Their future is to go back to their roots, says Georges Ugeux, chairman and CEO of New Yorkbased investment banking boutique Galileo Global Advisors, who spent seven years as head of the international group of the New York Stock Exchange. They should just be a trading platform. They are extremely efficient, and they do a lot of things very well. But they should abandon the idea of becoming a [corporate] listings venue. The U.S. market already has enough between Nasdaq and NYSE.In the annals of market history, electronic trading is still a relatively new phenomenon. Although Nasdaq, founded in 1971, is by far the oldest electronic exchange, younger upstarts such as BATS and Direct Edge owe their very existence to regulatory changes introduced in the 1990s that quickly transformed U.S. equity market structure. In a sense, BATS would not exist without its archrival, Nasdaq or, more specifically, without the price-fixing scandal in the mid-1990s that tarnished Nasdaqs image and set the stage for closer regulatory scrutiny. In 1996 the SEC adopted new order-handling rules designed to make markets fairer by allowing electronic communication networks, or ECNs, to publish their stock quotes alongside those of the listed markets. By 1997 newly formed ECNs like Island and Chicago-based Archipelago were providing faster trade execution than the incumbents. Canny and competitive as those new electronic challengers were, they faced an uphill battle to attract sufficient liquidity to make trading on them economical. At Island, Andresen and his team came up with an answer in 1998 by designing a revolutionary maker-taker pricing model that paid a small rebate to customers who were willing to supply bid-offer quotes to the trading book and charged a low take fee to customers who removed liquidity by hitting those bids and offers. The new fee model proved so popular that every ECN and exchange operator quickly adopted it, pocketing the difference between the rebate and the charge. Just two years later, in 1999, the SEC gave ECNs like Island another competitive boost by adopting Regulation ATS (for alternative trading system), which permitted them to operate as market centers and match bids and offers without having to register as exchanges. By the following year ECNs like Island and Archipelago had taken about one third of market makers volume in Nasdaq-listed stocks. With the freedom afforded by Regulation ATS, electronic trading spread quickly, giving rise to a new generation of liquidity providers, including high frequency trading firms. Using computer-driven algorithms, automated trading firms like Tradebot and Chicago-based Getco, both founded in 1999, began to replace exchanges traditional specialists by providing high-speed, high-volume order flow. These new market makers received yet another regulatory boost in 2001, when all U.S. exchanges made the switch from fractions to decimals. Decimalization was a natural fit with electronic trading, and the regulatory shift allowed high frequency trading firms to create faster, more nimble algorithms. Inevitably, as upstarts like Island and Archipelago grew and gained market share, they became takeover targets for the embattled incumbents, and the process of consolidation began. In 2005 the New York Stock Exchange, as it was then known, announced plans to acquire Archipelago and form a new, publicly traded company, NYSE Group. A few days later Nasdaq unveiled plans to buy Inet, which had been formed in 2002 by the merger of Island and Instinet. For Tradebots Cummings, the wave of consolidation signaled the end of competitive pricing and the potential loss of access to groundbreaking technology, says Ratterman. (Cummings declined to be interviewed.) Having already built his own successful trading firm, Cummings decided to take on the duopoly of NYSE and Nasdaq by setting up his own equity-trading platform, funding it largely with his own money and developing better technology hence the name Better Alternative Trading System, or BATS. Andresen, who has known Cummings for more than a decade, recalls how frustrated the computer engineer was by the prospect of seeing Inets technology absorbed by Nasdaq. Dave felt that he wouldnt have anyone left in the markets to speak for him, Andresen says. And as an independent trader, he really didnt want to give his business to the incumbents. With 12 employees handpicked from Tradebot, including Ratterman and Isaacson, Cummings stepped out of the trading company in June 2005 and took his new development team literally across the hall to an empty office to start coding an equity exchange from scratch. Ratterman says they had nothing but their knowledge of the industry-standard Financial Information Exchange Protocol, or FIX, which sets messaging specifications for the electronic communication of trade-related data, when they started to design their matching engine. But they knew firsthand how easy or difficult it was to work with every major stock exchange or ECN in the U.S. The impetus for the core design and development really came from our roots as traders, Ratterman says. We knew what we liked and what we didnt. Two months before BATS started working on its first matching engine, the SEC announced the adoption of Regulation NMS (for