January 13, 2014

The global capital markets have seen significant changes over the last 15 years. The advent of the Internet and adoption of other innovative technologies have made exchange-traded markets more transparent than ever before and substantially lowered the barrier to market entry. Along the way, electronic trading has become a competitive requirement for most major financial centers, and marketplace automation has created high levels of efficiency while eliminating many jobs that will more than likely never come back.

One of the most fascinating changes over the last decade has been the transformation of the exchange competitive landscape. The process of demutualization essentially altered exchange DNA, transforming them from member-owned (i.e., broker-dealer) industry utilities to profit-maximizing entities increasingly coming into conflict with their former members.

At the global level, market consolidation has been the major trend over the years as large exchanges have scrambled to further expand their presence regionally as well as broaden their support for different asset classes.

The launch of ECNs ultimately signaled the end of the old way of trading and triggered what amounted to a transformation of market microstructure.

While there are many reasons for this trend, one of the key drivers is increased competition in domestic markets, characterized as market fragmentation.

Market fragmentation can be traced back to the late 1990s in the US equities market (in particular to Nasdaq). The initial impact of the emergence of little-known brokers, dubbed electronic communication networks, or ECNs, driven by regulatory changes in the US market, seemed fairly innocuous at best. It was pretty difficult for Wall Street veterans to take these new market entrants, with names like Island, Strike, and BRUT, seriously.

Key Ingredients For Success

Nevertheless, the launch of these ECNs ultimately signaled the end of the old way of trading and triggered what has amounted to a transformation of market microstructure, not only in the US market but also in other major financial centers globally. In extreme cases in the US market, the market share of incumbent exchanges declined from more than 90 percent of the market to less than 25 percent. Increased competition led to a dramatic decline in explicit execution costs but has also generated less-than-appealing consequences and in some cases raised fundamental questions about the fairness and stability of the capital markets. The following factors have played a key role in facilitating the success of alternative trading systems in the US market and should be closely examined by those aspiring ATSes in other financial centers looking to shake up the status quo in their local markets:

  • Regulatory precedence: The order-handling rules of 1997, followed by Regulation ATS in 1999, clearly established a regulatory precedence under which ECNs could emerge and compete against incumbent market centers.
  • Electronic trading: Starting with Nasdaq, market centers and market participants in the US equities market quickly developed electronic trading infrastructures.
  • Precedence for competition: The US equities market has always had competition, despite the fact that it was more often than not dominated by the New York Stock Exchange and Nasdaq. The precedence of numerous smaller regional exchanges and the existence of the Intermarket Trading System for connectivity provided a basic foundation for the concept of order routing and industry recognition that technology could virtually consolidate fragmented markets.
  • Rapid development of industry infrastructure: The existence of consolidated tape as well as the independent status of clearing and settlement operated by the Depository Trust & Clearing Corp. created a competitive environment with low market entry barriers so that new entrants could compete on an equal footing against incumbent market centers.
  • Level of liquidity: As the most liquid market in the world, the US equities market has accommodated market competition.
  • Trading volume: It just so happened that during the height of market competition, the US equities market saw unprecedented volume growth.
  • Pricing innovation: ECN Island was the first to introduce the maker-taker pricing model, which has become a standard in today’s marketplace. Rewarding liquidity providers for their participation was a decisive way to attract much-needed volume into these new venues. BATS in 2006 temporarily introduced an inverted pricing model in which it essentially ended up paying firms taking liquidity, leading to loss on every trade execution.
  • Ownership structure: During the second wave of market fragmentation starting in 2006, one key business innovation involved market centers attracting ownership stakes from leading brokers and trading firms. Soliciting support from the market’s established liquidity providers became an important ingredient for both BATS and Direct Edge as they continued to increase their market share.
  • Client segmentation: Targeting specific client segments has also played an important role in supporting overall market share growth for ATSes. For example, during its initial growth phase, Island intentionally avoided going after traditional buy-side firms because Instinet had a big presence there already. Instead, Island focused on the underserved online brokers, hedge funds, and professional traders to gain market share. In recent years, there has been much focus on attracting high-frequency trading flow to build up liquidity for many of the ATSes and exchanges in the US equities market.
    Sang Lee is a co-founder of and currently serves as managing partner. Mr. Lee's expertise lies in the securities and investments vertical and has advised many global financial institutions, software/...