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Archipelago IPO Looks Well-Timed

The company plans to go public sometime next year, and analysts see reasons for optimism.

Archipelago

just announced plans to go public, and already the comparisons to

Instinet

(INGP)

have begun. Yet there are reasons to believe Archipelago will perform better in the public domain than its competitor has so far.

Instinet has declined 59% since making its public debut in May 2001, and the company has been bleeding red ink for much of that time amid a softer market for stock trading and increased competition.

It's hard to know how Archipelago has been performing because as a private company it does not release financial results. But the firm has rapidly increased its share of the market in recent years and now processes 24% of

Nasdaq

trades, according to a spokeswoman. Instinet, which has been around far longer, executes almost 27% of Nasdaq trades.

In a tersely worded press release late Monday, Archipelago said it intends to file a registration statement with the

Securities and Exchange Commission

in the next few months, with a view to going public sometime next year.

The timing of the IPO certainly bodes well for Archipelago. When Instinet went public, the economy was in recession and the stock market in the middle of a devastating bear market. But this year, conditions have started to improve and the trend is expected to continue into 2004.

Market makers "should do a whole lot better as the market comes back to life," said Charlotte Chamberlain, an analyst at Jefferies & Co.

Archipelago also stands to benefit from the recent investigation into specialists at the

New York Stock Exchange

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, say some analysts. The resignation of NYSE Chairman Richard Grasso, who was a strong advocate of the specialist system, represents an opportunity for new players to take a piece of the NYSE pie, according to Daniel Goldberg, an analyst at Bear Stearns.

"Over time, I see a significant amount of volume that is now done through specialists shifting to the ECNs," he said. "I'm definitely positive on the ECNs and alternative trading systems of the world right now with all the upheaval at the New York Stock Exchange."

While the NYSE is currently under scrutiny for poorly regulating its floor brokers, Archipelago stands out as an example of good corporate governance, some say. The company's electronic stock exchange known as Archipelago Exchange, or ArcaEx, operates the exchange business and regulation is carried out by the Pacific Stock Exchange. The Pacific Stock Exchange merged with Archipelago last year and each entity has a separate board.

Analysts also believe the potential reform of the trade-through rule could be a positive factor for Archipelago going forward. The trade-through rule requires traders to send orders to the exchange with the best price. For example, if an investor were willing to buy shares of

IBM

(IBM) - Get International Business Machines Corporation Report

at $90.01 but the Big Board was offering a price of $90, the electronic exchange would be forced to let the NYSE process the trade.

While this sounds good in theory, Goldberg noted that it can take up to 30 seconds to execute a trade at the NYSE, in which time the price could have changed. Electronic exchanges argue that while their prices might not look as good as those on the NYSE, the orders can be processed immediately.

The trade-through rule is under active review by the SEC right now, and some believe it will enact a 3-cent exemption rule, which has already proven to be successful in a pilot program.

"It would take away a significant barrier of entry, which has held back a lot of market share gains for the ECNs, and has really maintained the 80%-plus market share for the specialists on the floor," Goldberg said.

The mutual fund trading scandal is another positive factor for market makers like Archipelago, which could see a rise in institutional volume, some analysts say.

With no hard figures to look at, however, it's difficult to say that Archipelago will be a roaring success, and the IPO is no sure bet. If structural reforms don't materialize, some experts believe the company could struggle going forward. James Angel, a professor at Georgetown University, said Archipelago is engaged in a "bloody battle for market share" with Instinet and Nasdaq, and he noted that "no one's making a lot of money in that space."

"Archipelago has done everything right in terms of gaining market share," he said. "They actually got their exchange registration, which Nasdaq has not been able to get, and they held onto their broker dealership, so they have the best of both worlds. The real question is: How are they going to make money and where are the growth opportunities?"

Angel said major structural changes at the NYSE would be a huge bonus for Archipelago. "The 800-pound gorilla here is the SEC," he said.

Archipelago's biggest investors include

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report

,

E*Trade

(ET) - Get Energy Transfer, L.P. Report

,

J.P. Morgan Chase

(JPM) - Get JPMorgan Chase & Co. Report

and

Charles Schwab

(SCH)

, among others.

"The IPO could be a sign that they are looking pretty good right now, but it could also mean things aren't going to get much better and now's the time to cash out," Angel said. "The backers may be eager to get out. It remains to be seen."