The Rise of Electronic Communications Networks (ECNs)
Virtual Exchanges in the Financial Services Sector
“Today’s debate is really about how best to let unburdened competition and unbridled
innovation drive the future of the market. It is a debate about how best to equip our
markets to compete and win in an increasingly globalized electronic marketplace.”
--SEC Chairman Arthur Levitt, 03/00, Northeastern University
Matthew T. Dirr
Pique Marketing LLC
Version 1.2
April 10, 2000
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The Rise of ECNs: Securing Virtual Exchanges in the Financial Services Sector
Introduction
New technological partnerships have been rapidly eliminating inefficient channels and reducing
restrictions in the world’s capital securities markets. The result is a worldwide shake up in capital
markets. Electronic Communications Networks (ECN) are busy automating the exchange
process, equipping individual investors with the time and information resources to make
professional market decisions around the clock. At the same time, distinctive virtual markets are
combining new stock registries with quote and electronic transaction provision to supplement and,
in some cases, substitute for traditional stock exchanges. These two opportunities create
incredible potential for entrepreneurial financial service providers to extend their scope and
capture new activity in international capital markets.
ECNs: The great Equalizers
The passage of the 975 National Market System allowed for the emergence of ECNs in the
United States. The goal behind this legislation was to promote competition between markets and
to make quotation and investment information uniformly available (Andreson Testimony,
03/22/00). Two components came to manifest this objective: The Consolidated Quote System
and the Intermarket Trading System. The former promoted regular, widespread dissemination of
quotation material from all of the regional exchanges and Nasdaq to investors and market
professionals (Island, 03/27/00). The latter allowed individual and professional investors to read
quotation information across any of the participating markets (Island, 03/27/00).
However, information remained a premium in capital markets and led to insider advantages for
market professionals. In 1997, the Nasdaq market went through a crisis when the SEC published
a 21(a) report describing “improper market practices.” A Justice department study ensued, finding
examples of price fixing and collusion. Several decisions were rendered to make the securities
process more fair at the Nasdaq. First, the SEC adopted new Order Handling Rules to “introduce
competition and greater transparency” (Andreson Testimony, 03/22/00). Second, the SEC
reviewed its registry and listing procedures, making the NASDAQ even more appealing to new
companies to list their securities.1 Third, the SEC passed Rule 17a23 allowing for the registration
of electronic communications networks (ECN) to handle securities trades on this market.
Financial services technology had been slow to aid in streamlining the quotation and transaction
process at the exchanges, and entrepreneurial financial service providers quickly took advantage
of this new opportunity. They devised electronic trading software that coupled real-time,
sophisticated financial quotations with the back office functions that complete the purchase and
sale of securities: This is the birth of ECNs, themselves a more pure market situation. The ECN
marketplace allows buy and sell orders to be directly and electronically matched. The period after
1997 witnessed a proliferation of proprietary ECN systems from one to nine, each allowing
investors to seamlessly trade registered securities before and after market hours.
From their inception in 1997, electronic securities trading at the Nasdaq grew tremendously. The
growth of ECNs helped to fuel growth on the technology-focused Nasdaq, whose market cap
grew in value from US$310 billion in 1990 to US$5.2 trillion in 2000 (Halper, Business 2.0:
03/2000). Of the 4,829 companies listed on the Nasdaq, 26% are technology or Internet
companies. These firms represent 74% of the Nasdaq’s market value (Halper, Business 2.0:
03/2000). Activity through the seven major ECN providers in the space currently accounts for
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As a higher proportion of NASDAQ offerings are more recently registered stocks, this market was the ideal venue to
unveil ECNs. ECNs offer trade access to 19c-3 securities, or those listed after April 26, 1979, which are approximately
two-thirds of listed securities traded. The SEC Rule 390 preventing NYSE securities registered before 1979 from
listing on other exchanges was repealed in November, 1999, opening the door for new listings and liquidity for ECNs.
