The Trade Show.

Watch out - electronic communications are quickly changing the way stocks are bought and sold. Should you catch the ride?

Propelled into the headlines by a mass murder in Atlanta, day trading was a summer obsession almost as spooky as "The Blair Witch Project." Indeed, the two have a lot in common. Both involve outsiders taking on the establishment and winning, thanks in large part to adept use of the I-way. Young unknowns slapped together "The Blair Witch Project" on a ridiculously low budget and used the Internet to circumvent the usual costly channels of promotion and distribution, succeeding against the odds. The day trading boom also owes its popularity to young outsiders using cyberspace technology to beat almost incredible odds. But while "The Blair Witch Project" is already old news - last summer's movie - the impact of day trading will unquestionably endure.

That's because the story of day trading is only partly about individuals taking suicidal risks buying and selling stocks in direct competition with Wall Street's big Beneath the surface there's a much bigger story breaking, with remarkable implications for corporate finance. The online exchanges day traders have invented to make their game faster and better pose a clear threat to traditional exchanges, and have some knowledgeable observers wondering whether it still makes sense for corporations to list on well-known exchanges.

The buzz hasn't fallen on deaf ears. In fact, both the New York Stock Exchange and Nasdaq have been talking publicly about changing their ownership structure to cope with the rapidly changing competitive environment. Electronic communications networks, or ECNs, many created by day traders, do the basic job of trading stocks cheaper and faster than traditional mechanisms. And ECNs are on a roll. In fact, in a recent speech at Columbia Law School, SEC Chairman Arthur Levitt acknowledged, "ECNs have been dynamic contributors to the Nasdaq market. Now that some are registering as exchanges, we must insist that they be permitted to compete with the Nasdaq market and the established exchanges on fair and equal terms."

Archipelago Holdings, an ECN with roots in day trading, has over the past year attracted a corps of powerful investors, including Goldman Sachs, Merrill Lynch, E*Trade, Reuters subsidiary Instinet and General Electric subsidiary CNBC. In September, Archipelago filed an application with the SEC to change its status from an ECN to a full-fledged exchange. Upstart Archipelago has already announced its intention to trade listed stocks in direct competition with more traditional exchanges, and wants exchange status to put it on an equal regulatory footing with them.

Archipelago isn't the only ECN to go this route. Island, currently the biggest ECN in terms of volume of shares traded, was invented to serve day traders who couldn't get equal access to trading systems used by the big Wall Street brokerage and market making houses. A subsidiary of the electronic brokerage firm Datek Online, Island has made no secret of its interest in pursuing exchange status.

Trading Posts

ECN percentage of Nasdaq trades (as of June 1999)

                                          % Volume of
                              Trade           Share         Dollar

Instinet                      13.2%           13.1%          17.3%
Island                        11.5%            5.1%           8.1%
REDIBook                       1.2%            0.9%           1.1%
Brut                           1.2%            0.7%           0.8%
Archipelago                    0.9%            0.6%           0.8%
B-Trade                        0.9%            0.9%           1.0%
Strike                         0.2%            0.3%           0.2%
Attain                         0.1%            0.0%           0.0%

- Source: Mainspring Communications

Moreover, Island and Archipelago are only two of a burgeoning population of ECNs. There's Bloomberg Tradebook, owned by the eponymous financial information company; Brut, whose investors include Goldman Sachs, Morgan Stanley, and Merrill Lynch; and Strike, whose investors include Salomon Smith Barney, Lehman Brothers, Bear Steams, PaineWebber, and Donaldson Lufkin & Jenrette. Four more electronic exchanges trade bonds, including junk bonds. Three online firms specialize in Internet IPOs. And across the Atlantic, at least two ECNs have been launched with backing from some of the same investors to trade European stocks. In response, Europe's eight largest stock exchanges are trying to create one centralized system.

A Place for Tradition

Research by Prof. Ian Domowitz of Penn State University demonstrates that the cost of trading on ECNs is dramatically less than the cost of using a more traditional exchange floor. Moreover, the electronic venues are no less liquid. One implication of Domowitz's work: Listing on a traditional exchange may not make sense. "Once upon a time, exchanges sold listings to corporations," Domowitz explains. "The listing was a bundle of goods that included liquidity, some reputation-vetting, some standardized, off-the-shelf rules of trading to reduce costs to investors and make it easier for them to buy stock, some regulatory stuff and clearance and settlement. Exchanges can't compete on this basis anymore. So why should a company even list?"

Indeed, some of the biggest and most successful companies in the contemporary economy have decided not to. Intel's stock trades on the Nasdaq - in decades past, the stock market's nursery. There was a time when graduating from Nasdaq to the New York Stock Exchange was a rite of passage, a sort of corporate bar mitzvah in which the company was annointed a serious member of the business community. But the powerhouse high-tech companies that surged to prominence in the '70s and '80s abandoned this tradition. Apple, Cisco, Intel and Microsoft are a few giants who remain happy Nasdaq campers.

