Instinet has been a constant driver for change. Set up using teletype machines, the cutting-edge technology of the day, its goal was to facilitate trading between investors, cutting out the costs of middlemen. But the brokerage found it tough going for years, until in the early 1980s it saw an opportunity on the US exchange Nasdaq for a technologically advanced agency broker to cut costs for investors.
That business now accounts for 80% of its revenues but it is under severe pressure from largely retail-focused electronic commission networks [ECNs] that were born out of a loophole in Securities & Exchange Commission regulations in 1997 and have put pressure on Instinet’s prices.
Instinet began to diversify in 1992, setting up operations in Europe and later on in Asia, spending nearly $100 million. After six years, only 20% of its revenues come from these businesses. And there are other issues. The equities trading technology is getting old, its prices still seen as high by many in the markets. And its link to parent Reuters is being called into question again.
Far from being mired in such problems, however, Instinet has come out fighting. Its 37-year-old chief executive, Doug Atkin, has worked for it for his whole career, and was appointed last December after six years in London. He is ebullient, outspoken, and convinced of Instinet’s role as a leader in using technology to expand his business, and to make the markets more efficient.
While he has been at the helm he has directed the company into new markets to compensate for its total dependence on secondary equities trading. Instinet is a stakeholder in on-line investment bank WR Hambrecht, set up last year by Bill Hambrecht (of Hambrecht and Quist) to challenge the old rules on equity capital raising. It has a stake in on-line retail broker E*Trade, has since March been raising its profile by providing the after-hours trading report for CNBC’s financial news programme, and is set to launch its biggest venture of all: electronic trading of fixed-income products.
He is also the man behind the consortium that saved Tradepoint, the UK-based for-profit stock exchange that was near bankrupt and about to lose its stock exchange licence until Atkin stepped in.
Are these just examples of him hedging his bets? In some cases yes. But he is candid about the disruptive effects technology will have on his business, and the need to be willing to embrace them. There are few better models for how to deal with such change.
In the year that you’ve been CEO, Instinet has become one of the more high-profile firms investing in e-commerce and electronic broking. So what is your vision of what will happen here in the US?
People say they don’t know where this is going for US stock markets. I say get on a plane at JFK, go to the continental European capital of your choice and take a look over the stock exchange. That’s where I believe the US stock market should go. To me we should use the best of what the Europeans have done already. I was fortunate to live in London for six years while the continental European bourses went from exchanges where people took longer lunches than they had trading sessions to what, in my opinion, are some of the most efficient stock exchanges in the world. And I think that movie is going to play over here.
Whether we in the US have one exchange or two exchanges – one for OTC, one for listed, or one for certain types of stock, one for others, or whether it’s based on, say, market capitalization – what we’ll have will look like what is in Europe already: a frictionless common operating platform, with low costs and open access, for trading 70% to 80% of an instrument. That’s what the [French] CAC and [Swiss] SWX has. [In London] Sets is evolving towards that but still lacks critical components such as anonymity and a central counterparty.
And then the brokers will compete on providing efficient access and, more important, competing for the special-care orders that need the value-added of either capital or electronic block trading. The only question is whether it’s going to be a short movie, or a really long movie.
What does the time frame look like to you at the moment?
It’s all out of the bottle, but we’re in this weird transition period. I believe it’s going to take a couple of years, but what we’ve got at present is the equivalent of America Online, Infoseek, Yahoo!, Lycos, which are not only competing on how to add value on the top but also competing to develop their own separate protocols. For us as much as them that’s the wrong space to compete in, but we’ll figure it out. What’s needed is a for-profit electronic pool of liquidity. Whether it’s Nasdaq who does it or the NYSE, or both, or failing them a third party who comes in, it’s going to happen.
Liquidity likes one place, likes an efficient one place, and there should always be competition to unseat that place which has the 70% to 90% liquidity. But it’s not tenable to have five or six pools each with a certain percentage. It’s not good for the market.
Yet your first high-profile investment was in Tradepoint, the UK-based for-profit stock exchange. Why did you choose that?
I got close to the Tradepoint people when I was in London. We had a complex relationship. They were trying to change the rules of engagement, as were we, so we have a lot in common in trying to get the industry, especially the buy side, to view electronic trading as something appropriate for their attention.
But we are also competitors, as they were going directly after fund managers, which is something brokers, not exchanges, typically do. So I knew the people, I knew the business, I always thought it was a number of years ahead of its time changing the model of what an exchange is, completely breaking down any distinction between the historical members of the club and those outside the club.
And as a for-profit institution it keeps costs down and uses technology as a big enabler. And it has an efficient order-matching system. All it lacked was liquidity.
And as a result it was near bankruptcy. How did you persuade the investment banks and asset managers to join you, an agency broker, effectively under your leadership?
We did take a leadership role, that’s true, but if you really analyze it, it shouldn’t come as that much of a surprise when you look at how reliant our business is on market structure. That others were willing to join proves how much the industry has changed in the last two years.