national market system), which introduced a trade-through rule prohibiting any exchange from executing a trade at an inferior price to one quoted on another exchange. The rule, which didnt go into effect until 2007, essentially meant that orders had to be routed to the venue offering the best price, regardless of where the original order had been placed. BATSs team of developers spent six months designing the companys trading software, during which time BATS applied for and was granted a broker-dealer license, and won the SECs approval to operate an alternative trading system. With its regulatory clearances in place, BATS was ready to link into the national market system. The speed and ease with which it met those requirements spoke volumes about the provisioning in the U.S. of market liquidity, which was in the process of being fully democratized and fragmented across a multiplicity of new trading venues. On January 27, 2006, in the same old suburban bank building in North Kansas City that had served as Tradebots headquarters, all 13 of BATSs employees huddled around Isaacsons desk to watch the first trade get matched and filled. The volume of trading that morning was light. BATS had only two customers, Tradebot and rival Getco, whose traders had agreed to connect and help test the companys new infrastructure. The goal, Isaacson says, was simply to fire up the matching engine and make sure it worked. That day the technology ran smoothly. Over the next few months, BATSs daily trading volumes built slowly. But from the outset team members knew how they wanted to position themselves in the marketplace and they were willing to take risks. Toward the end of 2006, Cummings, BATSs first CEO, noticed that several prospective clients had begun to freeze their technology budgets. Although BATS had successfully attracted a strong roster of investors in its first year of operation, including Getco and investment banks Credit Suisse, Lehman Brothers Holdings and Morgan Stanley, the company was increasingly aware that many prospective customers were dragging their heels when it came time to connect. BATS decided that it needed to devise some incentive to get customers over the hump, as Ratterman puts it, and complete their connection. So the team came up with an inverted pricing model, playing off the maker-taker fee structure pioneered by Island. The SEC had helped standardize fees by mandating that the take fees charged to remove liquidity could not exceed 0.30 cents a share; rebate fees tended to be self-limiting given the economics of the exchange operator. BATS turned that model on its head. At the time, Ratterman recalls, NYSEs new electronic trading platform, Arca, was offering about a 0.20 cent rebate and a 0.30 percent charge; this allowed the exchange to make 10 cents on every 100 shares traded. BATS announced on December 19, 2006, that it would offer a rebate of 0.30 cents and charge only 0.20 cents to trade on its platform in January in essence, paying 10 cents for every 100 shares traded. BATS budgeted $5 million for the giveaway and declared that it would run the pricing offer for a month or until it had spent the $5 million, whichever came first. The gambit succeeded. By the end of the month, trade volumes had almost tripled, from an average of 100 million shares a day to nearly 300 million, and the company had spent less than $5 million. Perhaps the most surprising outcome: Even when BATS stopped paying the larger rebate, trade volumes continued to grow. Customers who had signed on for the cash rebate stayed. Were not crazy for the sake of being crazy, Ratterman explains. We actually targeted a particular behavioral change that we wanted to encourage, and we were willing to put money on the table to get people to do it and it worked. As BATS gained market traction in 2007, its management team began to consider the possibility of registering with the SEC as a stock exchange. But regulators made it clear that the companys leadership structure would have to change, because Cummings, who still owned Tradebot, would not be allowed to run an exchange as long as he still owned a registered broker-dealer. On July 1, 2007, Cummings stepped down as BATSs CEO (although he remains on the board) and Ratterman, who was then BATSs chief operating officer, succeeded him.
By January 2008 the exchange operator was handling more than 1 billion shares a day and the average speed of an individual trade execution, known as latency, was an impressive 568 microseconds and getting faster. (Last year the average latency on BATS was just 145 microseconds, or millionths of a second.) The U.S. equity market structure was also changing fast as Regulation NMS took hold. The duopoly of Nasdaq and NYSE was already crumbling under the cumulative effects of market fragmentation, and Ratterman understood that U.S. equity trading was destined to be commoditized. In addition to increased competition from other alternative trading platforms, BATS was competing head-on with so-called dark pools essentially, broker-managed pools of liquidity offered to institutions seeking to protect their trades from the prying eyes of other market participants which had emerged as a direct response to the rise of high frequency trading and begun to