Daytrading Places

Forget Nasdaq. Island ECN is tearing down Wall Street. There is nothing to suggest, as you ride the elevator to the sixth floor of 50 Broad Street, that you are arriving at the front lines of a revolution sweeping America's stock markets. The building, just down the street from the temple facade of the New […]

__ Forget Nasdaq. Island ECN is tearing down Wall Street. __

There is nothing to suggest, as you ride the elevator to the sixth floor of 50 Broad Street, that you are arriving at the front lines of a revolution sweeping America's stock markets. The building, just down the street from the temple facade of the New York Stock Exchange, is one of many importantly nondescript office blocks lining Manhattan's financial canyons. The cramped halls and stained ceiling tiles on Floor Six leave the impression that the place was last remodeled sometime before the Dow hit 1,000.

But 50 Broad Street is likely to be remembered long after the Dow tops 40K, if only because it is home to Island ECN. The initials stand for what the US Securities and Exchange Commission calls, with generic profundity, electronic communications networks. ECNs are simply stock trading systems that allow investors to swap shares directly with each other by entering buy and sell orders into a networked database. When orders match - when the bid and ask prices are equal - the systems instantly execute a trade. Island, which deals primarily with stocks traded on Nasdaq's national electronic market, is in essence an auction peopled by small traders. Most important, sales and purchases on Island take place without market makers, the middlemen who in Nasdaq's system set stock prices and profit from every trade.

Island ranks high in the new financial order that has made stock trading a do-it-yourself, do-it-from-anywhere pastime - sell short via pager, flip and go long with your Palm. The change marks the culmination of two long-standing market trends. First is the continuously expanding importance of technology in the markets - Nasdaq launched in 1971 as a proto-ECN, the first USmarket to use computers to eliminate the trading floor. Second is the ongoing shift of power away from intermediaries and toward small investors. In the last couple of years, the rate of transformation has accelerated with the growth of the Internet and a flurry of SEC rulings designed to help individual investors. The latest phase of the commission's effort kicked in last December, when it allowed for the creation of a new breed of exchanges to compete with Nasdaq and the NYSE.

Those rule changes mean that Island, which until recently ran off a couple of modest Compaq servers, could soon become the newest national stock exchange, competing on equal footing - at least in the eyes of the SEC - with Nasdaq and the NYSE. It would be an amazing feat for a company cobbled together less than four years ago in the Wall Street equivalent of a Silicon Valley garage.

Island was originally designed to redress what its builders mildly call inefficiency in the Nasdaq market. That's shorthand for the entrenched business practices that have made it hard for small traders to compete with Nasdaq market makers. In addition to building a fast, reliable electronic auction, Island focused on daytraders and the first wave of Internet investors, a market unserved by the only other ECN in the business at the time, Instinet. Instinet is a 30-year-old Reuters subsidiary catering to institutional investors trading big blocks of stock. By grabbing a market segment that Nasdaq broker-dealers served only grudgingly and by charging next to nothing for trading on its system, Island gained an early edge against Instinet and newer competitors. The result: Every day, the upstart ECN handles an average of 100 million shares worth billions of dollars, about 10 percent of Nasdaq's daily volume. Island appears to be on the verge of surpassing Instinet's market share, and it's the dominant player among a pack of ECN startups (some backed by big Wall Street money) that have popped up over the last few years.

Island's origins date back to 1988, when Jeffrey Adam Citron, then 17 and fresh out of high school, met Josh Levine, a 20-year-old college dropout. They bumped into each other at Datek Securities, a small brokerage firm, where Citron was a low-level clerk and Levine was a casual contract worker. Citron's goal was to make pots of money the old-fashioned way - trading. Levine was a talented programmer who wound up in a brokerage firm "pretty much by accident."

Neither man likes to talk about himself. In an interview at the Broad Street offices, Citron, looking every bit the CEO in a charcoal gray suit, hurries past the pre-mogul phase of his life ("all the mundane stuff") and starts his tale in 1995, when he had already amassed a big bank account and was working on Island. Levine agreed only to be interviewed by email, providing minute details that were heavier on info than insight - every residence during his youth, a catalog of friends ("age 11-15: no friends"), the location of his parents ("my Mom is buried at New Monefiore Cemetery, a few exits out on the Long Island Expressway"). What emerges is a picture of two ordinary-seeming young guys who somehow added up to one very big idea.

