Technology has the power to transform business practices and nowhere is this more visible than with the traditional exchanges. In just a few years, a raft of alternative electronic trading platforms has sprung up that are reshaping the landscape of equities, bonds and other markets.
In the UK, the electronic trading platform Tradepoint has been making steady progress against its 200-year-old rival, the London Stock Exchange (LSE), and it plans to expand into Europe this year. In Brussels, Easdaq – the European version of the US technology specialist exchange Nasdaq – plans to launch an automated version of its platform this year. In February, Morgan Stanley Dean Witter and Scandinavian exchange technology specialist OM Group announced that they are creating an electronic exchange to be called Jiway for cross-border trading of European stocks. Following a change in US securities regulations in 1997, electronic communication networks (ECNs) have snatched over a quarter of the volumes traded on Nasdaq from traditional market- makers. And a growing range of online systems is emerging across the globe to challenge the established bond, derivatives, commodities and other exchanges.
Such is the impact of these systems that they are forcing a rethink by the traditional exchanges. In Europe, the major stock exchanges are in talks about alliances and mergers, while derivatives exchanges, such as the London International Financial Futures and Options Exchange (Liffe) and Matif in Paris, are overnight abandoning open outcry in favour of online trading.
How have these upstart systems managed to gain so much ground so quickly and what do they now offer investors? Initially, the two key factors in their growth were the efficiency and access they provided. In doing so, they have come to challenge some fundamental assumptions about markets.
“Larger volume orders and those for less liquid securities still retain their best execution via the open outcry method provided by trading floors,” says Robert Iati, senior research analyst with Massachusetts-based Tower Group. “But personal relationships and local presence on the exchange floor are no longer essential for many types of orders where deals are anonymous and execution is based purely on price and volume.” And without the need to maintain a trading floor and all the infrastructure of a physical market, the new exchanges are able to undercut their traditional rivals on membership and transaction costs.
Tradepoint is an order-driven exchange where firms place orders anonymously which the system then matches automatically. Fund managers can access its market directly, which is open longer hours than the LSE. It offers netting on settlement through the London Clearing House, which also acts as the central counterparty, reducing risk. It has a standard membership fee of £1000 per firm, per year, irrespective of the size of the firm, compared with the LSE’s fees which can be tens of thousands of pounds, and it claims its transaction fees are also significantly lower because its direct access means investors do not have to pay broker commission fees. However, it does not have the liquidity of the LSE nor can it offer fund managers the range of services or the ability to develop trading strategies of the more traditional market.
In the US, the ECNs moved in quickly to exploit the opportunity to provide low-cost online matching services when the regulations governing Nasdaq changed in 1997. Prior to that date, there was only one ECN – Instinet, the online matching service of Reuters’ global agency brokerage. Now there are an additional 10 ECNs – Island, Brut, RediBook, Bloomberg Tradebook, Archipelago, Strike, Attain, NextTrade, MarketXT and Track ECN.
Like Tradepoint, the ECNs offer anonymous, order-driven services and they function very much like stock markets although they are still not recognised as such by the regulators. With around 25% of Nasdaq volumes now passing through their systems, the ECNs are clearly fulfilling a need in the US markets – Nasdaq does not yet have a central order book and it has struggled to cope with its three quarter share of the volumes.
Some industry experts, including Davis Gaynes, executive vice president at Instinet, see ECNs as a temporary phenomenon, meeting a transitory demand until Nasdaq establishes its central order book. Iati believes that the need for the lower cost services ECNs offer will remain but suggests that the exchanges will come to offer these themselves and that only a few of today’s ECNs will service.
However, several of the ECNs have expressed scepticism that Nasdaq could ever cope with the full volume of the market given the exponential growth of recent times. And some – Island, Archipelago and NextTrade – have applied to become exchanges in their own right. The big broker-dealers are hedging their bets on how this sector will develop and many of them have invested in one or more ECN.
In between ECNs and alternative electronic exchanges, there are a couple of niche platforms called crossing systems. Posit has been around in the US since 1987 and more recently with a European service, while E-Crossnet based in London and owned by 10 investment firms went live last month. Crossing services offer anonymous trading where orders are matched and the price is then taken as the mid point of the bid and offer prices in the market. Crossing systems offer a means of doing trades without impacting the market and without incurring the costs of using an intermediary.
Whether or not the ECNs survive, their high profile challenge to Nasdaq has done much to validate the concept of electronic trading platforms and proved the technology works even in a demanding, high volume market. Now a number of platforms are emerging to bring the benefits of online trading to the bond and other markets.
Euro MTS has paved the way in Europe with an electronic system that offers euro sovereign benchmark bonds, while BrokerTec is doing something similar for the US market. At the same time, State Street Bank has launched a platform called Bond Connect in the US, with plans for a European version to go live this year.
Bond Connect offers a more sophisticated service than most electronic trading platforms. Instead of simply matching buy and sell orders, it includes artificial intelligence that allows firms to make more complex trades, such as swaps or multiple related trades across a portfolio. Investors can specify conditions with orders that can include multiple instruments, which the system’s algorithms then automatically negotiate in an electronic auction market to find the optimal deals. In the US, Optimark offers similar capabilities for several equities exchanges and another advanced system called Primex is due to come online later this year.
The whole area of electronic trading is expanding rapidly, with many platforms extending their instruments they cover or branching out into new markets. Tradepoint plans to go live this year with a European version of its exchange. In February it announced agreements with the London Clearing House and Euroclear that will enable the ‘straight-through processing’ of cross-border trades. Richard Kilsby, chief executive officer of Tradepoint believes that the European version will offer significant savings for firms wanting to invest in its selection of leading European stocks. All the stocks will be available on the same platform and traded under the same rules, with integrated settlement and the possibility of netting. Tradepoint’s backers, which include ABN Amro and Morgan Stanley as well as Merrill Lynch, are bullish about its prospects as a major pan-European market. However, there is a powerful inertia that will keep much of the liquidity with the traditional national exchanges, although these are likely to transform and rationalise themselves in the coming years.
Technology has introduced a dynamic into the world of exchanges that is having a profound effect but whose outcome is difficult to predict very far into the future, says Iati. The electronic trading platforms have widened the choice for fund managers and other investors, providing them with alternative channels for their investments that offer lower costs, longer market hours, anonymity, direct access and other benefits.