Electronic Communications Networks (ECNS) - Duking It Out With The Exchanges

By the turn of the 21st century, ECNs were generating heavy enough trading volume to make the customary exchanges, such as NASDAQ and NYSE, extremely nervous. Indeed, several leading ECNs even filed with the SEC to acquire exchange status themselves, which set off a small war with the traditional exchanges. When ECN giant Archipelago Holdings LLC merged with the Pacific Stock Exchange to create the first ECN-exchange hybrid, it was able to simultaneously function as an exchange and trade stocks through NYSE. Island and NexTrade Holdings Inc. followed a similar path, and as they moved closer to regulatory approval the major exchanges, particularly NASDAQ, took arms in defense. Upon assuming exchange status, ECNs would enjoy direct access to the National Market System linking all stock exchanges, while having their quotations listed alongside those of other exchanges across the nation.

In 2001 NASDAQ attacked Archipelago's ambitions, going so far as to complain to the SEC that such moves were anticompetitive. At first blush, this complaint from a system that trafficked 2 billion shares per day against an ECN that moved 100 million daily shares looked incongruous, but it was in fact indicative of the exchanges' fear of ECNs' potential—particularly that of NASDAQ, which was the most immediately threatened.

The move toward exchange status had a pragmatic component as well. Following the tech market bust in 2000, day trading suffered a tremendous blow. While it hardly disappeared from the scene, a large portion of the natural customer base that ECNs enjoyed on their way to success was no longer a sure bet. Therefore, taking advantage of the benefits of exchange status would help to maintain them during the post-bull market. Exchange status also is the doorway to the extremely lucrative business of packaging and selling market data like stock prices. This is a coveted benefit, particularly since ECNs still suffer a competitive disadvantage when it comes to liquidity.

ECNs were given a break on the NYSE in 2000, courtesy of the SEC. The NYSE's Rule 390 prohibited ECNs from trading NYSE stocks that had been listed since before 1979. This added up to nearly one-third of total NYSE shares and half of the exchange's trading volume, including some of the biggest blue-chip stocks. This rule clearly restricted the range of business ECNs could conduct, and excluded them from some of the most widely demanded stocks on the NYSE. However, by 2000 the SEC strongly pressured the NYSE to repeal Rule 390, creating new opportunities for ECN growth.

One threat to ECNs was the looming possibility of a total overhaul of the NYSE and NASDAQ to create centralized systems that would effectively render ECNs superfluous by incorporating the major ECN functions. NASDAQ received approval in late 2000 to introduce its SuperMontage, a quote aggregation and execution system that will display the three best prices for a given stock and provide a vehicle by which customers' orders can be routed to any venue for completing the transaction. By combining the efficiencies and transparency of ECNs with the vastly greater liquidity of NASDAQ, SuperMontage posed a serious threat to ECNs, which registered their chagrin in the political arena. The ECN lobby caught the ear of House Commerce Committee Chairman Tom Bliley, who sent a letter to the SEC questioning the potentially unfair advantages SuperMontage would afford NASDAQ. Meanwhile, the NYSE began rolling out its own ECN, called Network NYSE.

ECNs also led the way in moving trading systems away from the antiquated practice of listing stock prices with fractions. Island ECN began the decimalization of its stock listings in July 2000, prompting other trading systems to follow suit. In this way, listed stock prices appeared in the form of dollars and cents. This practice also was competitively advantageous to ECNs in their struggle against the market makers. Market makers, earning margins by the spread between the buy and sell price, could use the fraction system to artificially pad those spreads. While this effectively adds up to less than seven cents a share—or one-sixteenth of a dollar, the smallest trading "tick" available in the fraction system—those pennies add up to astronomical sums over several million trades. And given that ECNs survive by the few pennies or less per share they charge for trades through their systems, switching to the more accurate decimal systems and pressuring the exchanges to do likewise closes off a major competitive rift between ECNs and market makers.

In the early 2000s, analysts were mixed in their predictions for the future of ECNs. Some felt they would drive securities trading while others insisted they would be phased out once the major exchanges co-opted their advantages. However, all agree that ECNs have been a major force in driving innovation in securities trading, and that the future of the markets will reflect the ECN influence.