs is just a time-buying move. It plans to launch its own ECN early next year, the SuperMontage trading system. It's fine that Nasdaq is moving to innovate. But its rivals ought to be allowed to do the same.

By Pallavi Gogoi

Gogoi covers markets from Chicago.

    Before it's here, it's on the Bloomberg Terminal.