We view market structure evolution as a global issue, and thought Tradepoint was a strategically very important asset which could be used and deployed around the world. It’s easy in retrospect to say what they could have done better, but they went after the domestic-to-domestic market in UK equities, which was very difficult. A lot of the buy side didn’t even have trading desks.
Nonetheless, we felt that it is surprisingly unencumbered in what it can do – it can trade any instrument that’s listed on any exchange around the world. And we thought that if we could get a number of big global players with substantial amounts of US and European order flow together, then the minimum it could do was help push forward the US market structure debate.
No-one can come in and challenge the French exchange in France, but we need one entity to trade and settle the top 300 to 400 European shares.
I went around to see people, and discovered the time was right. People said this makes sense, both in pushing to take the US market structure forward, possibly even importing Tradepoint into the US. In Europe there is a real need for one entity to trade and settle the top 300 to 400 European stocks. and through this consortium Tradepoint now has a lot of support from major liquidity providers.
Did the investment banks you spoke to take some convincing? They’ve joined in a trickle. Is that a sign of your managing the process slowly, or the banks being wary of jumping in?
Well, first off it had to be put together very quickly because Tradepoint was about to lose its licence to operate as an exchange. And it was not easy getting the first group in. It took a lot of work to sort out the details. I wanted to make clear that even though it’s a bit of a hedge for everybody, and at worst it becomes a forcing function to get the exchanges to innovate, what we wanted were institutions committed to proactively supporting Tradepoint. And the first to come in were those we were talking to on US market structure.
Now the consortium members are deciding and debating about who we want in. We don’t want it too big or else we’ll end up with the governance problems of the exchanges. We have about 75 firms, including exchanges, which want in.
Less than a week after setting up the initial Tradepoint consortium you made an investment in one of the ECNs, Archipelago. Is that an admission, as some have suggested, that your ECN-style business on Nasdaq might not exist in the future?
My view is that in a future with one place to trade, and it’s for profit, Instinet will have a significant shareholding in that for-profit exchange. Archipelago is trying to become that one place, which is why it has applied to become a stock exchange. So Archipelago is not an admission of anything except that it’s a horse we’re willing to bet on to become the US for-profit exchange. And it’s nice to have a seat at the table in influencing that.
At the same time we’re constantly in talks with New York and Nasdaq. If I were [UK betting company] Ladbrokes I’d make them the odds-on favourites as innovators to become the leading exchange of the future. But we’re agnostic on who gets there first.
We have a huge amount of liquidity which we can contribute, and we will help contribute it to that structure which we think will grow the market, and move the market structure forward, make it more efficient, and alter the rules of engagement to make it more investor-friendly. The pie gets a lot bigger, and that’s good for our business. It’s going to change our business, but that will change anyway.
So we’re not sending business to Archipelago right now. We trade with them occasionally, and they trade with us a lot. We bought into Archipelago not for its present business model but into what it has applied to become.
You’re expanding into the fixed-income markets. Why have you chosen this market after years as an equities specialist?
If there was ever a market that was in need of technology and its efficiencies, and needed a new way of trading, then fixed income is it. As I’ve said publicly before, it’s Nasdaq on steroids. It’s a huge market, and will benefit greatly from bringing efficiencies to that market – and we’re quite confident of our ability to do that.
There are already several inter-dealer broker systems set up or in the process of being set up, such as Cantor Fitzgerald’s system, EuroMTS, Brokertec, as well as broker-investor systems such as LIMITrader and Deutsche’s Autobahn. How do you see yourself fitting in with these? What can Instinet add?
What our fixed-income brokerage service provides is a totally anonymous electronic brokerage service for European government bonds and US treasuries and I think it is a fundamentally different model to what’s out there. I don’t believe from what I understand that Brokertec is anonymous, which we think is a critical part of providing a service which significantly lowers transactions costs, because identity reveals a lot about one’s intentions.
Instinet understands markets and how clients interact. We have a lot of experience at looking at the markets, seeing what the clients are doing now, seeing what the future’s going to look like. We provide the bridge, helping to create the future in these markets. We did it in US equities and again, with a different business model, in European equities. So I think we have a good track record in understanding the markets.
As for some of the other models, there are a lot of vested interests out there. They use technology to keep the rules of engagement the same. A lot of so-called electronic trading in fixed income has been point-to-point, sending orders electronically rather than picking up the phone. While that brings incremental efficiencies, it doesn’t fundamentally change the rules of engagement.
Admittedly this is a difficult business to be successful in, but we think that with what we’ve done in US and European equities we have a very good chance.
The ECNs have put a lot of pressure on you, not least on pricing trades for Nasdaq stocks, and that market still provides 80% of your revenues.