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30% of the Nasdaq daily transaction volume. Currently, one in every three trades is touched by
an ECN, and this figure is projected to at least double as ECNs proliferate. Although their activity
is strongest on the NASDAQ, electronic communications networks have also successfully
augmented trading hours on the traditional exchanges such as the NYSE.
How does an ECN work?
An ECN functions as a virtual exchange by electronically matching buy and sell orders in a real
time environment. It offers distinct advantages over traditional methods. Speeds of less than one
second per trade, low costs, extended trading hours, and extremely low failure rates are critical
differentiating features. The true value of an ECN, however, comes in the seamless provision of
several value-added financial services. More than just electronic brokering, the following
traditional components comprise the typical ECN:
ECN = Front End ISP+ Stock Registry + Quote Rate Provider + Brokerage Services
+ Back Room Transactions Provider
<< DIAGRAM OMITTED HERE >>
Each ECN provider maintains these functions across their system through mixtures of in-house
service and outsourcing.
An ECN has distinct advantages over brick and mortar exchanges. One is cost savings. The ECN
does not incur the high overhead costs required to maintain both hosts of human conduits and
expensive locales. A second advantage is ease of use for individual investors. While the bulk of
institutional investment continues to be conducted during business hours, the extended hours and
round the clock market access of an ECN allows thousands of retail investors to enter the
marketplace at their own convenience. Proponents argue that a third advantage of an ECN is
creating more democratic markets. Since their systems operate electronically and automatically, it
is conceptually much more difficult to use an ECN to collude or “move the market.”
The ECN Marketplace
Despite high growth in the ECN market, there are only nine primary providers in the segment.
The following list highlights the seven largest, describing their strengths and opportunities in the
marketplace (DJN: “The Role of ECNs in the After-Hours World,” 10/21/99).
Instinet Corporation
Instinet was acquired by the Reuters Group PLC (RTRSY) in 1987. Founded in 1969, it is the
oldest and most active of the ECNs. Based in New York City, it boasts membership in 17
exchanges worldwide with a trading volume of 170 million shares per day. (“Instinet Pledges
Court Fight To Protect ECN Access”) It is recognized as a leader in “institutional order flow,” and
provides the after-hours access to online broker E*Trade Group (EGRP). Instinet is also a
primary investor, along with Archipelago, in the UK-based ECN TradePoint, a for-profit, virtual
stock exchange that is completely electronic.
Island ECN
Founded in 1997, Island is owned by Datek Online Holdings Corporation. It maintains a network
of 280 broker-dealer subscribers, is available from 8AM to 8PM EST during the week, during
which it trades 200 million shares a day (equal to 12% of transaction volume on the NASDAQ).
In 1999, Island traded 26.5 billion shares, with a total dollar volume of US$1.56 trillion. This
volume makes it the second most active ECN on the market. Island captured 48% of NASDAQ
trades touched by ECNs in 1999. The company exemplifies ECN operations in speed, cost and
reliability. It boasts an average turnaround per transaction of .03 of a second and receives
US$.00075 per share per side per transaction executed through the system.
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The company has played the most visible role in the expansion of the ECN market. It was the first
to file with the SEC for stock exchange status. Island provides access to after-hours trading for
Datek’s brokers as well as Ameritrade Holdings Corporation.
Archipelago Holdings LLC
Born out of the software firm Townsend Analytics in 1996, Archipelago brings together a suite of
strong investors including E*Trade, Merrill Lynch & Co (MER), JP Morgan & Co. (JPM), Goldman
Sachs Group Inc. (GS), General Electric Company’s (GE) CNBC business news network, and
Southwest Securities Group, Inc. (SWS).
Archipelago filed for national securities exchange status in August 1999, on the strength of its
growing investment roster. It moved closer to establishing a virtual stock exchange that would be
fully integrated into the National Market System through an announced partnership with the
Pacific Exchange in March 2000.
The Archipelago system recently reached a volume of 52 million shares traded daily.