take market share.AT THE START OF 2008, RATTERMAN and his team realized that they would have to expand geographically and diversify their sources of revenue if they wanted BATS to grow. They looked to Europe, where just two months earlier the European Union had introduced the Markets in Financial Instruments Directive, or MiFID. The sweeping reform abolished concentration rules that for many countries had required trading to go through one central exchange and directed brokerages to provide best execution services to their clients. Like Regulation NMS, MiFID held the potential to transform order routing and encourage greater competition. We thought that our strategy in the U.S. of challenging monopolistic behaviors might work equally well in other markets, where there were other frictions, Ratterman says. So we went to our board and said, We think we should make a move into Europe. In opening European equity markets to greater competition, regulators had unleashed a whirlwind. New electronic exchanges known as multilateral trading facilities, or MTFs, took on the once-dominant national stock exchanges and quickly eroded their market shares. By the time BATS organized its European launch in October 2008, a host of new challengers had emerged. The first was Chi-X Europe, founded in March 2007 as a wholly owned subsidiary of agency brokerage Instinet Europe. Others soon followed, including Turquoise Global Holdings, created in 2007 by a consortium of nine investment banks and opened for trading in September 2008, just a month before BATS Europes launch. BATS entrusted its European operation to an industry veteran, Mark Hemsley, now 49, a former board member and chief information officer of London-based futures and options exchange Liffe. During his three years at Liffe (now NYSE Liffe), Hemsley had overseen its market solutions group and taken responsibility for reshaping its strategy to attract new business. Setting up BATS Europe played to Hemsleys strengths. I was one of the few people over here who already knew quite a lot about BATS, he says. Id kept an eye on what the company was doing in the U.S., and I thought it was a very good example of how to approach the electronic trading sector. By November 2009, BATS Europe had the second-largest market share among the new generation of MTFs by value of trading, at 4.13 percent; only Chi-X Europe had more, at 15 percent. As hard as Hemsley and his staff fought for traction, however, BATS Europe still hadn't turned a profit. Although the new, London-based subsidiary ran inverted pricing specials from June through July 2009 on all NYSE Euronext stocks to attract order flow, it never managed to encroach on Chi-X Europe, which continued to build on its momentum despite aggressive defensive moves by incumbent exchanges, including LSE Groups decision in December 2009 to buy Turquoise. Just eight months later, in August 2010, BATS joined a bidding war for Chi-X Europe, competing with Nasdaq OMX and Direct Edge for the business. By December 2010 it had entered exclusive negotiations, and it reached an agreement by February 2011. By then BATSs board of directors and management were planning to do an IPO and needed to provide evidence that the company had viable global growth prospects. Although the pace of market fragmentation in Europe had leveled off by early 2011, the region was still considered a key competitive battleground given the likely prospect of future regulatory changes. Buying Chi-X Europe instantly offered BATS the potential for major market-share consolidation and cost savings. BATS completed the acquisition on November 30, 2011. Chi-X Europes 16 private shareholders which included Getco, Instinet, hedge fund firm Citadel and investment banks Goldman Sachs Group and Morgan Stanley received 4.4 million newly issued shares of BATSs privately held common stock and $32.3 million in cash. BATS received an alternative trading venue that boosted its capacity to handle blue-chip and midcap equities in 15 European markets, as well as ETFs, exchange-traded commodities and international depositary receipts. The effect was dramatic. In 2011, BATSs European equity business accounted for just 3.1 percent of the parent companys total revenue of $926.6 million. With the pro forma addition of Chi-X Europe, the European equity business would have represented 10.1 percent. Buying Chi-X Europe also gave BATS Europe a huge boost in market share. In December 2011, BATS Chi-X Europe, as the newly merged subsidiary is known, commanded 25.4 percent of all pan-European equity trading by value of shares traded, putting it in a position to begin charging for some of its basic market data by the fourth quarter of this year. BATS also gained access to Chi-X Europes new pan-European equity indexes, known as the Chi-X Europe Russell Index Series Cheri for short. Launched in October 2011 with the help of Russell Indexes, part of Seattle-based financial services firm Russell Investments, the Cheri indexes were designed as a first step toward the creation of index-related derivatives products. Today, BATS Chi-X Europe appears poised to carry that project forward and is looking at registering as a full-fledged exchange to facilitate ETF listings as soon as the fourth quarter of 