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The impact of The impact of Electronic Communications Electronic Communications

Networks (ECNs)Networks (ECNs) on NYSE on NYSE

Presentation to

Mr. Richard Grasso and NYSE Directors

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Agenda

• ECNs – What they are / History and growth

• Strengths and Challenges

• Threats to NYSE

• Takeaways

• Questions

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History and Growth

1969

Instinet, the first ECN,

was created

Increased technology allows

for greater capacity and

efficiency

19901970 1996

SEC Order Handling

Rules triggers growth

# ECNs

2001

1

9

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ECNs have 30% of trading volume in Nasdaq

Trading Volume in Nasdaq

10%14%

36%28%

12%

Island

REDIbook

OthersECNs30%

Source: CSFB report

70%

Instinet

Archipelago

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ECNs - What they are

• Bring buyers and sellers together for electronic execution of trades.

• Have a wide variety of subscribers, including retail investors, institutional investors, market makers and broker-dealers.

• Allows subscribers to trade between themselves without having to go through a middleman

• Are alternative to formal Stock Exchanges (NYSE) or to dealer makers (NASDAQ) for trading securities

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How NYSE and ECN Transactions Differ

Investor Brokerage firm A Specialist

IT System

Own Inventory

Brokerage firm B

ECN

Investor ECN

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Limited orders

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Strengths of ECNs

• Anonymity (Signaling)

Information leakage is greatly reduced

• Commission Structure Reduced from $.06 to $.03 per share

• More efficient (Speed)

Orders post instantly versus wait up to three minutes

• Neutrality

Removes conflicts of interest in trading for own accounts

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Strengths of ECNs (cont.)

• Transparency

ECNs post size and price of customer orders

• After hours trading

ECNs offer an attractive venue for trading outside normal trading hours

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The Challenges Facing ECNs

• Liquidity

How to retain and attract volume

The greater the volume of transactions, the more likely trades will be executed successfully

Routing trades to other ECNs

Partnering with brokerage firms for order flow

• Differentiation

An exchange that provides superior transaction processing

Or a value-added broker that offers a range of products

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The Challenges Facing ECNs (cont.)

• Increased Regulatory and Compliance Demands Regulation ATS (Alternative Trading Systems) SEC Broker Dealer Regulations Exchange Specific Regulations

• Integrity Building an ethical reputation Excelling in treatment of customers

• Technology Continual upgrade requires substantial investments

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Why ECNs have had limited impact on NYSE

• Reluctance of traders to change trading places

• Better economies of scale through larger volumes per orders

• Better liquidity

• Automation of trading posts

• NYSE Direct + (limited orders

smaller than 1,099 shares)

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• ECNs are merging to obtain benefits of network effects

• If they are able to differentiate they can obtain

Market share

Profits inequality

Threats to NYSE

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The power of automation

Cost Reduction

Trading Cost of capital

27 % 4.2 %

Source: The Economist

Threats to NYSE

• Full automation of NYSE would cut trading costs and reduce cost of capital to firms

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• Exchanges around the world are merging

• Achieve economies of scale

• Get order flow to increase liquidity

• Reduce fragmentation

• Improve automation

• Eg.

London Stock Exchange + Deustche Börse = iX

iX has signed a JV with Nasdaq

Threats to NYSE

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• Archipelago has obtained approval to become first ECN-based national stock exchange

• Participants can trade NYSE, AMEX listed stocks, as well as Nasdaq shares

• Archipelago can connect with other exchanges through the Intermarket Trading System and collect fees for data access

Threats to NYSE

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Takeaways

• ECNs have consistently increased volume share

• ECNs have made inroads into the Nasdaq and into the European market

• ECNs are changing the way that security markets conduct business

• NYSE has remained the dominant player but will need to address its own capabilities to remain the market leader

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Questions?

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Supporting material

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Market capitalization has increased at the NYSE…

0

2

4

6

8

10

12

14

1990 1992 1994 1996 1998 2000

Market Capitalization

($trillion)

# companies listed = 1,769

# companies listed = 2,800

Source: The Economist

NYSE business

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… and so has the American passion for equities

30

48

0

10

20

30

40

50

60

1991 2000

% of adult population that owns shares

%

NYSE business

Source: The Economist

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The automation of trading posts in 1999 has brought substantial benefits to the NYSE … Increased volume

Additional sources of market information for specialists and brokers

Better visibility to institutions and investors

Enhanced liquidity

NYSE business

… however, ECNs can present a threat to NYSE

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How ECNs operate with Nasdaq

NasdaqSelectNet

ECN

Subscriber

Subscriber

Subscriber

Non Subscriber

Non Subscriber

Non Subscriber

Non SubscriberNon Subscribers access ECNs via SelectNet

Who are the ECNs and which services they provide

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In 1986 London Stock Exchange introduced a screen-based quotation system (SEAQ)

LSE

NYSE

3.96.9 9.8

2.6 4.10.28

0

0

0

1

1

1

1985 1992 1994

Daily volume (in $Billion)

Trends and Threats

Big Bang

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Attachment 1 - Automation of Trading posts

Post Information displays

Flat panel display screen

Point-of-sale workstation

Wireless data system

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Attachment 2 - The network effect

# of firms Sales of largest q1

Sales of second q2

Sales of third q3

Profits of largest p1

Profits of second firm p2

Profits of third firm

p3

1 0.6666 - - 0.2222 - -

2 0.6357 0.2428 - 0.1726 0.0294 -

3 0.6340 0.2326 0.0888 0.17007 0.0231 0.00035

Source: The impact of the Internet on financial markets -

Nicholas Economides