RediBook
Redibook is backed by investors PaineWebber Group Inc (PWJ), Credit Suisse First Boston,
Lehman Brothers Inc. (LEH), National Discount Brokers Group (NDB), Spear, Leeds and Kellogg,
Charles Schwab Corp. (SCH), TD Waterhouse Inc. (TWE), Fidelity Investments, and Donaldson,
Lufkin & Jenrette Inc. (DLJ). The visibility of Redibook has increased with the recent addition of
some of these investors, who are presumed to send orders through this system and improve its
liquidity. Owners have said they will offer access to after-hours trading through the REDIBook
system, which is open from 8AM to 10PM EST.
Marketxt Inc.
Formerly known as Eclipse Trading, MarketText recently expanded its hours from 4:30 PM to
8PM EST. It maintains agreements to provide after-hours access to trading for Mellon Bank
Corp. (MEL), Dreyfus Business Services unit and Morgan Stanley Dean Witter & Co.’s (MWD)
online brokerage business. MarketXT Inc was recently acquired by the day trading firm,
Tradescape.com. Currently, MarketXT averages only 100,000 shares traded/night and
Tradescapes.com averages about 40 million shares traded/day (“MarketXT, e-trading system
operator, to be acquired by day trading firm Tradescape.com in $100 mil stock deal”).
Tradebook
Owned by Bloomberg LP, Tradebook has witnessed exponential growth. The company’s daily
transactions during the fourth quarter of 1998 averaged 500 million shares and increased to 800
million shares by the second quarter of 1999. (“In the US, ECNs acount for 30% of Nasdaq
volume”)
Brass Utility LLC (BRUT)
RUT ECN merged in February of 2000 with Strike Technologies to create the 3rd largest ECN. Its
post-merger investors include 30 equity partners, among whom are Bear Stearns, Bridge Trading
Company, Herzog Heine Geduld, Inc., Lehman Brothers, Merrill Lynch, SunGard Data Systems
Inc. (SDS), Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney, and
Knight/Trimark Group Inc. (NITE)
NexTrade
Although on the smaller end of current ECNs, NexTrade has also filed with the SEC seeking
exchange status. It is owned by Professional Investment Group, Inc. (PIM), a Florida software
development company.
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Attain ECN
Attain is owned and operated by All-Tech Investment Group, a direct access electronic daytrading firm based in New Jersey. Attain offers after-hours services to the NASDAQ, NYSE, and
AMSE.
Tradepoint
This London-based ECN has emerged to fill the need for electronic matching of buyers and
sellers on European exchanges. Tradepoint began in 1995 as an ECN but upgraded to a virtual
exchange this year with capital infusions from a consortium of eleven members including: ABN
Amro, American Century, Archipelago, Credit Suisse First
Boston, Dresdner Kleinwort Benson, Warbury Dillon Read, Morgan Stanley Dean Witter, Merrill
Lynch, JP Morgan, Deutsche Bank, and ECN Instinet. Tradepoint boasts over 2,000 listed British
equities and has more than 150 member firms worldwide. Tradepoint received SEC Approval in
March 1999. (www.tradepoint.co.uk)
Virtual Exchanges: Alternatives Abound
The surge in activity among ECNs alludes to an even bigger change in global capital markets: the
establishment of global, virtual securities exchanges. Two of the primary ECNs, Island and
Archipelago, have already filed with the SEC to become the first for-profit virtual exchanges in the
United States. This status would develop a new exchange model, allowing them to rival the
marketplaces they already service.
Despite these prospects, the United States is far behind the leading edge. The model for global
virtual exchanges already finds precedent throughout Europe. The following list describes the
quintessential vertical markets and where they are headed.
