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New Electronic Networks Push Big Changes at NYSE, Nasdaq

Wall St.: The need for a middleman comes into question as more investors can trade cheaply through ECNs.


The likelihood that the New York Stock Exchange and Nasdaq Stock Market both will take the once unthinkable step of selling shares in themselves to the public reflects a stark reality for Wall Street: A crop of upstart electronic networks is drastically transforming--many say improving--the way investors trade stocks.

Only a couple of these trading systems, known as electronic communications networks, or ECNs, even existed three years ago. Today, nine ECNs are estimated to control nearly 30% of Nasdaq volume, and have created such a stir that a who's who of major brokerages is scrambling to buy stakes in them.

The emergence of ECNs demonstrates the convulsive changes sweeping through all corners of the investment world, and particularly the upheaval being wrought by technology. Just as powerhouse Merrill Lynch & Co. long scoffed at the notion of offering online trading only to suddenly reverse itself last month, so the NYSE and Nasdaq are acknowledging that they must act to meet the competition posed by nimble electronic challengers that go by names such as Instinet, Island and Archipelago.

It isn't just the traditional stock-trading systems that are under assault. The rise of the Internet, along with ever-faster data communication, is fueling new ideas about the best ways to trade bonds, stock options, futures contracts and other securities.

"The changes [to markets] in the past two years and in the next two years are clearly the biggest since the Great Depression," said David Whitcomb, a Rutgers University finance professor and head of a private trading firm.

A central issue is whether the role of the middleman--the Nasdaq dealer or NYSE "specialist," in the case of stocks--is becoming obsolete.

ECNs, for example, eliminate the middleman in stock trades by matching buyers and sellers of Nasdaq stocks directly and automatically, instead of having both parties trade with a dealer.

Once used exclusively by institutions, ECNs now complete many individual-investor trades as well--even if those investors don't know that their brokerage is putting their trades through to an ECN.

Indeed, a key reason the NYSE and Nasdaq are strongly considering going public is to raise capital to buy or develop their own ECNs, analysts say. Similarly, such Wall Street giants as Charles Schwab, Fidelity Investments and Goldman Sachs are either invested in ECNs or are developing them.

ECNs are cheaper to operate and charge lower trading fees to brokerages than traditional stock markets. Perhaps more important, at their best ECNs sometimes allow investors to secure better "executions"--a better buy or sell price than a dealer might give.

Research by the American Century mutual fund group, which bought a small part of the Archipelago ECN last month, shows that ECNs save institutional investors an average of 1% to 1.5% on each purchase and eventual sale of a stock. That's a savings of $1,000 to $1,500 on $100,000 in transactions.

Part of the savings come from investors' anonymity on ECNs. When institutions buy stock on the NYSE floor or via a Nasdaq dealer, for example, there's a risk that word of their order will leak out and affect the market price. How? Other traders or dealers, knowing a big buyer is in the market, could push up the price on the shares they have for sale. Such "leakage" can't occur if buyers and sellers are meeting anonymously in an electronic market.

But if ECNs are so superior, why haven't they grabbed more Nasdaq trading--and why do they account for just a sliver of trading in NYSE-listed stocks?

For one thing, the NYSE and Nasdaq are household names, a status the ECNs are a long way from achieving.

"They've got the brand name, the order flow and the systems in place that have been processing trades for years," said Stephen Franco, an analyst at U.S. Bancorp Piper Jaffray.

What's more, although ECNs can efficiently pair willing buyers and sellers, they're of no help when there's a shortage of either.

In those instances--for example, when stock prices are falling rapidly--the market can only keep functioning if NYSE specialists and Nasdaq dealers use their own capital to either buy or sell stock.

Indeed, some observers believe the hoopla over ECNs is excessive.

James Marks, an analyst at Deutsche Bank Alex. Brown who last December called ECNs a "profound threat to the current structure," now says their impact is limited to only the largest stocks and that they won't capsize the traditional markets.

The big investments in ECNs are being "made out of fear and ignorance rather than any real vision for what these things might become," Marks said.

Many others disagree, however. That type of talk is "extremely shortsighted," said Ian Domowitz, a finance professor at Pennsylvania State University. "We're witnessing the birth of an industry."

The explosion of new ECNs has occurred just since 1996. It was triggered by reforms that followed the Securities and Exchange Commission's investigation of Nasdaq in the mid-1990s.

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