2012, according to Hemsley. It is also exploring the possibility of trading derivatives securities in Europe, but that will not be easy. Europes powerhouses in exchange-traded derivatives, Deutsche Börse and NYSE Euronext, are likely to dig in and defend their territory. BATS Chi-X Europe can only hope that regulators will once again help to level the playing field, through the adoption of MiFID II, which seeks to strengthen the changes wrought by its predecessor and increase competition in derivatives markets. But the road from draft proposals to final legislation is a lengthy one, and leading incumbents can be expected to lobby fiercely to shape the final rules. If regulators succeed in protecting the core tenets of MiFID II, the pace of change in European derivatives markets could accelerate dramatically.
Wed be in a situation where derivatives trading would be much more akin to equity trading as barriers to entry broke down, says Richard Perrott, a London-based analyst who covers diversified financials for Hamburg-based Berenberg Bank. Arguably, futures trading would be even easier to fragment than equities given pools of derivatives liquidity are that much deeper.REFOCUSING ON NEW MARKET opportunities in the months ahead may finally give Ratterman and his team a chance to put the infamy of BATSs failed IPO behind them. By every statistical measure, the companys core customers already have: Although BATSs daily market share dipped slightly on March 23, to 9.2 percent, it bounced back the next trading day to 10.3 percent. For the entire month of March, average daily trading volumes in U.S. equities gave BATS an overall market share of 10.9 percent. During the month of April, the companys market share rose slightly, to 11.5 percent. Looking ahead, market experts dont anticipate any lingering impact on BATSs core U.S. equity-trading business as long as the team doesnt bungle any more technology projects. Having a spectacular problem with its own IPO was obviously a significant challenge for the company, says Andresen. But I dont think it was a big deal from a trading perspective. Market participants have to deal with these types of minor outages across the exchange industry all the time. With the memory of the mishap still fresh in customers minds, BATS has to be careful. Every new coding challenge is being met with renewed vigilance as Isaacson and his team seek to strengthen the companys software development. Since the error BATS has made changes to the way it tests new code and has introduced extensive permutation tests to get the full implications of all the different types of orders that can interact in our markets, Isaacson says. The next public test came on April 30 when the London team migrated all of Chi-X Europes order books, including the one belonging to its dark order pool, Chi-Delta, to BATSs technology platform. Fortunately for Hemsley and his crew in London, the transition went smoothly. The greatest challenge that Ratterman faces, however, is restoring BATSs public image with its prospective investors, whose introduction to the company came during the March road show in the run-up to the IPO. From their perspective, the matching-engine failure was undeniably spectacular. But the damaging effect of the market mishap was compounded by an article that appeared on the front page of the Wall Street Journal the morning of the IPO. Using material that had been published one month earlier, the story called attention to a disclosure BATS had made in a pre-IPO regulatory filing in February: The SECs Division of Enforcement had recently written to request information and communication about the development, modification and use of the companys order types and technology systems. Were interested in figuring out the ownership structure and history of exchanges and high frequency trading firms, says Daniel Hawke, head of the SECs market abuse unit, by e-mail. Were seeking information about these firms origins, investors and coding practices. Although frustrated by the timing of the March 23 story, BATSs executives and directors remain committed to rebuilding their companys trust with potential investors. BATS still hopes to go public to capitalize on its growth, create a currency with which to undertake future acquisitions and extend its ultracompetitive ethos into new geographies and securities. The question is simply one of timing. In the days following the botched IPO, Cummings proclaimed loudly in an industrywide e-mail that BATS ought to dust off its wounded pride and simply move past the issue by going public in the second quarter of 2012. Other members of the board, however, do not share his desire for haste. The management team will have to redo the entire IPO process, which will take time, says one director, who asked to remain anonymous. But the opportunity for BATS still looks good. The risks that lie ahead will test every U.S. exchange operator. In the U.S. equity market, structural forces, including macroeconomic factors, continue to hurt trading volumes, which have declined by 19 percent in the past two years, according to BATS. The volume of equity trading has a direct impact on the company because market data and net transaction fees account for such a significant percentage of its net