ECN Traffic Jam Hinders Some Near-Term Prospects

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New York, NY – By some estimates, over three dozen new electronic crossing networks sprang up last year – developed either by start up firms or existing broker-dealers.  This explosion in the number of ECNs has had a measurable impact on the fortunes of existing electronic execution providers as the trading volume pie is split up into a larger number of pieces.

One firm that has experienced a marked slowdown in execution volume growth in the U.S. has been Liquidnet – one of the world’s largest equity block crossing networks.  According to the Wall Street Letter, Liquidnet’s U.S. trading volumes grew 28% 1Q 2007 over 1Q 2006.   This compares to 53% volume growth in all of 2005.  It is interesting to note that Liquidnet’s European trading volume grew 150% 1Q 2007 over 1Q 2006 (albeit from a much lower base).

Of course, the big question facing Liquidnet, and many of the new entrants in the market is, “How will this rapid increase in the supply of electronic trading venues impact the cost of low touch trading?”

Based on the laws of supply and demand, we would guess that commissions for electronic trading are likely to fall – consistent with the steady declines we have seen in full services commissions over the past decade.

Fortunately for Liquidnet and the dozens of other ECNs, we also suspect that any loss in revenue resulting from price declines will be more than made up for by a pick up in trading volume as buy-side firms shift an increasing portion of their business from high touch execution providers to low touch venues – particularly as regulations like NMS here in the U.S. and MiFid in Europe focus client attention on “best execution”.

According to a survey conducted by Greenwich Associates, low touch execution (including algorithmic trading, DMA, portfolio trades, and trades done through crossing networks) totaled 33% of all U.S. institutional execution business in 2006.  The proportion of trading conducted through these various low touch platforms is expected to rise to 43% by 2009.

In Europe, low touch execution also totaled 33% in 2006 – though portfolio trades comprised a huge portion (20%) of this figure.  The Greenwich survey indicates that clients expect this total will reach 44% by 2009.

Despite this rather bullish trend for ECNs, we are rather skeptical that a majority of the ECNs that have recently sprung up in the U.S. can attract sufficient trading volume to survive.  In fact, we would not be surprised if in three years, less than half of the ECNs that launched last year will still be in existence – at least as stand alone platforms.  This means that the firms that survive should benefit from a larger market and fewer number of competitors.

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