The future of stock exchanges

The future of stock trading is electronic, seemingly pitting the remaining traditional New York Stock Exchange specialist system against the relatively new, all Electronic Communications Networks, or ECNs. ECNs extol their speedy execution of large block trades, while specialist system proponents cite the role of specialists in maintaining orderly markets, especially under extraordinary conditions or for special types of orders.

The ECNs contend an array of special interests profits at the expense of investors from even the most mundane exchange-directed trades. Machine-based systems, on the other hand, are said to be much more efficient, improving the traditional execution mechanism and eliminating the requirement of dealing with an intermediary.

Historically, the 'market' (which, as noted, encompasses the totality of stock trading on all exchanges) has been slow to respond to technological innovation. Conversion to all-electronic trading could erode/eliminate the trading profits of floor specialists and the NYSE's "upstairs traders."

"I'd definitely say the ECNs are winning," declares William Lupien, founder of the Instinet trading system and the OptiMark system. "Things happen awfully fast once you reach the tipping point. We're now at the tipping point."

Congress mandated the establishment of a national market system of multiple exchanges in 1975. Since then, the 'electronic communications networks' have been developing rapidly.

Electronic networks, by executing large trades at lightning speed, reduce the possibility of front running, or trading ahead of a customer's order, an illegal practice for which several NYSE floor brokers were investigated and severely fined in recent years. Under the specialist system, when the market sees a large trade in a name, other buyers are immediately able to look to see how big the trader is in the name, and make inferences about why s/he is selling or buying. That is how the Street anticipates price action.

ECNs have changed ordinary stock transaction processing (like brokerage services before them) into a commodity-type business. ECNs could regulate the fairness of initial public offerings (IPOs), oversee Hambrecht's OpenIPO process, or measure the effectiveness of securities research and use transaction fees to subsidize small- and mid-cap research efforts.

Some, however, believe the answer will be some combination of the best of technology and "upstairs trading"— in other words, a hybrid model.

Trading 25,000 shares of Lucent stock (recent quote: $2.80; recent volume: 49,069,700) would be a relatively simple e-commerce transaction; trading 100 shares of Berkshire Hathaway Class A stock (recent quote: $88,710.00; recent volume: 450) may never be. The choice of system should be clear (but always that of the trader), based on the characteristics of the security to be traded.

Even with ECNs forming an important part of a national market system, opportunities presumably remain to profit from the spread between the bid and offer price. That is especially true for investment managers that direct huge trading volume, and own a stake in an ECN or specialist firm. For example, in its individual stock-brokerage accounts, Fidelity Investments runs 29% of its undesignated orders in NYSE-listed stocks, and 37% of its undesignated market orders through the Boston Stock Exchange, where an affiliate controls a specialist post.

Fidelity says these arrangements are governed by a separate brokerage "order-flow management" team, which seeks to obtain the best possible execution for customers, and that its execution is highly rated.