Yes, the ECNs do provide us with competition. But are they direct competitors? No. Is EasyJet a competitor to British Airways? You can say yes and no; on a global basis, no, but would you prefer that EasyJet did not operate on some of your routes? Sure. If you wanted to fly London to Nice, it was either Air France or BA. Now EasyJet comes along. There are those who still want the meals, business people will still want to travel first class, but a proportion of BA’s customers will want, at least sometimes, to fly EasyJet. More important, it creates a whole new market segment.
So it is with the ECNs. Island has gone after a very different group of clients to us. So there is competition and I am concerned. But it is the big sea change in the industry we’re worried about. And we’re positively influencing change and in a way that is best for investors and which will be best for our shareholders.
Some bankers think you should have reduced your prices two years ago as they requested, and so possibly avoided some of the competitive pressures.
We constantly bring our costs and prices down, that’s a reality of the industry. There is no ECN on the horizon on the institutional side with substantial liquidity. If you think of ECNs as generic routers into the quote, trading 500,000 shares of, say, Intel with just that functionality wouldn’t be easy. You’d need to offer a lot of services in addition to the ECN to be able to do it effectively, such as an order-management system. And a lot of our business is in global portfolio trades. On average we’ll get five to 10 portfolio trades a week from just UK institutions of $50 million or more across 15 countries or more, rebalancing entire portfolios.
Believe me, I would rather the ECNs didn’t exist. I keep going back to the British Airways analogy. They’ve created an airline to rival EasyJet, called Go, and we’re wondering whether Instinet should go the same route.
You have also invested in WR Hambrecht. Is that part of your retail strategy?
It’s part of our capital-raising strategy, a decision to buy rather than build. It’s ironic, as we, as a lot of firms do, have a lot of investment bankers coming in and telling us that our business is going to change. And then I talk about the Hambrecht investment and how we think it’s going to change their business, and they say no, no, it’s not going to. But it’s deeply threatening. Bill Hambrecht’s model is effecting a change in the rules of engagement – and this is disruptive competition. We’re not doing it to be disruptive, but we sense there is an opportunity to provide the issuer with lower fees, not just 6% instead of 7%, but also on pricing. Everyone says about a hot IPO that it was a great deal, and you’ve got to say “for who”? If you’re the company and you sold 5 million shares at $10, and the first trade is $50, you’re losing $200 million.
On the flip side, the retail investors, on average, despite all the hype, only get 10% of an allocation. So isn’t it a more equitable process to let the investment banks still add value on the advice, and let technology deal with distribution and allocation and so cut out all the overheads, and allow supply and demand to determine where these things get priced?
You’re also involved with E*Trade. What is your rationale for taking Instinet into the retail markets?
There are big opportunities to make the markets and clients more efficient in other areas of the value chain than we’re operating in today. Retail is one of them. They get shut out of the hot deals, getting most of the not so hot deals.
We think we can provide the retail investor with the same institutional quality execution capability on a global basis. That means giving retail investors the performance-enhancing capabilities such as best execution which electronic execution provides. That’s a big opportunity for us.
Are there other areas besides retail?
We want to leverage our relationships with these independent research boutiques. We’re one of the biggest providers of independent research in the world. Our clients bought over $100 million of research products through us last year. So we’re introducing some ideas to fund managers around the world, building a confederation of independent research techniques, and the challenge is to package that in a better way using technology. It’s a great opportunity to alter the research landscape. It isn’t easy sometimes as there a lot of people who don’t want the business to change but if you are successful you have a very good business.
So the research side is a case of you trying to get into the space where the big brokers are seen as being a bit too partial?
Absolutely. A lot of traditional research is like that, especially if there are big banking relationships. One of the problems with independent research is that typically they’re small boutiques, and the search costs are so high. It’s just so much easier as a fund manager to go to Morgan Stanley or Goldman, but if they could get independent research in one place, their search costs would fall.
And what does the relationship with Reuters look like in the future?
That’s been the scouting report on us for a long time. I was at a conference in London three or four years ago when a guy from a big UK house got up and let loose a diatribe on why should his firm spend $50 million on Reuters kit every year, and along comes Instinet to eat their lunch. I was unusually calm, and simply asked him if he was in the money-management business. He said yes, and then turned beet red. Here was one of the biggest brokers competing with his core constituency.
If we only dealt with people who didn’t compete with you, you wouldn’t deal with that many people. It’s more a question of managing and minimizing the conflicts of interest, working out where the places are within the company that we can create synergies and add value, and where we compete.
On the more fundamental question of the link between Instinet and Reuters, I think we have a very aggressive programme and Reuters has been quite supportive of it. Anything which is done will be in the context of what is best for Instinet in executing its strategy. As I say internally to our people, if we weren’t part of Reuters I’d probably spend a lot of my time on the plane to London to see them. Reuters has a treasure trove of assets. An integral part of our new technology for fixed income, for example, was part of Reuters’ greenhouse investments, which got us to market a lot more quickly.
I’ll leave it up to Peter Job [Reuters’ CEO] to decide what the financial structure of the firm should be.