Nasdaq Europe
Based in London and slated to open in the 4th quarter of 2000, Nasdaq Europe envisions great
things. It has formed a joint venture with an Indian Software Company, SSI, to develop an
internet-based exchange system that can link US, European, and Japanese Nasdaq listings. The
system will begin with 20 listings, and will trade for two hours before opening and after closing of
traditional exchanges (CNET News, 01/14/00). This development puts pressure on ITG Europe’s
Posit and Tradepoint, virtual exchanges already operating alongside the London Stock Exchange.
Euro.NM Group
This exchange represents one attempt at the creation of pan-European stock exchange. While
the offerings would be linked, this system is designed to be multi-jurisdictional, with each national
segment adhering to its respective national market regulation. The following are components of
this exchange:

Neur Markt - Germany
This virtual exchange was initiated in March 1997, and is administered by the brick and
mortar Deutsche Borse. It has focused on the high tech companies and has grown from
80 companies to 200. Among these companies, Information technology accounts for
25%, media listings for 24% and telecommunications companies for 15%. Neur Markt
has a market valuation of more than Euro 80 billion. With a performance of 546.5% since
its inception, Neur Markt is poised to be the premier virtual exchange of Europe, an
international Nasdaq.

Nieuwe Markt - Holland
Opened in 1997, this exchange lists 14 companies and has a market capitalization of
Euro 1.2 billion.
Euro.NM - Belgium

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

Also opened in 1997, it counts 2 Israeli and 2 Dutch companies among its 12 listings.
Euro.NM Belgium has a market capitalization of more than Euro 300 million (1999).
Nouveau Marche - France
The Paris-based Nouveau Marche opened in February 1996, and is managed by the
Paris BourseSBF SA. It has grown to over 100 listed companies, and has raised capital
of Euro 1.5 billion. This exchange’s market capitalization represents more than Euro 5.5
billion.
Nuovo Mercato - Italy
Milan’s Nuovo Mercato is the newest attempt at a virtual exchange. It was established in
1999 as an extension of the Mercato Telematico di Borsa, and is overseen by Borsa
Italiana. To engage investors, the Nuovo Mercato offered free transactions for members
already trading on the MTA and for new intermediaries to the NM. It has only 1 stock
listed, and a market capitalization of Euro 100 million.
Easdaq
Headquartered in Belgium, the European Association of Securities Dealers Automated Quotation
(EASDAQ) system was formed in partnership with Nasdaq in 1996, to initiate Nasdaq markets
abroad. Easdaq has struggled to build its listings to 66 companies, and has a market
capitalization of US$11.5 billion. One of the primary differences for Easdaq is its focus on a single
market governed by a single system, based upon Belgian legal, banking, and finance laws. The
hope behind this system is based upon the notion of a screen-based market, by which “financial
institutions can become member of a screen-based regulated market through delocalized
screens, without having to establish a branch or a subsidiary in the Member State where the
market is located.”
Alternative Investment Market (AIM)
This market was opened in June 1995 by the London Stock Exchange as a successor to the
Unlisted Securities Market, which was closed in 1996. It contains more than 260 companies and
has a total market value of more than US$10 billion. Companies must have a prospectus
approved by the London Stock Exchange prior to admission on AIM.
The Future of ECNs and Virtual Markets
Drawing upon the success of European virtual exchange models, ECNs in the United States will
position electronic exchange environments to rival the NASDAQ. ECN leaders Island,
Archipelago, and NexTrade have applied for official exchange status with the SEC. Those
pending applications could have a tremendous impact on traditional exchanges.
Currently, ECNs pay a reporting fee per trade to the exchanges to use their communications
system. The fee for Nasdaq, for example, is one dollar per trade to use SelectNet. If granted
official exchange status, ECNs will bypass this reporting stage and deprive Nasdaq of a
significant source of revenue amounting to tens of millions of dollars annually.
The value of ECNs will increase as virtual exchanges take hold in the United States. Today’s
investors require real time information and up-to-date research. They want to be able to trade
easily and inexpensively, based upon complete information. Most importantly, investors are
willing to pay substantial premiums to meets these needs.
