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ECNs Push the Envelope

A price war with the Nasdaq is now in regulators' hands.

First the upstart electronic communication networks put the

Nasdaq Stock Market


on the defensive. Now they're going to the

Securities and Exchange Commission

in a bid to keep the Nasdaq from striking back.

With ECNs' volume increasing daily, the Nasdaq has proposed slapping new fees on electronic exchanges. The Nasdaq plan, pending SEC approval, would make it more difficult for the ECNs to undercut the Nasdaq's prices. But the slow-to-move SEC has delayed any changes for now, suggesting that the pricing war on exchanges isn't going to stop anytime soon.

In mid-March, the threat of ECNs prompted the Nasdaq to propose a change in its fee structure. The new rule would charge the party delivering shares -- in this case, the ECNs -- $0.001 per share. Unlike other traders on the Nasdaq who are charged a flat $10,000 monthly fee if they provide more than 500,000 shares per day, the ECNs would have no caps on fees.

Traders have recently moved business to ECNs in order to avoid potential price increases caused by a duopoly in the industry. The move is ironic considering that both the



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and Nasdaq swallowed other ECNs -- Archipelago and Instinet, respectively -- to achieve their current scale.

By undercutting the Nasdaq's price by as much as 50%, the ECNs saw business boom. But the success has now come at a price, and the new fees from the Nasdaq may be the tipping point for ECNs. In order to stay in business, they would have to pass the Nasdaq's fees along to the traders, negating any pricing advantage they have. That's why they want to air their complaints with the SEC.

Last week, the regulatory body delayed the Nasdaq's change without signaling when it would rule again. But the process demonstrates an impending change in regulation that could ultimately define how the exchanges compete.

"The pricing model is going to be essential for success or failure for ECNs," says James Angel, associate professor of finance at the McDonough School of Business at Georgetown University. "The structure of the equity trading business is in the hands of the SEC, and they haven't decided what they want it to be. Are they hell-bent out to destroy the existing players in order to create a brave new world?"

It seems that the SEC isn't ready to decide. The regulatory body already has a number of issues to face with the expanded NYSE, and the industry is still digesting National Market System (NMS) regulation that recently went into effect. The SEC will probably take its time on making any rulings on this issue.

But time isn't necessarily something the Nasdaq has. After just months, ECNs such as BATS Trading and DirectEdge, a subsidiary of one of the largest Nasdaq trading execution firms,

Knight Capital


, have chipped away at the Nasdaq's volume.

"How long can the Nasdaq tread water until ECNs eat their lunch? It's really a function of what the SEC wants to do," says Angel.

Still the SEC can't be hasty on this decision, given its ramifications.

"The SEC has a history of doing things where they don't understand all the consequences of what they are doing, which is why they tend to be very slow," says Angel. "I think right now they will wait and see what happens with the implementation of NMS."