Archipelago: "The Thorn In NASDAQ's Side"

Its powerful electronic stock exchange is rapidly stealing market share from the leader. And now it's on the verge of going public

Gerald D. Putnam has been stalking his prey for eight years now. At the height of the late 1990s day-trading frenzy, he devised a quicker way for investors to get the best prices for stocks and bypass NASDAQ's aging automated marketplace. Today, as chief executive of Archipelago Holdings LLC, operator of the superfast ArcaEx stock exchange, Putnam finally has NASDAQ squarely in his sights.

In the past year, his Chicago-based outfit has snared nearly a fifth of the trading volume in NASDAQ stocks. With a pending initial public offering expected to raise a war chest of several hundred million, the 45-year-old Putnam is poised to do more damage. Says Celent Communications LLC analyst Jodi Burns: "He represents the thorn in NASDAQ's side."

Putnam's assault is triggering fierce resistance from NASDAQ. On April 12, just a few weeks after Archipelago filed its IPO papers, NASDAQ announced steep price cuts for trades between its biggest-volume customers -- slicing its levy on trades from a tenth of a penny per share to a hundredth of a cent. It hiked the rebates it pays broker-dealers who bring in new business. And it eliminated their fees if they trade New York Stock Exchange-listed securities on its system. "NASDAQ seems to be trying to derail the Archipelago IPO," argues Seth Merrin, CEO of New York institutional broker Liquidnet Inc.

The battle will certainly be furious, but Putnam may have the upper hand. Just as NASDAQ disrupted less electronically savvy players in the 1970s by pioneering a novel computer-trading system, Putnam's ArcaEx exchange is creating havoc for NASDAQ. ArcaEx, along with electronic trading networks run by Instinet Group Inc. (INGP ) and a few others, has been luring traders with low fees and more user-friendly systems that often provide better access to the best prices for stocks.

MOMENTUM SHIFT. By its own reckoning, NASDAQ's share of trading volume in its own listed stocks has plunged from 86.6% in January, 2003, to just 47.8% last month. Meanwhile, ArcaEx picked up 18.8% of the volume, up from virtually nothing, while Instinet reached 24.2%, compared with 12.4% before. The business, says Instinet Executive Vice-President Andrew Goldman, has become "hypercompetitive."

NASDAQ's reversal of fortune is showing up in its bottom line. Despite a surge in trading on Wall Street in recent months, its revenue plunged 21%, to $128.4 million, in the first quarter. It eked out a paltry $4.6 million profit only because it cut costs to the bone, slashing its staff by 29% in the past year. By contrast, Archipelago's revenue surged 67%, to $146 million, producing a $21.6 million profit, vs. an $18.5 million loss in the year-earlier period. Instinet, which is controlled by Reuters Group PLC (RTRSY ) and owns 4.4% of Archipelago, boosted its revenue 21%, to $313 million, and turned a $34 million loss a year earlier into a $19 million profit. Unlike Archipelago, Instinet doesn't run a full-fledged exchange, but it does have Reuters' deep pockets to bankroll its efforts to poach business from NASDAQ.

Now, Putnam is getting ready to step up his assault on NASDAQ. Even if some of the original investors -- such as the IPO's lead underwriter, Goldman, Sachs & Co. (GS ) -- cash out, Putnam will probably be left with a minimum of several hundred million to pump into Archipelago. That's in addition to some $50 million Archipelago collected in November when it sold a 23.4% stake to private-equity firm General Atlantic Partners LLC, which usually holds investments over several years. Putnam is expected to devote much of the cash to keeping ArcaEx's technology ahead of its rivals and to build its brand in a push to win listings from companies that might otherwise go to NASDAQ.

Putnam could also pursue more acquisitions by using his quoted stock as currency. Archipelago already has snapped up a competing electronic-trading network, REDIBook ECN LLC, and partnered with the Pacific Exchange Inc., which gave it exchange status -- something NASDAQ has never been able to persuade the Securities & Exchange Commission to grant it. Celent's Burns figures that Putnam will have a "huge cash reserve" to use as he sees fit. Archipelago hasn't said when it will start marketing the IPO, when it will launch the offering, what it will do with the proceeds, or how it will price it. It declines to comment while the IPO is pending.

Despite the threat of an Archipelago suddenly flush with cash, NASDAQ insists that its price-cutting isn't aimed at killing the IPO. Executive Vice-President Christopher Concannon says NASDAQ is only "staking out a price-leadership position." But if NASDAQ's lower rates prove to be enticing to broker-dealers, they could shift millions of dollars in business back to NASDAQ -- and cause a world of hurt for Archipelago. Transaction fees accounted for 93.5% of Archipelago's revenue last year. It's too early to tell whether Archipelago is losing much business by not matching NASDAQ's price cuts, or to know how long NASDAQ can maintain them. So far the move hasn't done much for NASDAQ's bottom line: Its market share crept up just a tenth of a point in April.

Whether or not NASDAQ is deliberately targeting Archipelago, its moves have unsettled Putnam. In fact, he had to file amended papers with the SEC on Apr. 20 and list extra risk factors that could make potential investors jittery. He warned that the price-cutting could trim Archipelago's revenues "materially and adversely." While some observers think the IPO could raise $1 billion, NASDAQ's moves might make that figure unrealistic. Already, the IPO is taking longer than expected to get on the road, and now markets have been faltering and the slack summer IPO season is approaching.

Putnam faces some other complications. For one, the SEC is threatening to cap certain fees, which would make life more difficult for all the market players. And Archipelago is wrestling with a serious legal challenge that could cloud the IPO's outlook: Trader and author Lewis J. Borsellino, a former partner who had a falling-out with Putnam in their pre-Archipelago days, claims he is owed at least $80 million for financing the original technology. He's trying to force the company to put the IPO proceeds into escrow while his case proceeds. Archipelago is fighting the suit.

But if Putnam keeps winning more business, his rivals probably will have bigger worries. And it may not be long before Putnam takes aim at even bigger game. He told global leaders at a World Economic Forum session a few years ago that he wasn't sure the NYSE "is really such a national treasure that we all need to protect." While Putnam already is craving the NYSE's business, the Big Board hasn't taken note of Archipelago -- at least not yet.

By Joseph Weber in Chicago

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