Securities and Exchange Commission
is like the Internet. It has the potential to move at breakneck speed; usually it doesn't.
More than a year after the SEC made it official that alternative trading systems -- which trade stocks from electronic platforms -- could apply to become for-profit exchanges, the number of new equity exchanges is, well, zero. That's not surprising given that the SEC has approved only one new exchange in the past 30 years, and had never approved a for-profit exchange.
But the wait may prove too costly for these fledgling trading systems as structural changes and ever-increasing competition have pressured exchange revenue and made the business less lucrative. So while they wait for the SEC's exchange-status blessing, the for-profit exchanges are busy lobbying Congress, investors and just about anyone else for changes that can benefit their businesses, just in case.
The act of juggling the arduous exchange-application process with remaining competitive pressures already has sent one alternative trading system, or ATS, in another direction. Chicago-based
pushed its exchange application to the side earlier this year and instead merged with the
to trade its small equity orders.
Other exchange applicants -- namely
and privately held
-- still are pursuing becoming exchanges, but more than a year into the process, their applications have stalled.
The major hurdle, according to the trading-system executives and people familiar with the exchange process, is the SEC's doggedness about placing controls on the individuals who run and operate any for-profit exchange. Because electronic trading is usually run by private, for-profit entities, that's no small problem.
When the new electronic options market, the
International Securities Exchange
, went to the SEC with its plans more than two years ago, it knew that control of the exchange would be a large issue. Almost from the get-go, the exchange planned to structure itself similarly to existing member-owned exchanges such as the
New York Stock Exchange, with companies like
Knight Trading Group
owning both seats and a stake in the exchange. It does not return profits to its members.
"We had to compromise on issues that the ECNs are less willing to compromise on, and the biggest of those issues is governance," says Mike Simon, general counsel for the ISE.
The commission won't be able to avoid concerns about how a for-profit exchange should operate much longer. As part of its demutualization, the
Nasdaq Stock Market will need to register as an exchange with the SEC, changing its current status as an association of securities dealers. A Nasdaq spokesman says it is discussing the matter with the SEC.
That's where ISE's Simon believes the standard for a for-profit exchange will be set. "They'll have to make decisions that they've so far been able to avoid," he says.
, the SEC's formalized rule on electronic trading systems, may never have been meant to make it easy. Regulation ATS was finalized in April 2000, shortly after Richard Lindsey, SEC head of market regulation, left the commission. And while the regulation has been portrayed as the driver behind the new exchange applications, Lindsey says its goal was nothing of the sort.
"What Regulation ATS is about is for the SEC to have a set of rules by which they can deal with this kind of entity," says Lindsey, now a managing director at
Both Island and NexTrade say they aren't changing their minds about their applications. They say being for-profit is essential to their business success because as membership organizations they would lack the flexibility to compete. "If it's five years, it's five years. We will still be waiting for approval," says NexTrade's President John Schaible.
Currently, Island is 85%-owned by Datek Online, with the rest held by venture capital firms
, which own some of Datek, too. Datek's holding company is also owned by a group of private investors, including former Datek head Jeffrey Citron. NexTrade's holding company is owned by a group of private investors as well.
These platforms briefly held sway in the headier days of 1998 and 1999, but competition is flooding in. The NYSE already handles most of its small orders electronically, and Nasdaq market making is now a largely automatic-execution business.
In some cases, though, the changing economics make the reason for becoming an exchange less pressing.
"For example, market data fees generally get mentioned, and they have been a fat pot of honey, but they're under a lot of pressure and they are going down. I would be hard-pressed to write a business plan based on that," says Sam Scott Miller, a lawyer with
Orrick Herrington & Sutcliffe
in New York.
And he points out, since many of these exchanges filed, the New York Stock Exchange already has repealed Rule 390, which stopped members from trading certain listed stocks off the exchange. Trading listed stocks was one of the reasons Island cited first for wanting exchange status.
Island general counsel Cameron Smith says that even though Rule 390 has been repealed, the exchange still can't grow its listed business because it is not part of the consolidated quote system, or the tape, which shows all exchange quotes.
Island's efforts in this area are just one indication that the battle for exchange status is on the sidelines. Smith says he talks to the SEC sporadically, having last spoken to the agency a few weeks ago.
"I think the commission itself is still talking within itself about how a for-profit exchange should look," Smith says.