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This article was first published in the Electronic Trading Journal - FIXGlobal, Vol. 2 Issue 5 - March 2008. Please visit www.fixglobal.com to view all articles.

The ATS Revolution and an Exchange Renaissance

One only needs to look at the US equity transaction volumes reported to the various trade report facilities (TRF) to see the profound impact alternative trading systems (ATS) and electronic communications networks (ECN) have had on liquidity in the overall marketplace.
By James G. Ross, Vice President, NYSE MatchPoint
Over 20% of all US equity volumes are currently transacted through these electronic off-exchange brokerage trading systems. Expectations by some analysts are that the ATS volume surging through these systems will increase by 20-30% over the next two to three years. The emergence of the ATS industry over the past 20 years has been nothing if not revolutionary. It has affected every facet of the securities industry: new laws and regulations, new technologies and infrastructure, new industry standards, new business models, new products and services, and even new investors. Broker-dealers, exchanges, vendors, regulators, legislators, and investors have all played a critical role in the evolution of this new market paradigm. The exchanges, interestingly enough, have been more of a causal factor as opposed to an active participant in the early stages of the ATS revolution. That, of course, is understandable. For no revolution worth its salt can emerge without a monopolistic, self-serving, and heavy-handed bureaucratic power to rail against. The traditional exchange environment provided more than enough fuel to fire up this revolution. But as much as the traditional exchange environment was a singular motivating factor for the ATS revolution, it is now becoming a primary solution as the ATS revolution plays out. crossing networks. Dark liquidity and quantity discovery that are the lifeblood of the ATS revolution have always existed as unassuming alter-egos to posted liquidity and price discovery since the beginning of structured public markets. But it was the birth of the first electronic crossing networks that commenced the ATS revolution by introducing a trading structure for dark liquidity and quantity discovery.

...no revolution worth its salt can emerge without a monopolistic, self-serving, and heavy-handed bureaucratic power to rail against.
Whereas today, the agendas and motivations of the ATS providers are as varied as the number of products that make up this industry, the 1980s were a blank slate for the crossing network innovators. There was no defined ATS regulatory framework (no order handling rules or decimalization, for that matter), there was no technology or connectivity infrastructure to deliver or support an ATS, and the concept of competition (the rallying cry for ATS providers) was simply between brokers for IPOs and exchanges for listings. Yet there was a singular, critical, driving factor that motivated the nascent crossing network providers: institutional demand and the index- and mutual fundmanagers in particular. These first crossing networks were heavily influenced by the input of these managers. Their relatively low margin investment products that generated portfolio-based or large block liquidity through index fundings and liquidations, as well as manager transitions and rebalancings, were significantly impacted by the

Origins of the ATS Revolution

The ATS revolution did not spring up overnight nor did it arise over the past few years. Instead, its origins can be found in the early to mid 1980s with the rise of the electronic

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transactions costs and operational inefficiencies associated with executing them in the traditional transparent marketplace. This institutional influence is reflected in the near mirror image design of the first two crossing networks: Instinets The Crossing Network and Investment Technology Groups POSIT that were launched within five months of each other. Both were point-in-time trading systems. Both were completely opaque and anonymous. Both used benchmark reference prices from the primary marketplace. Both were portfolio-based systems. And both were agency brokers open to all customers. The only real difference between the two systems was the time at which they operated. The Crossing Network operated after the market closed. POSIT operated during regular market hours.

independent ATSs, and bulge bracket ATS internalizers. Each has its own approach regarding opacity, functionality, and pricing. A few are point-in-time; most are continuous. Some permit negotiation within the NBBO; others are auto-execution (or both). All are anonymous, yet some do not disclose any pre-trade information, while others selectively display pre-trade information. It is quite a smorgasbord of dark pools. The business motivations of each are equally divergent. Some internalize existing customer liquidity in order to lower costs and increase margins. Others are consortiums of brokers who are concerned about the potential for increased exchange transaction fees to support their for-profit model. Several are trying to better compete against the thriving, independent ATS that are disintermediating the brokers from their customers. Finally, there are a few that cater to a specific subset of investor or customer. While the ATS revolution has dramatically changed the financial services landscape for the better, a host of market quality issues have emerged as well. Exclusive ATS business models exclude certain market participants or liquidity. Liquidity dislocation and segmentation has

Engaging only like-minded investors or trading styles greatly limits the opportunity of finding a natural match in a non-displayed liquidity pool.
These system characteristics were well suited to address the needs of the institutional portfolio and block order community. Benchmark prices gave the indexer and mutual fund manager exactly the mark to market reference prices that their funds required. The sheer size and breadth of these funds required anonymity and opacity to protect them from market impact and front running. The point-in-time operation and portfolio-based functionality made the aggregation of multiple orders into bigger blocks, and their portfolio trading process, more efficient and effective. The low-cost agency executiononly model promoted conflict-free neutrality that customers were willing to pay for and could trust. By designing a dark liquidity environment that could accommodate the passive index fund as well as the active mutual fund, these early crossing networks recognized the critical importance of investor diversity. Engaging only like-minded investors or trading styles greatly limits the opportunity of finding a natural match in a non-displayed liquidity pool. By merging business model design (pointin-time operations and complete opacity) with system functionality (portfolio-friendly platform with portfolio risk and cash management capabilities), these crossing networks were able to centralize diverse investor and trading strategies into one liquidity pool.