revenue. Last year BATS derived 43.3 percent of its net revenue from market data fees, specifically fees associated with the U.S. consolidated tape plan; it earned a further 41.6 percent from its own net transaction fees. Although the continuing sovereign debt crisis in Europe has caused occasional bursts of trading volume and volatility in equity markets, the steady erosion of U.S. on-exchange trading volumes may also be linked to the rising importance of dark pools. For the year ended December 31, 2011, over-the-counter trading in off-exchange venues, including broker-dealer internal crossing networks and dark pools, accounted for 30.4 percent of consolidated U.S. equity trading volume, according to Rosenblatt Securities. Exchanges are facing a double whammy the overall volume pie is shrinking, and so is their slice of that pie, says Justin Schack, a partner at Rosenblatt who writes the institutional brokerage firms Let There Be Light report on dark-pool volumes and trends. BATS continues to move into new markets. In February 2010 it launched its first U.S. effort in exchange-traded derivatives, BATS Options, which is being led by Jeromee Johnson, a former president of New Hope, Pennsylvaniabased equity options software specialist 3D Markets (since acquired by Pipeline Financial Group). Johnson, 37, a former market structure analyst who was instrumental in designing the first dark-pool trading network for U.S. equity options at 3D, is keen to develop innovative approaches to the market as regulatory changes in the U.S. gradually transform OTC derivatives markets. I was one of those people hoping that wed see a flood of OTC trading activity into the regulated exchange markets, but that flood never came, says Johnson, who is working hard to increase BATS Options market share, which hit 3.1 percent for the first time in April. It has only been a steady trickle, but I do think that the glacier will continue to head downhill as regulators and legislators seek to better understand and control some of the risks involved in trading derivatives. Beyond derivatives, Ratterman and his team are openly discussing the possibility of diversifying into other types of securities in the months ahead to buttress their argument for relisting. They dont intend to make any rash moves and they will only act when they believe they can gain a competitive advantage but their desire to expand into new geographies and securities remains unchanged. The most likely targets, Ratterman says, are U.S. Treasuries, U.S. futures and foreign exchange. But BATS is not ruling out the possibility of expansion into other equity markets and is watching to see what happens in Canada with the regulatory scrutiny of Maple Groups proposed acquisition of Toronto-based exchange operator TMX Group. Outside North America, BATS is conducting extensive market research in Brazil, where it has a memorandum of understanding with Claritas, a São Paulobased asset management firm, to explore competitive opportunities, including the possible creation of a new stock exchange. The most compelling strategic issue in the months ahead, however, concerns the uncertain fate of BATSs ill-starred corporate listings service. Listings have always relied heavily on the marketing power and brand-name visibility of the incumbent exchanges and have long been unscathed by the technology wars that have revolutionized every other aspect of equity trading in the U.S. and Europe over the past decade. Ratterman was looking forward to competing for corporate listings by offering less expensive, client-focused services, but his ambitions have now been put on hold. For now, we are hitting the pause button, he says, and we will come back to that business at some point down the road. From a strategic perspective the likelihood of attracting corporate listings when BATS has just failed so spectacularly on its own behalf appears low if not nonexistent. Since early this year, however, BATS has begun quietly listing ETFs on its exchange without incident. The first seven, issued by BlackRocks iShares, debuted during the last week of January. Since then, BlackRock whose iShares unit, with its 474 funds, commands 43 percent of the worlds total ETF assets under management has added nine more ETFs to those trading on the BATS BZX Exchange. Although Ratterman hasnt given up hope of attracting corporate listings, he is prepared to bide his time. His more pressing concern is to deliver on the growth strategy outlined in the companys offering documents. BATSs opportunity to list will come again. The greatest unknown is whether the companys board will allow its management team to relist BATS on its own exchange. No decision has been made, nor is one likely to be made for many months. But the management team will have to consider the possibility that BATS may be forced to list with one of its archrivals, Nasdaq or NYSE, dealing a sharp blow to the pride of its founders.
Without corporate listings, BATS may never have a chance to become a national brand name and it would lose out on its bid to represent the solid intellectual capital of emerging U.S. companies. But it would still be known as a nimble and skilled purveyor of new trading technologies, and, at least for now, that may have to be enough.