Citron grew up in the New Springville section of Staten Island, home to the largest shopping mall in New York's five boroughs. After graduating from Port Richmond High School - a rough and academically sluggish place where he took advanced math classes and geeked around with a Commodore 64 - he was ready for something more than the island's trash-blown, anti-Gotham sprawl. He took a $25,000-a-year clerk's job at Datek Securities, a position that Sheldon Maschler, a friend of his dad's, was glad to arrange. Once at Datek, Citron lived on cheap Chinese takeout and worked like a fiend. Turned on to arbitrage, he regularly logged 90 hours a week and says he earned a total of $1 million by the time he was 21.

Levine spent most of his childhood in the middlebrow suburb of New Rochelle, New York. After failing out of the electrical engineering program at Carnegie Mellon, he was hired by Maschler as a tech handyman. One assignment was programming a quotation system for Datek traders.

"I first got involved in programming because I sucked at sports and girls didn't like me," Levine recalls. "I got involved with programming for a securities firm because they had a computer and I hated going home to my lonely apartment."

__ Island's cofounder Josh Levine is still a geek who believes in knocking down market barriers. Ring a bell and you can watch him dance via webcam. __

In just four short, work-soaked years, both men have grown very rich. Citron, who took over Datek in 1998, now lives far from the gull-crowded kills of Staten Island, in a mansion in Brielle, New Jersey, a wealthy enclave on the Jersey shore. His 40 percent stake in Datek Online Holdings could be worth billions if the company, which operates Island and Datek Online, the fourth-biggest online brokerage, goes public.

He gathered a few toys along the way, including a Gulfstream jet, which, like the Brielle estate, he bought in 1996 from Robert Brennan, a New Jersey penny-stock manipulator who made a fortune fleecing small investors before he was busted in 1995. (The jet was destroyed in a 1997 accident at LaGuardia airport.) Brennan was an acquaintance of Citron's old boss Sheldon Maschler, who also ran into trouble: He has been chased from the securities business for his alleged participation in a 1993 stock fraud. Neither Citron nor Levine has been linked in any way to Brennan's or Maschler's misdeeds.

Levine has also earned a small fortune, but money has changed his life less. He lives in an apartment near the Manhattan anchorage of the Brooklyn Bridge, next door to his sister. When he got married last year, he did it at one of his favorite spots in the city: Coney Island. Now 31, Levine still exudes a certain nerdy puckishness. His Web site (www.josh.com) invites visitors to check up on him and Datek's CTO Peter Stern via webcam and even promises that the guys will dance if you ring a bell linked to the page. In "Josh's Corner" you'll see a bullet-headed, pale, dark-haired young man wearing a T-shirt and tapping away at a computer amid a dumpster-like heap of bottles, cans, take-out food containers, papers, and books.

Levine is matter-of-fact about his financial standing. He says he's made "between $2 million and $4 million after taxes, and I still have most of it. Definitely enough for my family and me to live happily ever after." He owns about 1 million shares of Datek Online Holdings, "which could be worth $0 or $100 million, depending on who you believe. For planning purposes, I figure $0."

Levine is suspicious of the press and expresses doubt that reporters are willing to take the time to understand Island's implications for the market and investors. His distrust extends to many in his own industry. Asked who he might admire in the financial world, he answers, "Admire is a pretty strong word to be using in the securities industry."

Such barbs hint at a reservoir of conviction in Levine's work. He routinely speaks of making Island's mission clear to "the people." He cares about making good software and knocking down market barriers. What he envisions is a "pure auction" market - much like the days when buyers and sellers met in the Tontine Coffee House or in the open air along Wall Street to trade in centuries past.

When pressed, Levine espouses a pragmatic manifesto for a marketplace that would be libertarian (markets should be fair by design, so they don't need regulation or monitoring), democratic (the more participants, the better), and rational (usage fees should be reasonable and encourage participants to behave in ways that are good for everyone). But despite the explosion of ECNs, the new access afforded by technology, and the SEC's strong actions, Levine remains unimpressed by the progress toward his ideal marketplace. "So far I haven't seen anyone do anything strikingly bold or brave," he says. "Most are just reacting to the changes that technology forced upon them. Myself included."

