Concerned that exchange consolidation could raise your trading costs? Don't be. Another wave of electronic communication networks is popping up to challenge the big boys, and their early success suggests that pricing power in the stock trading business is a thing of the past. With their low prices and rising volume, these electronic platforms are emerging as a new threat to the public exchanges -- which is ironic considering that both the NYSE ( NYX) and Nasdaq ( NDAQ) swallowed ECNs to achieve their current scale. Buzz about new networks started to circulate in securities' circles last week, as traders looked for ways to protect themselves in case the established exchanges tried to charge more for their services. The new ECNs leverage several advantages, the main one being the virtually nonexistent barriers to entry in the business they are pursuing. New electronic platforms are easy to start up and, despite their relative obscurity, can quickly become a viable alternative in this elastic market. "It is very cheap to buy a computer, put in a couple of communication lines, and you are in business," says James Angel, associate professor of finance at the McDonough School of Business at Georgetown University. "Pure trade matching has become a low-cost electronic commodity. Without entry barriers, it becomes a competitive, cut-throat business." Rumors about possible mergers sparked a run-up in the shares of major exchange stocks two weeks ago. Stock markets from New York to Germany were dragged into the speculation. Since the drama has cooled, however, many of the big exchange stocks ticked down, and real probing of the industry has begun. Shares in the Nasdaq ( NDAQ) declined $3.22, or 7.4%, last week to $40.56. The NYSE Group ( NYX) fell $8.28, or 9.5%, to $78.57. Representatives from both companies declined to comment for this story. In pre-electronic times, consolidation would have given the exchanges an advantage. Fewer players in the industry would have meant more pricing power. If there was a situation where there were two main exchanges -- the Nasdaq and the NYSE, for example -- per-trade prices could become very expensive.
But that is no longer a threat. "In an electronic world, everyone can see what is available on all platforms," says Angel, "With National Market System regulation, the exchanges are expected to offer the best quote. It doesn't matter what trading platform you stick your order on." As a result, traders are preemptively seeking other options. "A lot of people are hedging the risk of the duopoly. They want to have alternatives," says Rich Repetto, equity analyst at Sandler O'Neill. One forum meeting with early success is Better Alternative Trading System, an ECN started in January. The company charges 15 cents per 100 shares traded, roughly half the amount charged by the Nasdaq and Archipelago, which was recently acquired by the NYSE. Although Better Alternative, or BATS, rebates less for limit orders -- about 14 cents per 100 shares vs. Archipelago's 20 cents and Nasdaq's 25 cents -- it still is gaining momentum. Early this month, on an active trading day, volume hit almost 30 million shares and it has averaged almost 19 million shares since the beginning of the month. In only its third month in business, the network claims to have captured almost 1% of Nasdaq's trading share. BATS trading isn't the only successful ECN. DirectEdge, a subsidiary of one of the largest Nasdaq trading execution firms, Knight Capital ( NITE), is another up-and-comer. Knight Capital acquired the ECN last October. Since then, the average daily volume executed has more than doubled, going from 38 million shares in November to over 91 million on average in March. "We expect that the fight for liquidity will be intense and that BATS has a reasonable chance of gaining market share from the incumbents," Repetto said in a note Thursday. "However, the amount of share won't come easy as Nasdaq has shown with its recent pricing change."
To be sure, like many Internet start-ups, these electronic exchanges could disappear. Nasdaq has proved that it is willing to compete on price, rolling out plans to lower fees effective at the beginning of April. But the rise in trading on these no-namers brings up questions about how low trading fees can go, and, if faced with the right pricing pressure, how much a name can really carry an exchange. "Fees matter," says Angel. "This is a business where a hundredth of a penny multiplied by millions of shares a day adds up real fast." As the swallowing of Instinet and Archipelago show, this isn't the first time the established exchanges have had to fend off electronic competition. But the venture capitalists of the Internet start-ups have nothing to lose. BATS, for instance, is only expected to eat up $3 million to $4 million in costs over the next year -- a relatively minor gamble in the quest to build volume. The initial investors, who funded only $7.8 million at the onset of BATS, are willing to be aggressive. The Nasdaq has shown signs of adapting to the dynamic industry. Last Thursday reports suggested the Nasdaq has been able to integrate Instinet's INET network faster than expected. That kind of progress could prove to be imperative if the exchange wants to ward off competition. "In the end, the customers will decide whether the NYSE and Nasdaq will be skillful enough to appease traders and keep them from hedging their trading bets on the emerging, price-competitive liquidity pools like BATS," Repetto says.