Aite: Rough Times for U.S. Equities Markets

EXCHANGE TECHNOLOGIES

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NEW YORK-Government regulation and the evolution of trading strategies and technologies has led to an equities market that is destined for fierce competition in the next three to five years, according to a report from Aite Group.

"While on the surface, fragmentation appears to have spread in the U.S. equities market, the harsh reality is that the market is still dominated by the NYSE Group and Nasdaq, who combined account for close to 80 percent of the market," says Sang Lee, an analyst at Aite. "Buoyed by broker support and aggressive pricing strategies, we expect to see increased market share for some of the regional exchanges and ATSes (alternative trading systems) over the next five years."

The adoption of the Regulation National Market System (NMS) market reforms of the U.S. Securities and Exchange Commission (SEC) is one impetus for the current wave of fragmentation, according to Aite. "Reg NMS will function as the foundation for U.S. equities market competition for years to come," the report says.

Reg NMS also paved the way for recent market consolidation, with Nasdaq acquiring Inet and the New York Stock Exchange (NYSE) buying ArcaEx. But Aite sees this trend as "short-lived," because several ATSes and ECNs emerged in the wake of these deals. "As a result, market fragmentation has occurred again," according to the report.

At NYSE, officials opted for the Hybrid Market approach. Aite researchers say reaction to the choice is generally "lukewarm" but they cannot give a definitive assessment of the hybrid model until implementation is complete. Aite does say, however, that adopting hybrid systems says to the world that "electronic trading is inherently volatile" and that manual intervention is necessary. "This assumption generally goes against the global market trend in equities trading," the report says.

Aite is also critical of the Intermarket Trading System (ITS), the de facto national market system connecting major U.S. stock exchanges. "In order to comply with Reg NMS, the antiquated ITS will simply not work," the report says. The ITS serves as a preliminary electronic link among the NYSE and the regional exchanges, the Chicago Board Options Exchange (CBOE) and the NASD.

The Intermarket Trading System (ITS) Electronic communications network links the trading floors of seven registered exchanges to permit trading among them in stocks listed on either the NYSE or the American Stock Exchange (AMEX) and one or more regional exchanges. Through ITS, any broker or market maker on the floor of any participating exchange can reach other participants for an execution whenever the nationwide quote shows a better price available. A floor broker on the exchange can enter an ITS order to assure execution of all of an offering or bid, instead of splitting it with competing brokers

Reg NMS will favor direct market access (DMA), however. "The role of the DMA players will become even more important as firms need to be able to access a variety of execution venues in order to meet their fiduciary best execution obligations," the report says.

As a result, some current players will go out of business or be eaten up by larger players to remain in the game in the next few years, say Aite's analysts, who contend that the U.S. equities market cannot support 20-plus players. "Inevitably, massive market consolidation will occur and leave only four to five legitimate players with enough internal liquidity to survive," analysts conclude.

"Barring an alien invasion of New York City," Aite predicts that regional exchanges and ATSes will be acquired by Nasdaq and NYSE as they continue to build up market share.

Chloe Albanesius

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