A Forecast: Trading in 2001: Of Markets and Mania.

• Author: Latimore, Dan

The traditional trading picture is about to turn upside down. With emerging electronic networks, just where will equity trading be in a year? And which players will survive?

In the late '90s there is a looming threat to the markets that have heretofore remained immune to seismic shifts: the emergence of electronic communications networks, which promise to connect buyers directly to sellers, without the need for intervening parties.

ECNs are not operating in a vacuum, but against a backdrop of market structure, practices and customs that have grown and evolved over centuries. But the change accelerated by the ECNs will transform the old world of securities trading. Market-makers, ECNs and exchanges all will suffer. The genie is out of the bottle: Incumbents must develop a strategy for surviving in this even harsher new world.

After the Confusion

With the rise of electronic trading - and after today's dust settles - just how will investors adjust? Will there be a place for brokers? How many markets will exist? And what will they look like?

Not surprisingly, the institutions most radically affected by the changes in the financial world will be broker/dealers, market-makers and the exchanges themselves. Because they all know how the current arrangement works, and have developed business models and technical infrastructures that make them money in that framework, they have little incentive to change the system.

If incumbents refuse to adapt, however, investors will bypass them. Change is being forced upon them by upstarts with little vested interest in the current system or by farsighted, established players who have seen the handwriting on the wall and decided that they want to be part of the new world. By exploiting opportunities that the incumbents have had little incentive to go after, the new entrants will radically alter the business models of all market participants.

In a world with only a single conduit that matched all buy and sell orders for all securities, commission costs would be virtually non-existent. But there would be significant problems, problems that exchanges today address. There would be no entity with an economic interest in guarding against market manipulation. While the SEC could perform that function, it does not have the same financial stake in ensuring regulatory compliance that the NYSE does, for example. There would be no market-makers willing to set a price in the absence of other activity. Thinly traded stocks could have little or no price information available about them. Order imbalances could take small investors unawares, and the concept of a trading halt would be nonexistent. There would be no listing requirements, which would not be a problem for big, actively traded stocks, but could be for smaller ones.

So there is a valuable role for markets. But ECNs threaten some of their core functions. Where will we end up?

We believe exchanges and ECNs will converge in the next three years. The functionality they provide is too similar for them to coexist. Yet it's unlikely that they will converge into a single mega-market. Instead, the most likely outcome is...