ALTERNATIVE TRADING SYSTEMS MAY BE THE UNMAKING OF THE MARKET MAKER: GOLDMAN, E*TRADE LATEST TO JOIN THE ACT

Stock traders increasingly are turning to electronic trading systems to execute transactions more cheaply, and earlier this month Goldman Sachs Group LP and E*Trade Group Inc. got into the act by jointly buying nearly 40% of Chicago-based Archipelago Holdings LLC.

The purchase, for $50 million, comes a month after the Securities and Exchange Commission issued rules allowing the new alternative trading systems, known as ATSs, to set themselves up as full-fledged exchanges. Such systems account for more than 20% of Nasdaq trades and 4% of exchange-listed securities transactions. Systems that don’t act on the new rules can remain registered as broker-dealers.

Henry Carter, compliance chief for the discount brokerage arm of E*Trade in Palo Alto, Calif., says his discussions with SEC commissioners prior to the deal “centered on best execution. They were very intrigued about these ATSs.”

“There is a sense that the day of the market maker is going to hit the wall,” he adds. “People are going to figure out a way to get around market makers, and I think these ATSs are the first attack… There is a sense that Nasdaq is run by people who have disproportionate influence in the market maker community.”

The new trading systems match customers’ orders electronically without intervention by a broker and do not take positions in a security the way market makers do. They also post stock orders faster than Nasdaq, and allow participants in the systems, many of whom are retail brokers, to see more stock quotes than are shown on Nasdaq.

The advantage for investors, according to Mr. Carter and other trading system officials, is they will have “more control over the trades,” Mr. Carter says.

“This thing — it’s growing rapidly,” says Jerry Putnam, chief executive officer of Archipelago, which has been in business for two years. The remaining 60% or so of the company is owned by Townsend Analytics of Chicago and Southwest Securities of Dallas.

Still, newcomers to electronic trading systems could soon find their path crowded. “The market is only going to handle so many, like in Nasdaq, where there’s only a handful of market makers,” he says.

Some 40% of Archipelago’s business is from retail investors, according to Mr. Putnam, with the balance from advisers, mutual funds, pension funds and broker-dealers. Alternative trading systems make money solely through commissions.

Mr. Putnam says he is looking at registering Archipelago as an exchange. “There’s some significant benefits,” he says.

A big advantage: The exchange can charge for stock quotes, a major source of revenue for the New York Stock Exchange and Nasdaq.

For their part, customers are able to see other customers’ orders and deal with them directly, Mr. Putnam says, “with no human intervention … It’s a huge advantage. That’s exactly what people want to do.”

The issue for the SEC, when it issued its rule last month, is that, while alternative trading systems “may become the primary market for some securities … these markets are private, available only to chosen subscribers,” as stated in the rule.

“These trading systems have no obligation to provide investors a fair opportunity to participate in their systems or to treat their participants fairly,” and they may not check their markets adequately for manipulation and fraud, the commission stated in its release.

“In fact, market participants can manipulate the prices in the public securities markets through the use of alternative trading systems,” the SEC said. The rule includes measures that require alternative trading systems to take steps to guard against such practices.

Peggy Rappaport, senior vice president of Instinet Corp., owned by London-based news service Reuters Group PLC, says alternative trading systems saved their customers, who make up more than 90% of U.S. equity funds, $1.2 billion in trading costs in 1997. She says individual investors and financial advisers who represent them have an interest in alternative trading systems both for their own trades and because “they want to make sure their mutual fund performs” well. Instinet’s goal, she asserts, “has been to … put more in investor’s pockets.”

Bill Broka, senior vice president of Nasdaq trading, says that alternative trading systems have “narrowed (price) spreads as much as 40%” since they were allowed to operate in 1997. The systems are part of Nasdaq, he says, and “provide additional price discovery, liquidity and exposure in terms of prices.” Nonetheless, he says, “that hasn’t taken business away from Nasdaq. They’ve been a benefit to the market.”