ECN: A new force in the stock markets?

• Author: Millman, Gregory J.
• Position: Global Securities - Electronic communications networks - Editorial

Editor's note: Traditional stock exchanges, led by the New York Stock Exchange, remain the most visible and prestigious channels for trading securities in this country. Electronic communications networks (ECNs), however, represent an emerging band of competitors. This article looks at a number of the major entrants, assesses their strategies and attempts to understand why this movement developed and what it could mean to corporate finance executives

David Whitcomb joined the faculty of New Jersey's Rutgers University in 1975, pioneering the study of market microstructure and tinkering around with financial models on the side. He rose through the ranks to full professor, but it was his move out of academia that has really put him on the map.

Whitcomb's tinkering at Rutgers allowed him to benefit in a big way from the regulatory and technological sea change that is reshaping the Nasdaq securities market. A few years ago, he founded a company called Automated Trading Desk that applied his models to the markets; the models help him predict short-term stock price shifts. His company trades about 50 million shares of stock a day, and he estimates profits for the year 2001 at around $50 million, on revenues of less than $100 million. Most of those trades are in Nasdaq stocks.

That's not bad. But the big game, Whitcomb says, has yet to get underway. He's licking his chops at the prospect of applying his technology and models to the listed stock market. "That marketplace needs reform," he says, "Spreads are now wider in the [listed market] than in the Nasdaq for comparable stocks, an absolute flip-flop from two years ago. I'd like to see some ECN (electronic communications network) or ECNs change the way business is done in the listed market."

He points to one spot of hope. This March, the Pacific Stock Exchange closed its trading floor and shifted its listings to Archipelago, an ECN that had become an official exchange. Through its relationship with the Pacific Stock Exchange, Archipelago gained the right to trade not only Pacific but also New York Stock Exchange listings.

A spokesperson for the NYSE declined to comment on this development. "We don't talk about our competitors," she said. But others in the industry expect that the stage may be set for a new wave of change at the very heart of the stock markets.

"If you look at what will be the key goal for ECNs in the next year or two, it will be delving into NYSE types of stocks. We're late in it, but all of us are focusing on it," says Joel Steinmetz, senior vice president of Instinet, a New York-based ECN.

Chris Keith, now president and CEO of Exchange Lab, invented and implemented the New York Stock Exchange's electronic trading system, called DOT. After retiring from the job of chief technology officer at the NYSE, he set himself to solving a riddle. Given that electronic trading was more efficient in processing transactions, why hadn't ECNs been able to take more market share away from the New York floor?

His answer was that ECNs weren't able to duplicate the flexibility of human traders. But that's changing, he says. "Look at what an ECN does now!" he says. "Rather than one or two different kinds of orders, an average ECN might have 15 or 20. I think the [big exchanges are] going to begin to lose market share at this point, simply because of the fact that the advantages of their systems are being replicated by electronics -- and...