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Stock Exchange Titans Fight Back

Established stock exchanges are trying to compete with a growing flock of upstarts.

Nasdaq OMX Group’s share of the U.S. equity trading market is in serious decline. Since the beginning of the year, the New York–based institution, the largest U.S. exchange by share volume, has seen its piece of the pie plummet by 6 percentage points, to 21 percent, thanks to competition from dark pools and electronic communications networks. ECNs and dark pools are both alternative trading platforms, the chief difference being that the former display prices and the latter do not. These increasingly potent rivals have forced incumbents such as Nasdaq to respond with similar products of their own.

“It’s fair to say that we’re feeling the pain,” says Brian Hyndman, senior vice president for transaction services for Nasdaq OMX.

The exchange is not alone. NYSE Euronext saw its market share drop to 14 percent this April from 15 percent in December 2008. The two exchanges have had to defend themselves against more than 40 dark pools, electronic venues where institutional investors can trade large orders anonymously. Broker-dealers have increasingly been bypassing exchanges to execute trades using their own dark pools, a process known as internalization, which reduces transaction costs. In addition to dark pools, Nasdaq and NYSE Euronext face stiff competition from ECNs like Jersey City–based Direct Edge, which is owned by Citadel Derivatives Group, Goldman Sachs Group, International Securities Exchange Holdings, J.P. Morgan Securities and Knight Capital Group.

Nasdaq is fighting back. Last month it introduced two new types of electronic flash trading that it hopes will help it reclaim some of the institutional trader business it has lost. The first, INET Flash, beams an order on the exchange’s proprietary data network to its broker-dealer customers and dark pools, where it is flashed for 500 milliseconds; if the order goes unexecuted, it is canceled. The second type, known as Routable Flash, checks Nasdaq’s proprietary data network of broker-dealers for an execution; if none is found, the order can either be canceled or routed back to the public exchanges. Flash orders are already generating 60 million to 70 million trades daily. (Nasdaq OMX trades more than 2 billion shares a day overall.).

In addition to Nasdaq, the Kansas City, Missouri–based BATS exchange last month introduced BOLT, a flash-trading system intended to protect its market share — 9.6 percent in April — from further incursions by ECNs. NYSE Euronext has chosen to mount a legal challenge. In a letter to the Securities and Exchange Commission, says NYSE Euronext executive vice president Joseph Mecane, it complained that flash trading is “creating a two-tiered market, with some participants having privileged access to orders and information.” SEC chairman Mary Schapiro announced that her agency would be “taking a serious look at what regulatory actions may be warranted in order to respond to the potential investor protection and market integrity concerns raised by dark pools.”

According to Adam Sussman, head of research at TABB Group, a New York–based market research and consulting firm, Nasdaq’s current market share is a far cry from the 30 percent it once enjoyed. Meanwhile, dark pools have seen their portion rise, going from 6 percent in December 2008 to 7 percent in April; in the same period that of ECNs climbed from 9 percent to 12 percent.

Although share trading has become a low-margin, high-volume business, some dark pools owned by big brokers have an advantage because they don’t charge anything to trade off the exchange. Direct Edge has been particularly successful in attracting business, with a proprietary enhanced-liquidity program that takes orders from a private network of 25 to 30 broker-dealers.

“This is a critical issue for the exchanges, because Direct Edge has been such an effective competitive weapon,” notes Justin Schack, a market structure analyst at Rosenblatt Securities in New York (and a former Institutional Investor editor).

Beyond developing its flash-trading products, Nasdaq is expanding in Europe, where a similar battle is shaping up between the long-standing exchanges and newcomers like Nomura Holdings’ dark pool, Chi-X. “We are the most competitively priced of the dark pools in Europe at the moment,” asserts Charlotte Crosswell, president of Nasdaq OMX Europe. The hope is that by coming to market early, the exchange will gain the kind of advantage that dark pools have achieved in the U.S.

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