Josh and Jeff arrived at Datek just as the SEC was doing something big for small traders. Provoked by Nasdaq brokers' ostrich tactics during the October 1987 crash - as the market plunged, they simply stopped answering phone calls from investors trying to escape the disaster - the commission made it mandatory for market makers to not only honor but give precedence to orders entered on a then little-used network called the Small Order Execution System. For market makers, the acronym SOES soon carried roughly the same emotional charge as the words "James Gang" did for Midwestern bankers in the 1870s.

__ The SEC and DOJ nailed the financial priesthood for artificially wide spreads. Now the once-lowly small fry are market makers themselves. __

The SEC intended SOES to be an equalizer, a way for a small investor who wanted to buy relatively small lots of stock - generally less than 1,000 shares - to get a market maker's best price. But SOES did much more than that: It revived widespread daytrading, which had been in extended hibernation since the crash of 1929. Before long, market makers complained of being under attack by "SOES bandits." These hit-and-run artists, they feared, would pick off market makers who were slow to revise their prices and use SOES to force a quick trade at the outdated quote. The system trimmed market players' profits and stirred their resentment of small players.

As daytrading blossomed, Levine and Citron hacked together Watcher, a program that let traders enter SOES orders, keep an eye on Nasdaq market maker quotes, and track their own positions all on one screen. The software's success led Citron to make a career move: Convinced that writing and licensing software could be more profitable than trading, he left Datek in 1992 and started a succession of small firms, eventually founding SmithWall Associates in 1996 and bringing on Levine as a minority partner. The firm licensed the constantly improving Watcher to the daytrading industry and raked in a small fee for every transaction processed.

Along the way, Levine built a program that detected moments when the several hundred traders using Watcher made bids or offers that matched. Such occurrences were, in fact, far from rare, but when orders fell inside market makers' buy and sell quotes, they would go unfilled. The customers were stuck - one with cash to buy and the other with shares to sell - even though they agreed on price.

In late 1995 and early '96, Citron and Levine built a system that allowed Watcher customers to bypass the market makers altogether and trade directly with each other. It was the first iteration of Island.

"We saw people trying to sell stock or buy stock at the same prices or overlapping prices, and their orders were going unexecuted," Citron recalls. "There was tremendous inefficiency in the markets."

The "inefficiency" that Citron cites was, in fact, evidence of what SEC and Justice Department investigators had already concluded was widespread collusion among Nasdaq market makers to fence off their profitable realm and screw independent traders. Alerted to suspicious trading patterns by an academic study in 1994, the SEC and DOJ found that market makers worked together to keep spreads (the difference between the price at which investors buy shares and the price at which they sell) artificially wide. The market makers colluded to ignore buy and sell orders that fell inside the spread. Such orders - carrying a fractionally higher bid to buy or a fractionally lower offer to sell - were too competitive for the market makers' taste; executing the orders would narrow the spread, cutting into their profits.

The government inquiries led to a series of lawsuits - by investors, the SEC, and the Justice Department against dozens of market makers, including Wall Street stalwarts like Merrill Lynch, Bear Stearns, and Goldman Sachs - that eventually cost the industry more than $1 billion in fines and settlements. The investigations prompted a sweeping new set of SEC regulations, known as the Order Handling Rules. They officially recognized ECNs (Island and Instinet had previously operated in a regulatory gray area) and abolished the market makers' artificially wide spreads by requiring that the best bids and offers from all trading systems - including ECNs - be represented in Nasdaq's quotes.

One thing that Reuters' well-established, full-service Instinet had in early 1997 that Island desperately needed was liquidity - enough buyers and sellers to ensure competitive prices. Instinet got nearly all its volume from one place: institutional investors, primarily big players trading for mutual funds and pension plans by buying and selling in lots of 100,000 shares and up. Initially Island had to depend on the few hundred daytraders using Watcher for orders. Then in September 1996, Datek launched a Web brokerage. Peter Stern, a 1995 arrival at Broad Street who met Levine through mutual Carnegie Mellon pals, built a Web-based trading system that would interact with Island and serve as the basis for a new Net brokerage, Datek Online.

