E-commerce - Redefining exchanges

After the summer craze for investing in all things electronic and e-commerce-related, things have calmed down on the surface in the US. Now the challenge is to make the investments work. The major stock and derivatives exchanges know they have to respond more forcibly to the myriad threats to their franchises. At the same time the start-ups and the investment banks which are equity partners must transform their ideas into reality while trying to avoid the organizational nightmares which have plagued the exchanges. The next few months are more likely to be ones full of frustration for both groups, reports Antony Currie.

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NASDAQ let down by its own technology
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When you first visit Richard Kilsby at his office there is a surprise in store. He is the chief executive of Tradepoint, the London-based for-profit electronic exchange saved from extinction in May by a consortium led by agency broker Instinet and also including investment banks, an asset manager and a US electronic commission network (ECN) called Archipelago which itself has since applied to become an exchange in the US.

What provokes the surprise is preconceived ideas of what an exchange should look like: large buildings in the centre of financial districts proudly showing off their history. In the executive dining room of the New York Stock Exchange, for example, hang the portraits of past chairmen, and in the corner stands a magnificent Faberge egg donated to the exchange by Tsar Nicholas II at the start of the century.

That is not Tradepoint's style. Its office is in London's Soho, better known for opera, Chinese restaurants and more recently for being one of London's gay meccas. It is only one of several businesses in the building, and the walls are adorned with posters of pop art by Ray Lichtenstein. While the NYSE ponders whether it should take advantage of the $600 million the City of New York has kindly provided it with to expand into more buildings in downtown Manhattan, Kilsby is looking at annual overheads of £10 million ($16 million)

Elsewhere, it's a similar story. In Manhattan the area around Union Square is fast becoming the city's silicon alley; home to new financial services companies. Wit Capital, the on-line retail investment bank run by former Salomon Smith Barney banker Bob Lessin and former Schwab vice-chairman Ron Readmond, is just south of the square on Broadway, based in cramped offices in a walk-up above one of the city's most famous second hand bookshops, the Strand.

Just north of the square, off Fifth Avenue, is an even newer operation, Creditex, set up in early summer by two former Deutsche Bank credit derivatives traders, Sunil Hirani and John McEvoy. They are creating a virtual market place to trade, initially, default swaps. They have less than 20 employees, occupying just one office of several on their floor. It is still so new that they have yet to put a proper sign on the door, instead having a double photocopy of the firm's name and photocopies of the main employees, stuck on with sellotape.

They are new, nimble, staffed with people who are experts in their field and lack all the organizational nightmares which are plaguing the incumbents. And, on the equities side at least, they would appear to have the backing of SEC chairman Arthur Levitt. His plan is to use the ECNs as a way to provide effective competition to the exchanges, and he has openly signalled that he is willing to end the regulatory bias in favour of the entrenched exchanges. "At one time or another, all of us have failed to act outside the scope of parochial interests - refusing to recognize the market as a marketplace, and not an institution," he said in a speech at New York's Columbia Law School at the end of September. "This is not the time to cling to the comforts of custom; it is time to demand value. We should be asking ourselves: what best serves the interests of investors? Anything that doesn't should be part of our history - not our future."

He has already proved willing to turn words into actions in the way he has dealt with the options exchanges. He made it clear that they needed to start to work with each other, even compete openly with each other by trading the others' contracts. They failed to do so for themselves, so he imposed it upon them. Now it is a free-for-all, with customers searching out the best price on all three major exchanges for the first time.

A month later he was back in New York speaking in front of the Economic Club of New York, this time speaking in favour of a level playing field for all investors. But one of the questions at the end referred back to his earlier speech. In fact, it tried to refer to just about everything. Bill Donaldson, co-founder of Donaldson, Lufkin and Jenrette, and a former president of the NYSE, spent five minutes asking a question which included so much information he must have hoped it would make him look clever. His bottom line was that the SEC should put all developments on hold and set up a commission to investigate what would be best for the market.

Few outside the exchanges, and probably not too many inside them, would be all that keen. "We don't want to see the regulators coming in to sort this out for us," says Richard Korhammer, CEO of Lava Trading, a developer of trading systems that provides direct access to all sources of liquidity. "It should be left up to competitive forces. There are applications, such as ours, which can address Levitt's desire to tap all pools of liquidity efficiently once regulations allow."

Levitt appears to agree. After a stifled giggle at the preposterous length of Donaldson's speech, and a short pause during which most of the audience must have feared that he would ask for Donaldson to repeat the question, Levitt answered. No, a commission would be counter-productive and waste too much time - a year, possibly longer. So the stock exchanges remain on the back foot, destined to be forced to prove their worth without the regulatory barriers to entry which have in the past kept them in almost unassailable positions.

Good news for the new firms, but no guarantee that they will as a result prosper, or even, where appropriate, replace, the incumbent institutions they compete with. E-commerce is a wonderful tag to be able to put on a business, but if the main focus is on the technology there could be trouble ahead. In other words, they need to use the 'e' to maximize the benefit of the 'commerce'.
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