Instinet Group LLC

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INSTINET GROUP LLC

Instinet Group is the oldest and largest of the electronic communication networks (ECNs), privately owned systems that post the buy and sell prices of stock. Unlike traditional institutional stock brokers, Instinet uses an Internet-based electronic platform to match stock buyers and sellers and to process transactions instantaneously. Rather than purchasing large chunks of stocks and holding on to them until it can sell them at a better price, a practice known in the industry as seeking a favorable spread, Instinet makes its money by charging a fee for each trade it completes. The firm also levies charges for displaying public stock order prices on its terminals, a practice that helps NASDAQ meet order handling requirements put in place by the SEC in 1997. In 2000, parent company Reuters Group PLC announced its intent to spin off Instinet as a publicly traded company. This set the ECN apart from competitors like Island and Archipelago, who were petitioning the SEC for permission to operate as exchanges. Another distinguishing component of Instinet's service is its ability to keep confidential the name of the company buying or selling the stock, which allows a firm to place orders without impacting the market. The firm also has the furthest international reach of the ECNs, with membership in several exchanges in Europe and the Pacific Rim, as well as in the U.S. and Canada.

Instinet was founded in 1969 as Institutional Networks Corp. by Jerome Pustilnik, once a director of research at Spingarn Heine. It was purchased in the early 1980s by Bill Lupien who continued to develop the computer-based trading system that served large institutions. By conducting transactions electronically, the firm was able to offer its clients, mainly large institutions, anonymity in their stock purchases and sales. However, it wasn't until Reuters acquired it for $120 million, or $8.50 per share, after the stock market crash in 1987 that Instinet began to attract widespread attention. According to Forbes writer Paul Pedrosky, "Institutions, weaned on a decade of spectacular market growth, started looking for ways to cut costs and improve performance. Enter Instinet." The firm's technology, which eliminated the need for a team of in-house brokers, allowed it to charge lower transaction fees and stay open 24 hours a day, seven days a week. Even more important, however, was Instinet's ability to offer anonymity. Because traditional traders would quite often have to deal with several other brokers before closing a deal, the potential for information leaks was high; as a result, using Instinet as a trading vehicle was seen by many large companies, particularly other traders like mutual fund companies, as a way to avoid unwanted publicity—quite often a cause of major market fluctuations—regarding the purchase and sale of large chunks of stock.

Another factor in Instinet's success was its ability to link up to multiple international stock exchanges. The firm's international initiative was given a boost in 1995, when a London Stock Exchange regulation was loosened, granting the ECN access to that market. That same year, despite years of vehement protests from Canadian traders, the Ontario Securities Commission allowed Instinet to install terminals in organizations there for the first time. Eventually, Instinet gained entrance to nearly 20 different exchanges in Asia, Europe, and North America.

In 1997, the U.S. Securities and Exchange Commission (SEC) made changes to the order handling rules for stockbrokers, opening the door for new competition to Instinet, by then the largest electronic broker in the world. The revisions grew out of a price-fixing investigation conducted by the SEC regarding measures taken by certain Wall Street companies and NASDAQ dealers to ensure specific spreads between buy and sell stock prices. The defendants settled the resulting class-action suit for roughly $1 billion, but the SEC felt changes to trading practices in general were in order to prevent future abuses of the system. The new rules "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," said Ian Celarier in an Investment Dealers' Digest article. Consequently, newer ECNs like Island and Archipelago, who were approved by the SEC to display quotes on NASDAQ terminals, gained access to the NASDAQ market they would not have otherwise enjoyed. Along with displaying quotes, these ECNs were able to list their own prices, which were sometimes better than the NASDAQ quotes.

The increasing growth of ECNs brought with it intensified scrutiny of the burgeoning ECN industry. Concerned that the lines between brokers and actual exchanges were becoming a bit too blurred, and leery about the unregulated exchange activity conducted by ECNs, the SEC decided in April 1999 to allow ECNs to apply for permission to operate as official stock exchanges. Although Island and Archipelago both submitted applications, Instinet opted for another route: an initial public offering (IPO). Along with preparing for its IPO, the firm sought other ways to distinguish itself as much as possible from the upstart ECNs by continuing to diversify into things like bond trading and expanding its solid international foothold with the purchase of a stake in Belgium's Tradeware S.A. Plans to set up an online retail brokerage site were delayed late in 2000 due to a downturn in the industry.

Instinet faces competition from more traditional operations as well. Determined to compete in the new landscape carved out by ECNs, NASDAQ and the New York Stock Exchange (NYSE) both began considering public offerings of their own. In addition, NASDAQ—which saw in 2000 more than one-third of its transactions being processed by ECNs, roughly 16 percent of which was handled by Instinet—began working on the Super Montage, an ECN that would display stock buy and sell prices on a single system. Despite charges by Instinet and other ECNs that the Super Montage would eliminate competition, the SEC approved NASDAQ's plans to build the new system in January 2001.

Wall Street brokerages, who found themselves having to expand their hours and cut their prices to compete with ECNs like Instinet, also waged their own war against the ECNs beginning in the late 1999s. By arguing that the growing number of ECNs resulted in the stock market's fragmentation, which can make it more difficult for smaller investors to get the best price, Wall Street convinced the SEC to launch a one-year investigation of the impact ECNs have had on the industry. The ECNs contend that the Wall Street firms are simply trying to eliminate competition. These battles for control of the stock trading industry will likely continue to play out during the early years of the 21st century, and as the Internet-based platform that prompted the market's transformation continues to evolve, new conflicts will likely emerge.