While the ATS revolution has dramatically changed the financial services landscape for the better, a host of market quality issues have emerged...
forced investors to incur significant opportunity costs as they pick their way through the various dark pools trying to find liquidity. Large customers of ATS systems receive cheaper undisclosed rates. Most ATS businesses are not open to all investors and they rarely disclose operational procedures or execution priorities. Dark algorithms create post trade information leakage as they ping the available ATS liquidity pools. The ATS trade report process into the TRF does not identify the ATS or the type of transaction, making accurate transactions cost analysis difficult. All of these have arisen out of the ATS revolution and oddly enough many of these issues were exactly the problems that the ATS revolution was intended to resolve.

The Exchanges Role

As important as the exchanges role was in the beginning of the ATS revolution, so will its role be in its ongoing evolution. Clearly, the traditional exchange was ill-prepared for this state of the art, non-displayed, ATS juggernaut. Burdened with decades of out-dated rules, business practices and technology, the exchanges are forced to play catch up with an ATS industry that is launching new products every six months. But only the exchange environment can bring the benefits and lessons learned from the ATS revolution in a sustainable and practical way to all investors.

Dark Pools
If we jump ahead in time to the present day, the ATS revolution has been in full force for two decades. Today, there are more than 40 crossing systems vying for customer business. Joining the original crossing networks is a cacophony of different and varying business models and operational designs. There are broker consortiums,

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Neutrality, fair and equal access, a secure IT infrastructure, tough and independent market surveillance and oversight, and operational and execution transparency are hallmarks of an exchange environment today. For the ATS revolution to realize its ultimate goal, it will need to rely upon these basic tenets of the traditional exchange to fulfill its potential.

environment. Ultimately, we hope to leverage our global platform and offer a MatchPoint capability for global portfolios. Once NYSE MatchPoint and the BIDS facilities are fully rolled out in the U.S., NYSE Euronext will provide the marketplace with a fully functional ATS-like environment where all investors (passive and active, portfolio and block traders) can leverage the benefits of the ATS revolution. There will be more on the global horizon, as well, as NYSE Euronext extends the dark strategy to global securities and other asset classes. Today, trading is coming full circle, as the ATS revolution is brought inside the exchange, changing both ATSs and exchanges in the process. A new global market model is being born.

As important as the exchanges role was in the beginning of the ATS revolution, so will its role be in its ongoing evolution.
NYSE Euronext has established a dark strategy that is specifically designed to leverage the lessons learned from the ATS revolution but apply them in the formal, neutral, centralized, and regulated environment of NYSE Euronext. The first of the initiatives in the dark strategy is a point-in-time, portfolio-based matching facility called NYSE MatchPoint. It operates completely non-displayed matching sessions at pre-determined times throughout the regular trading day and after market hours using reference prices from the primary and consolidated markets. NYSE MatchPoints portfolio-based functionality, complete opacity, and point-in-time operations are reminiscent of the early crossing networks that were able to attract both passive portfolio-based orderflow as well as large block orderflow into a single matching session. As a facility of NYSE Euronext, MatchPoint is open to all members and their customers regardless of size or trading style. As an exchange neutral facility, there are none of the competitive business issues that unnecessarily fragment dark liquidity. Later in 2008, NYSE Euronext will launch a second initiative in its dark strategy with the joint-venture with BIDS. Whereas MatchPoint is point-in-time and portfolio-based, the BIDS facility will operate an anonymous, non-displayed, continuous trading system to enable automatic block order execution and negotiation. Though some of the details are still being worked on with the regulators (a uniquely valuable and effective exchange process I might add), the BIDS facility is being designed to integrate dark block order liquidity with displayed liquidity.

Today, trading is coming full circle, as the ATS revolution is brought inside the exchange, changing both ATSs and exchanges in the process.
NYSE Euronext dark pool strategies will also enable us to provide services on an international and local basis. In our Euronext markets, we expect to launch a new facility called SmartPool also in 2008. A partnership with BNP Paribas and HSBC, SmartPool will operate in a manner similar to NYSE MatchPoint and the BIDS joint venture by providing continuous and point-in-time trading in a dark

Any thoughts on this or other articles? Please send any comments, refering to this article as Vol 2 Issue 5 AM1 , direct to Edward at edward@fixglobal.com

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