ECNs: Investing By the Book.

Individual investors may be reaping the benefits of the explosive growth of electronic communications networks (ECNs), but institutional investors may be suffering. And the resulting market - one that's fluid, fragmented and more fully automated - is crying out for a central limit order book, according to "ECN Proliferation: All Roads Lead to a Central Limit Order Book," a research note from TowerGroup, a Massachusetts-based consultancy.

The author of the note, Robert Hegarty, TowerGroup's director of investment management technology research, says, "ECNs now account for nearly 30 percent of Nasdaq volume, up from 12 percent at the beginning of [1998]. However, nearly 6 percent of that 30 percent is trades routed among ECNs themselves. ECNs could garner as much as 50 percent market share over the next two years as they partner more extensively with investment management and brokerage firms. Or their share could drop to zero if Nasdaq or another organization is able to launch a centralized system in a timely manner."

As the number of ECNs grows, Hegarty says, institutional investors and other market participants are asking, "Can they benefit our firm and our shareholders and, if so, how?" His view: Many institutions have been sitting on the sidelines waiting for a consolidated view of the order book, opting not to spend valuable time traversing the ECNs for liquidity. The natural large order size the institutions are seeking is generally unavailable in the ECNs, resulting in limited buy side participation. This isn't expected to change in the near term because many investment managers are and will remain reluctant to trade with the retail flow that represents most current ECN order flow. But over time, several developing forces will combine to draw institutions into this marketplace.

Hegarty thinks ECNs won't consolidate to the point where only the largest survive. Rather, he says, they'll probably be forced to link to the rest of the market - thus, a central limit order book. Such a tool would let investors, both individual and institutional, view quotes of and execute trades against the best bid or offer among all of the ECNs and market makers. By joining the consolidated market, ECNs with the most attractive liquidity will outlast the niche players attempting to enter the market without the ability to attract order flow. But whether Nasdaq, another organization or a "virtual" grassroots group creates the central limit order book remains to be seen, he notes.

The U.S. markets' proliferation of execution venues, liquidity fragmentation and low barriers to entry, according to Hegarty, are just a staging point for a more advanced, more automated market structure that will evolve over the next year or two. "The U.S. has lagged the rest of the developed world in automation of capital markets exchanges. Many other world markets have forgone traditional trading floors in favor of total exchange automation, as evidenced by the big bang in London in 1987 and last year in Japan," he says. "Pressure from ECNs, electronic trading and market participants will force the U.S. markets to adopt a more automated, efficient structure."