And why shouldn't they? Tradition not withstanding, Cisco CFO Larry Carter says, "We've reviewed where we should be listed, but to date we haven't found a compelling reason to change. Think about fundamentals. Our liquidity is excellent where we are, our spread is comparable with large-cap firms on the New York Stock Exchange. From a fee perspective, we pay significantly less. And from an international perspective, we get pretty good coverage."

In fact, the Nasdaq owes much of its success attracting and keeping top-drawer firms like Cisco to the electronic trading technology behind ECNs. Instinet, the pioneer, was invented in the 1970s by an aerospace analyst with a dream of eliminating stock market middlemen. In the early 1980s, a Pacific Stock Exchange specialist named Bill Lupien saw Instinet's true potential differently. Because it allowed buyers and sellers to execute orders immediately, electronically, at low costs (no more phoning around to dealers), and because it also provided previously unavailable information about supply and demand for stocks, Instinet could be the best friend a middleman ever had. Lupien bought into the company, became chairman, targeted the brokers, specialists and market makers and was rewarded with compound growth in Instinet's business of about 75 percent a year in the '80s - most of that from trading Nasdaq stocks.

As Instinet grew, a strange thing happened in the Nasdaq market. It became, in effect, two distinct markets. Dealers, market makers, institutions and other big players traded with each other on Instinet, while the public accessed the Nasdaq through the traditional phone-a-broker channel. In the early 1990s, spurred by the tedious work of two then-obscure academics who had pored over years of stock price data, regulators charged some of Wall Street's biggest firms with collusion to maintain artificially wide spreads on Nasdaq stock price quotes. They punished the collusion by broadening public access to the market, and opened the door to new ECNs.

A group of technically savvy traders seized the advantage. Dubbed SOES bandits, these pioneering day traders were adept at using Nasdaq's Small Order Execution System (SOES) to seize arbitrage profits from the market makers. Moreover, shut out of Instinet, they had developed their own alternative electronic trading systems. These ECNs did many of the same things as Instinet - and, in some cases, more. The day traders depended on fast execution and comprehensive information about stock supply and demand. They were already engaged in a technological race for faster, cheaper, better order executions. And in practical terms, the new trading venues they'd invented were adding liquidity to the market for Nasdaq stocks. That was good news for Nasdaq companies, according to Prof. Junius Peake of the University of Northern Colorado.

"It matters very definitely," Peake says. "The theory of raising capital is to maximize shareholder returns, so you want to raise capital and attract shareholders at the lowest cost. Nobody buys a stock he can't sell, and everybody wants to buy a stock at a price close to that at which the previous sales took place. Just as in selling a house, you'd rather multiple-list than go with a single broker to maximize the number of potential buyers." And, like houses, stocks have built-in liquidity premiums. Buyers are inclined to pay less if they know it will be time-consuming, inconvenient and expensive for them to sell the property in their turn. If they know selling will be cheap, quick and simple, they may be inclined to pay more when they buy.

Up Off the Floor

Viewed strictly in economic terms, the contest between traditional, floor-based exchanges and the new electronic trading systems seems foreordained. Arvind Sodhani, Intel's treasurer, says, "My belief has been for a long time that eventually all stocks will trade on electronic networks, be they public or private, and ultimately stocks will get traded on the Internet." He doesn't just mean people will buy and sell via e-mail messages to online brokers, but that they'll actually trade with each other, much as floor traders do at traditional stock and futures exchanges. Prof. Peake also sees today's ECNs as evolutionary rungs on a ladder leading to a much different global electronic market.

Meanwhile, some companies are finding a lot to love in the online trading revolution. Cisco's Mary Thurber, senior director of investor relations, says, "I think online trading has been fabulous. It means shareholders are not only able to trade at very good rates, because commissions are low, but they can also get lots of information on companies. We've seen a real sophistication in our investors as they become more knowledgeable." She credits the development of online trading for helping bring retail investors from below 20 percent to almost 30 percent of Cisco's investor base.

Cisco goes farther than most companies to cultivate those investors. Says Thurber, "All shareholders, whether they own one share or 44 million, can have equal access to the company. They can call and we'll respond. They have access to the web site, they can listen to the earnings call every quarter - we treat them equally." Cisco's quarterly earnings conference call has drawn as many as 1,300 listeners, and the replay of the call available on the web attracts about 5,000 hits. "The message is, I don't see online trading as anything negative. It's good. It means more people are able to get into the market and have access at a reasonable price, and they become better shareholders of Cisco. We want them to be partners, and we even want them to feel comfortable giving us advice on how to run the company," Thurber says. "They might see something we've overlooked."

The development of online trading even has interesting implications for the management of pension funds and corporate investing, according to Rene Goupillaud, managing director of Arco Investment Management Company. Goupillaud has used Instinet for years. "To the extent that electronic trading reduces transaction costs, and is transparent so you know the price information you're getting is good, then I'm not sure pension funds should object to competition in the market," he says. And after reflecting a moment, he adds, "When people think the New York Stock Exchange may not be here in a few years, they might be optimistic. Or pessimistic, depending on who you are."

Gregory J. Millman is the author of The Day Traders: The Untold Story of the Extreme Investors and How They Changed Wall Street Forever.