Archipelago Holdings LLC

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ARCHIPELAGO HOLDINGS LLC

Archipelago Holdings operates Archipelago LLC, one of the four original electronic communications networks (ECNs) approved by the Securities and Exchange Commission (SEC) to serve as a new breed of institutional stock broker—one that matches stock buyers and sellers more quickly than traditional brokers by using an Internet-based electronic platform. Rather than attempting to secure profits like a conventional trader—by selling stocks at a higher price than it paid, which involves waiting for a favorable spread—Archipelago simply matches buyers with sellers, executes transactions immediately, and charges a small commission, much lower than typical processing fees, for each trade it completes. Like most other ECNs, Archipelago also displays the prices and sizes of public stock orders, although it does so for free, unlike its bigger competitors Instinet Corp. and Island ECN. At the end of the twentieth century, Archipelago agreed to merge with Pacific Stock Exchange into a new electronic stock exchange that would compete with NASDAQ and the New York Stock Exchange (NYSE). That deal was pending SEC approval in early 2001, though by autumn of the year analysts were skeptical of the outlook for future consolidation among big ECNs, citing a lack of overlap between their strong market niches.

Archipelago got its start in November of 1994 when Wall Street broker Gerald D. Putnam established TerraNova Trading LLC, a day trading firm, in Chicago, Illinois. Putnam met Stuart Townsend, founder of stock trading industry software manufacturer Townsend Analytics Ltd., and the two eventually began discussing the viability of an electronic communications network. Motivated by new SEC regulations in place that encouraged the development of ECNs, TerraNova launched Archipelago as an Internet-based equities trading service in January of 1997.

It was no accident that the firm's founding coincided with SEC-mandated revisions to the order handling protocol required by brokers and traders. The modifications came in response to a trading scandal in which the SEC accused the leading Wall Street players and NASDAQ dealers of price fixing. While the ensuing class-action suit was settled out of court for roughly $1 billion, the changes in order handling "opened the door to ECNs by requiring limit orders be displayed on the NASDAQ system and that the best prices be matched by market makers," according to Ian Celarier in an Investment Dealers' Digest article. In short, the new rules gave NASDAQ market access to ECNs like Archipelago who were approved by the SEC to display quotes on NASDAQ terminals. However, beyond simply displaying quotes, ECNs also were able to make public their own prices, which were sometimes more attractive than NASDAQ listings.

By mid-1998 Archipelago had secured nearly 4,000 subscribers, most of whom were institutional. While individual investors were not able to buy or sell stock via the ECN, they could work through a trading firm willing to place orders with Archipelago. In 1999, Instinet Corp., E-Trade Group Inc., and investment bankers Goldman Sachs & Co. and J.P. Morgan spent a combined total of more than $100 million to buy roughly 66 percent of Archipelago, which was valued at $300 million and employed 21 professionals. Growth continued when subsidiary Archipelago Investment LLC expanded the company internationally for the first time by investing $3.6 million in London's Tradepoint Stock Exchange.

In August of 1999, another of the firm's subsidiaries, Archipelago Securities Exchange LLC, submitted a request to the SEC for permission to operate as a full-scale national stock exchange. Becoming a stock exchange would move Archipelago out of the jurisdiction of the National Association of Securities, the owner and operator of competitor NASDAQ, and allow the firm to regulate itself under the direct authority of the SEC. It also would allow Archipelago to levy transaction charges for listing new stocks, to market statistics and other trading information, and to trade NYSE stocks. Access to NYSE stocks would open a lucrative door for Archipelago whose trading, like all other ECNs, was restricted mainly to NASDAQ. At the time, most ECNs made money by completing mass quantities of trades. Therefore, gaining access to the high-activity stocks of the NYSE was viewed by many as crucial to Archipelago's long-term success. The request garnered a great deal of attention because the SEC had not considered such an application since the 1970s.

Archipelago moved to New York in January of 2000 and leased a facility there to hold more of the computers it uses to electronically match stock buyers and sellers. At that time, the firm conducted roughly one percent of all NASDAQ trading market transactions, compared to the 11 percent processed by competitors Instinet and Island. Because its trading activity was so much lower than its rivals, Archipelago had developed software that routinely channeled a large portion of its trading through other exchanges and ECNs to secure premium prices for clients. The technology, known as SmartBook, is based on an algorithm that searches several internal and external prices. If external prices are better, the program then looks at information regarding the external participants before determining who receives an order. Although the firm initially developed this process as a means of getting around its lack of customers, the willingness and ability to use other sources to secure the best deal for its clients later emerged as a feature that distinguished Archipelago from other ECNs.

Determined to realize its goal of becoming an exchange, in March of 2000 Archipelago agreed to merge with the Pacific Stock Exchange and form the first completely electronic stock exchange to trade NYSE stocks. Although the two firms finalized the terms of their deal in July, its completion remained subject to approval by the SEC. A month later, Archipelago saw another major barrier dissolve when it gained access to the Intermarket Trading System, "a computer system that links the nation's exchanges and that is jealously guarded by those who use it, against those who want access to it," according to Investment Dealers' Digest writer Heike Wipperfurth.

Archipelago's battle to become an exchange reflects a much larger clash between ECNs in general and Wall Street in particular. As of 2001, they processed more than one-third of all NASDAQ transactions, and their success represented lost business for traditional brokerages and trading houses. In 2000, the SEC launched a one-year investigation of what the major Wall Street players refer to as fragmentation in the marketplace, which they assert makes it more difficult for smaller investors to get the best price. One proposed solution is the creation of a Central Limit Order Book (CLOB) through which all orders would be processed on a first-come-first-served basis. In contrast, ECNs argue that what Wall Street calls market fragmentation simply is competition. They argue that a CLOB would undercut a key factor in the success of ECNs: the ability to execute orders quickly.

Like many Wall Street giants, NASDAQ also is determined to win back market share from the ECNs.In 2000 it began working on Super Montage, a voluntary centralized order book for national stock that would display stock buy and sell prices on a single system and allow traders to complete deals electronically. While the impact this will have on ECNs remains to be seen, one thing is certain: by using the Internet as a platform for matching stock buyers and sellers, electronic communications networks like Archipelago have permanently altered the stock trading industry.