The inclusion of ECNs on the Nasdaq will force a consolidation in the marketplace. Four
players—Instinet, Island, Knight Securities, and Mayer and Schweitzer, trade a combined 60
percent of the NASDAQ. This figure is a substantial increase from the 40 percent they traded a
decade ago. Moreover, ECN service providers have argued before the US Senate Banking
Securities Subcommittee that failure to open up the NYSE and other exchanges actually inhibits
the National Market System. The line between multi-dimensional brokerages and ECNs will get
even fuzzier when the Nasdaq reveals plans to launch its own ECN, Order Display Window,
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sometime early next year. Recall that Nasdaq has played a central role in the emergence of
several of the virtual exchanges in Europe.
Investment banks will drive the ultimate success of these capital market changes. The rules have
changed: “Investment banks are helping to keep stock exchanges liquid by underwriting new
listings, providing research to attract other investors, brokering the sale and purchase of equities
and filling voids by ‘making markets’—buying stocks when there are no buyers” (Halper, Business
2.0, 2000: Pg. 3). These banking institutions have enabled two systems to emerge—ECNs in the
US and virtual exchanges in Europe.
The international aspect of this market sector cannot be denied. The case of ECNs on the
NASDAQ opens up incredible opportunities for investors and investment abroad, yet no single
ECN has managed to establish a global presence. Further opportunities are abundant for the
implementation of ECNs in European, Asian, and Australian markets, despite slow progress.
Moreover, there are prime international opportunities for strategic alliances with US-based ECNs
looking to:

Expand their presence to encourage the flow of capital into US exchanges as well as foreign
markets;

Establish worldwide platforms for round the clock trading;

Establish partners to modulate and load balance the flow of activity across their networks
throughout the day.
Traditional exchanges have begun pooling resources in order to maintain a critical mass for
securities trading.
EuroNext is the most recent of these efforts. EuroNext was formed as a result of a merger in late
March 2000 of Paris Bourse SA, Amsterdam Exchange (AEX), and Brussels Exchange (BXS).
This pan-European trading exchange will incorporate as a Dutch company, creating the largest
exchange in continental Europe. EuroNext will list at least 1,300 companies. While the combined
value of the three separate exchanges was Euro 1,453 billion in 1999, the new exchange is
expected to have a market capitalization of Euro 2,380 billion. The transition is expected to be
painless as shareholders of the current exchanges swap their current holdings for shares in
EuroNext.
Conclusion
It is inevitable that capital flows will soon follow the sun in daily circumnavigation of the globe. In
short order, the sun will play no role whatsoever as markets begin to run around the clock.
For savvy investors, the challenge is gauging who will have the upper hand in the consolidation
that is forthcoming in this sector. Will the American ECNs gain exchange approval soon enough
to catch up to operational virtual exchanges in Europe? Will the virtual exchanges gain access to
listings in the United States? What will the role be for virtual exchanges in Asia, Latin America,
and other parts of the World?
One thing is certain. The financial information flow will dramatically increase as a result of these
new outlets in capital markets. The names and faces of stock exchanges may change radically in
the next few years, but the real winners in these markets will be the companies that are able to
process transactions and deliver investment information in a secure and reliable fashion.
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______________________________________________________________________
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Bibliography
Andreson Testimony. 22 Mar. 2000.
CNET News. 14 Jan. 2000. www.cnet.com.
Halper, Business 2.0. Mar. 2000.
“Instinet Pledges Court Fight To Protect ECN Access”. Traders Magazine. Jan. 2000.
“In the US, ECNs acount for 30% of Nasdaq volume”. Financial News. 3 Jan. 2000.
Island Website. www.island.com 27 Mar. 2000.
“MarketXT, e-trading system operator, to be acquired by day trading firm.
Tradescape.com in $100 mil stock deal”. New York Times. 10 Feb. 2000.
Tradepoint Website. www.tradepoint.co.uk 30 Mar. 2000.
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