But in those early days, Island's liquidity remained minimal. So Citron and Levine tried to sell Instinet on a cooperative arrangement under which trades executed across the two systems would enjoy a preferential commission rate. Citron says Instinet executives dismissed the idea out of hand. By one account, the Instinet people laughed out loud when Citron promised that Island would build a competitive system on its own.

"That fired us up," Citron says. "That arrogant attitude had a lasting impact in terms of our determination to displace them as market leaders."

__ Island's jolting growth has produced a flood of greenbacks - and a growing pack of competitors. __

Doug Atkin, who was with Instinet at the time and is today its president and CEO, acknowledges that Island "approached us about getting access to our liquidity" and was told it could get access like any other customer: by paying the going rate. "I guess we would ask, 'Why do you want access to our liquidity if your model is so great?'" he says.

"I would have laughed, too," Peter Stern now reflects. "I don't fault them for laughing - but it was a poor business decision."

The system that Levine, Citron, and Stern put together is shockingly simple in concept and operation. Hundreds of thousands of traders, from individual investors dialing in through Datek Online to professional daytraders using Watcher, have their offers to buy and sell shares represented in what Stern calls "a big list of orders." When the system detects matching orders, it executes them immediately. The cost is very low: Other ECNs generally charge 1.5 to 3 cents a share for executions, while Island pays traders to generate liquidity. People who post quotes that lead to completed transactions are paid one-tenth of a cent per share. Folks who take those offers - whether buying or selling - pay a quarter of a cent per share for the privilege. The system nets Island fifteen-hundredths of a penny on every share traded. It doesn't exactly seem like the Idea That Changed the World. But the low, low prices have very quickly created liquidity, and more significant, they allow individuals to set prices in Nasdaq issues. In effect, the small fry the market makers once disdained are now market makers themselves.

Perhaps unsurprisingly, some on the Datek team sling around ideology to explain their venture. You don't have to wait long to hear "investor empowerment" hailed as one of the signal virtues of Island and Datek Online. The firm waives its $9.99 commission if trades aren't executed within 60 seconds - by far the fastest performance among Net brokers and the only one that's guaranteed. Another theme is freedom of information. Not long ago, Island president Matt Andresen notes, real-time quotes and good market research were available only to a select financial priesthood. For an investor to take advantage of it, "you had to go to the gatekeeper. Now everyone's a gatekeeper. Every computer is now a branch office of a full-service brokerage firm."

Although such declarations sound like a sales pitch, Island walks the walk. In a rare example of voluntary disclosure in the notoriously secretive industry, Island posts a summary of its activity - orders accepted and executed, share volume, total value of trades - every day. And, using a tool Levine devised, anyone with a Web browser can pull up a list of asks and bids for any stock traded on Island (at www.isld.com/itchclient/index.htm).

The ceaseless fury of securities trading is something like Niagara Falls plunging through a turboelectric generator. The product is not electricity, but revenue for everyone who has a turbine dipped into the current: Exchanges like Nasdaq charge fees for membership, listing, and regulation, and for the torrent of quotes and other data they release every day. Broker-dealers charge commissions for executing trades, and profit from trading spreads and their own positions in stocks. And the growing army of ECNs like Island take a slice of every share that passes through their networks. Datek Online Holdings doesn't disclose its revenues, but industry experts estimate that if you add up the fees from Island, the commissions from Datek, and the licensing fees from Watcher, 1999 revenues should easily top $300 million. And unlike most of the .com's on the block, Datek, with about 500 employees and few expenses outside of marketing and paying the exchanges for quotes, is undoubtedly extremely profitable for an online brokerage.

Envious of that stream of greenbacks, a small pack of new ECNs has emerged since 1997. Instinet aside, Island is currently competing against seven brand-new trading networks: Archipelago, a system launched by Chicago brokerage Terra Nova Trading; Bloomberg's Tradebook; Redibook, owned by NYSE brokerage Spear, Leeds & Kellogg; All-Tech Investment's Attain; Brass Utility, partly owned by Knight Securities, a mammoth securities wholesaler; Strike, held in part by Bear Sterns; and NexTrade, operated by PIM Global Equities.

