ECNs Look to New Links for Liquidity

Electronic trading systems hunt for order flow through alliances with brokerages and other institutions.
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Electronic trading is taking yet another turn.

Once independent, electronic order-matching companies are now moving toward links with brokerages and institutions to get the one thing that will keep them afloat amid increasing competition and possible regulatory changes: liquidity.

One of the newest electronic trading firms,

Island

, and the oldest,

Instinet

, each moved last week to increase the traffic coming into their electronic communication networks, or ECNs.

The fact that these two firms already top the list for transaction volume among the nine ECNs only indicates the need for alliances with brokerage firms, exchanges or other institutions to protect or grow their businesses through captive order flow, analysts say. They're hoping their new partners keep their relationship -- and investment -- in mind when they are directing retail trades.

"In order for

ECNs to survive, they need order flow. By establishing agreements, they are basically guaranteeing themselves a source," says Greg Smith, an analyst at investment bank

Putnam Lovell de Guardiola & Smith

, which hasn't done any underwriting for any of the firms mentioned in this story.

Waterhouse Securities

, an online and discount brokerage owned by

Toronto-Dominion Bank

(TD) - Get Report

, agreed Tuesday to buy a 12.5% stake in Island, a unit of

Datek Online Holdings

. That move, Island President Matt Andresen says, will enable the ECN to "take a few giant steps forward."

Island's news followed a recent announcement from Instinet -- a unit of

Reuters

(RTRSY)

that has long catered to institutional customers -- that it is talking to both online brokerages and traditional brokerages about moving into the retail realm. Investment bank

Goldman Sachs

(GS) - Get Report

and online brokerage

E*Trade

(EGRP)

found themselves unlikely bedfellows as partners in

Terra Nova Trading's

Archipelago

ECN.

All-Tech Investment Group

, a Montvale, N.J.-based daytrading firm that offers the

Attain

trading system, is talking to different parties, including a large mutual fund complex, about a strategic partnership that could include a stake sale, according to All-Tech Chief Executive Harvey Houtkin.

And Datek Online President Ed Nicoll says, "a firm like Island could partner with a lot of different firms and institutions."

Amid this climate, Island is taking a path that is likely to guarantee revenue. Island will use part of Waterhouse's $25 million investment to apply with the

SEC

for exchange status. That could lead ECNs to generate the kind of big money that exchanges do by charging for the transmission of real-time equity quotes and other data.

Such developments may seem far removed from investors trading shares of

Yahoo!

(YHOO)

or

Amazon.com

(AMZN) - Get Report

over the Internet, but it's those investors who so far have enabled ECNs to ambush the establishment.

Online investors send their orders via the Internet to their brokerage. A company like E*Trade or

Ameritrade

(AMTD) - Get Report

will then either send that order to a

Nasdaq

market maker or to an ECN.

In addition to the quest for order flow, though, link-ups between brokerages and institutions are also happening because of changes ahead in the Nasdaq stock market, analysts and industry executives say.

Primary among those changes is the handling of limit orders -- orders in which the customer asks to buy or sell at a set price -- and a key volume factor for the ECNs.

With pressure from regulators concerned about unknowing customers getting caught up in volatile markets, online brokerages are advising their clients to place limit orders when possible, making the ECN a more likely destination.

Bernie Madoff, head of wholesale firm

Bernard L. Madoff Investment

, says that about 50% of order flow is now in limit orders. Market makers do handle such orders, but they are less profitable. And market makers don't pay brokerages for limit orders as they do for market orders (so-called payment for order flow).

Most stocks that online investors trade actively are listed on Nasdaq and quotes are disseminated between market makers and ECNs. With the millions of orders being handled in so many different places, there has been pressure to allow customers to see more information about other existing orders. The SEC is currently considering two proposals: One creates a central order file for limit orders (called the central order book) and the other enables market makers to list market orders and limit orders separately.

If the central limit order book is approved, it would essentially duplicate the function of ECNs, Putnam Lovell's Smith says. "There is no need for nine different ECNs. The ideal marketplace is one single order book," he says.

Whether such a book will be created soon is unclear. In addition to SEC approval, such an idea needs Nasdaq member support. Madoff, who heads the

Securities Industry Association

trading committee, says that the proposal, which failed when it was first brought up last year, won't do any better this time around. The agency quote proposal does enough to improve transparency, he says.

"The industry basically feels that the NASD shouldn't be building a central limit order book that would compete with its membership, which all have their own order books," Madoff says.

Lon Gorman, president of

Schwab Capital Markets & Trading

and a member of both the SIA board and Nasdaq's influential Quality of Markets Committee, agrees that the agency quote plan may win over the central limit order book. It has both the institutional and retail support needed to be accepted, he says.

That proposal, in fact, could also put a dent in the ECNs' limit order business because market makers could create competing pools of limit orders. "The agency line is a mechanism to take your limit orders out of your quote," he says. "Instead of sending them to an ECN, you create your own ECN."