The most threatening of the crowd is Archipelago, which matches customer orders much the same way Island does. Archipelago got a big boost earlier this year when E*Trade and Goldman Sachs each bought 25 percent stakes in the company. Bill Burnham, an ecommerce analyst with CS First Boston, says E*Trade invested in Archipelago only after failing to swing a deal to get all or part of Datek. Citron says simply, "We're courted all the time, and our goal is to turn all the deals down." The other ECNs have yet to prove they can build enough trading volume to give customers consistently competitive prices.

In the midst of all that competition, Island's growth has been jolting. In the third quarter of 1997, the first for which Island was required to file trading numbers with the SEC, it handled an average of 17.1 million shares and 28,446 trades a day. In the first quarter of 1999, it averaged 89.8 million shares and 257,140 executions daily - by contrast, Archipelago handled 65 million shares in all of December.

__ To some, Island is a symptom of a marketplace driven insane by desktop investors snapping at every .com. __

At those levels, Island's piece of Nasdaq's daily share volume is 10 percent. Analysts, including James Marks of Deutsche Bank and Greg Smith of Putnam, Lovell, de Guardiola & Thorton, note that there is no industry standard for reporting Nasdaq trading volume, but what's clear is that Island has rapidly eaten into Instinet's market share in the past year.

BancBoston RobertsonStephens estimates that in the fourth quarter of 1997, Instinet accounted for 90 percent of ECN trades and Island 7 percent. By the fourth quarter of last year, Instinet's share had fallen to 59 percent and Island's had shot up to 33, with the remaining tenth of the market split among the smaller players.

Deutsche Bank's Marks notes that what Island lacked when it approached Instinet back in 1997 - liquidity - it now has in spades: "The be-all and end-all is liquidity. Liquidity is a chicken-and-egg question. You have to have customers to drive liquidity, but you need to have liquidity to attract customers."

Burnham of CS First Boston adds that, in its main-event struggle with Instinet, Island enjoys the advantages of entering the battle unencumbered either by legacy technology or historically high prices. If Instinet were willing to cut its prices - it charges institutional customers around 5 cents per share to trade - the company would bring potent weapons to a battle for Island's retail market space, especially its global market reach and proprietary research services. "In essence, Instinet has to go to retail," Burnham says.

Instinet's Atkin acknowledges that his firm's commissions place the price point for retail trades far above the $10 level set by Datek. But he argues that Instinet's ability to give investors access to 40 markets worldwide sets it apart from discounters, whose services he scorns as "glorified email." And Instinet is exploring ways to offer individual investors access to after-hours trading, a service it has long offered big institutions.

"I give Datek a lot of credit," he says. "But I think they only operate in one market. Instinet, on a turnkey basis, can offer any broker in the United States the ability to have their retail clients send their orders to 40 markets around the world. Island is Southwest Airlines, we're American Airlines. Southwest Airlines is great if you want no-frills, discount service."

So far the consensus is that Island, Instinet, and the Goldman/E*Trade-backed Archipelago will be locked in a dogfight indefinitely. The smaller players? Unless they carve out a secure source of order flow - for instance, by the common practice of paying brokerage firms to send orders to their systems for execution - they face extinction or merger.

Among the uncertainties facing Island's application to become an exchange is how long it will take the SEC to evaluate it and act - approval could come as soon as October, or take more than a year. There is agreement, though, that Island and parent Datek Online Holdings could benefit in several ways from becoming an exchange. At the top of the list, says SEC commissioner Laura Unger, is that exchange status would greatly facilitate Island's trading of NYSE-listed securities. Becoming an exchange would also give Island a new source of income. As a Nasdaq-registered broker-dealer, Island must now pay the exchanges for their real-time quotes. At the same time, Island is required to send its quotes to Nasdaq for free. As an exchange, Island could begin receiving a cut of the revenues exchanges get from wholesaling their market data.

The biggest cost, Unger says, will be creating and enforcing a self-regulatory structure - rules dictating the conduct of broker-dealers and traders involved in Island. That cost, in fact, has led Island's president, Andresen, to consider the possibility of contracting out the service to a Big Five accounting firm or the National Association of Securities Dealers - in essence outsourcing compliance.

Citron says that what he hopes to create is an exchange with a straight line between the investing public and the execution of their trades - direct market access enjoyed today almost exclusively by the small population of true daytraders who have signed up with brokerages offering SOES access and professional-level Nasdaq data feeds. Most casual online traders have their orders executed through an invisible series of intermediaries, including brokers, market makers, and ECNs. By promoting a pure buyer-seller auction and undercutting the intermediaries' charges, a full-blown Island exchange would minimize such detours.

But Citron adds that creating an exchange is not the ultimate aim. "That's the first layer of brick in building your virtual building," he says. His goal is to extend Island's capabilities into many trading arenas - including international equities, commodities, and derivatives.

__ Risk aside, investors are voting with their online trades. The number exploded 123 percent last year. __

Some are convinced that the ECNs are a symptom of a marketplace that has been driven insane by desktop investors snapping indiscriminately at any issue with a .com attached. In this view, such investors - unrestrained by traditional evaluation of stock values, trading on margin, and armed with the ability to make quick stock plays - provoke rapid run-ups and plunges in prices and disturb markets' overall stability. In truth, small investors are avid participants in the Net stock sector, prices in many online and technology stocks frequently do move in huge leaps or stumbles, and Island, the other ECNs, and online brokers do handle heavy volumes of .com stocks. Still, this interpretation ignores a lot. For instance, individual investors' leverage in the marketplace has been growing for decades, and the increase in volume is a long-term phenomenon, too.

If another big crash comes, however, many enthusiastic electronic investors - especially those trading with borrowed money - are going to get crushed, and finger-pointing will inevitably follow. The ECNs may well be cast as market villains, the source of volatility. For his part, Citron sees no downside to the free-trading culture. Asked about a session early this year in which Dell Computer was beaten down 8 percent as a total of 112 million shares changed hands, he said the trading was "a testament to how good things are, not how bad things are. Why in the past hasn't Dell traded so much when they've released bad earnings? Because of cost. When Dell does something bad, they should get punished for it. And how do they get punished? Their stock moves 110 million shares and a lot of people sell."

Peter Stern, the Datek Online architect, argues that the ability to act on changing realities is crucial, and shouldn't be stripped away. "The way to solve excessive speculation is not to restrict access to the markets. That actually makes matters worse. The true problem with speculation is that people are stupid and they don't recognize that they're stupid, so they repeat the problem every 20 years. So the solution is education, understanding, and access to information."

The brokerage industry, the stock exchanges, and the SEC have separately launched aggressive but haphazard efforts to educate newbie traders. Investor sites are now all but plastered with basic instruction on issues such as the difference between market and limit orders.

Regardless of the risks, investors are voting with their trades. The number of online trades exploded 123 percent in 1998. "Direct access to the markets has been decided by the SEC to be more of a good thing than a bad thing," says Stern. "Systems, whether it's Island or something else, are going to be around to promote direct access to the markets."

Financial historian Ron Chernow has written that the history of the capital markets is a long tale of the movement of market power out of the hands of banker demigods such as J. P. Morgan (who built his headquarters at 23 Wall Street, just blocks from 50 Broad Street) into those of the corporations that need to borrow money and finally into the hands of those who provide the funds - individual small investors. Chernow sees the online brokerages and developments such as direct underwriting of new stock issues on the Internet as a continuation of the trend toward breaking down the role of the middleman, something that's been under way for more than a century. Not that he doesn't have misgivings about the electronic acceleration of change: "It's all wonderful for ease and efficiency, but sometimes I worry that we have too much ease and efficiency. In the past, the banker or broker could act as an intermediary and could advise investors on their choices. But time is such a big factor, things are moving so fast, it isn't always possible now."

Marks, the Deutsche Bank analyst, not given to overheated rhetoric about heroes or revolutions, says of the Datek team, "They deserve a lot of credit for creating the niche they're in." For Citron, whose goal is to leave no physical monument to his accomplishments, and to Levine, who questions whether heroism is possible in the marketplace, that's probably credit enough.