The impact of Electronic Communications Networks (ECNs) on NYSE Presentation to Mr. Richard Grasso and NYSE Directors

Agenda ECNs – What they are / History and growth Strengths and Challenges Threats to NYSE Takeaways Questions

History and Growth Instinet, the first ECN, was created Increased technology allows for greater capacity and efficiency SEC Order Handling Rules triggers growth 1969 1970 1990 1996 2001 9 # ECNs 1

ECNs have 30% of trading volume in Nasdaq REDIbook Archipelago ECNs 30% Others Instinet 70% Island Source: CSFB report

ECNs - What they are Bring buyers and sellers together for electronic execution of trades. Have a wide variety of subscribers, including retail investors, institutional investors, market makers and broker- dealers. Allows subscribers to trade between themselves without having to go through a middleman Are alternative to formal Stock Exchanges (NYSE) or to dealer makers (NASDAQ) for trading securities

How NYSE and ECN Transactions Differ Own Inventory Investor Brokerage firm A Specialist IT System Brokerage firm B ECN ECN Investor

Limited orders

Strengths of ECNs Anonymity (Signaling) Commission Structure Information leakage is greatly reduced Commission Structure Reduced from $.06 to $.03 per share More efficient (Speed) Orders post instantly versus wait up to three minutes Neutrality Removes conflicts of interest in trading for own accounts

Strengths of ECNs (cont.) Transparency ECNs post size and price of customer orders After hours trading ECNs offer an attractive venue for trading outside normal trading hours

The Challenges Facing ECNs Liquidity How to retain and attract volume The greater the volume of transactions, the more likely trades will be executed successfully Routing trades to other ECNs Partnering with brokerage firms for order flow Differentiation An exchange that provides superior transaction processing Or a value-added broker that offers a range of products

The Challenges Facing ECNs (cont.) Increased Regulatory and Compliance Demands Regulation ATS (Alternative Trading Systems) SEC Broker Dealer Regulations Exchange Specific Regulations Integrity Building an ethical reputation Excelling in treatment of customers Technology Continual upgrade requires substantial investments

Why ECNs have had limited impact on NYSE Reluctance of traders to change trading places Better economies of scale through larger volumes per orders Better liquidity Automation of trading posts NYSE Direct + (limited orders smaller than 1,099 shares)

Threats to NYSE ECNs are merging to obtain benefits of network effects If they are able to differentiate they can obtain Market share Profits inequality

The power of automation Threats to NYSE Full automation of NYSE would cut trading costs and reduce cost of capital to firms Cost Reduction Trading Cost of capital The power of automation 27 % 4.2 % Source: The Economist

Threats to NYSE Exchanges around the world are merging Achieve economies of scale Get order flow to increase liquidity Reduce fragmentation Improve automation Eg. London Stock Exchange + Deustche Börse = iX iX has signed a JV with Nasdaq

Threats to NYSE Archipelago has obtained approval to become first ECN-based national stock exchange Participants can trade NYSE, AMEX listed stocks, as well as Nasdaq shares Archipelago can connect with other exchanges through the Intermarket Trading System and collect fees for data access

Takeaways ECNs have consistently increased volume share ECNs have made inroads into the Nasdaq and into the European market ECNs are changing the way that security markets conduct business NYSE has remained the dominant player but will need to address its own capabilities to remain the market leader

Questions?

Supporting material

Market capitalization has increased at the NYSE… NYSE business Market capitalization has increased at the NYSE… # companies listed = 2,800 Market Capitalization ($trillion) # companies listed = 1,769 Source: The Economist

… and so has the American passion for equities NYSE business … and so has the American passion for equities % % of adult population that owns shares Source: The Economist

… however, ECNs can present a threat to NYSE NYSE business The automation of trading posts in 1999 has brought substantial benefits to the NYSE … Increased volume Additional sources of market information for specialists and brokers Better visibility to institutions and investors Enhanced liquidity … however, ECNs can present a threat to NYSE

How ECNs operate with Nasdaq Who are the ECNs and which services they provide How ECNs operate with Nasdaq Subscriber Non Subscriber Non Subscriber Subscriber Subscriber Nasdaq SelectNet ECN Non Subscriber Non Subscriber Non Subscribers access ECNs via SelectNet

Daily volume (in $Billion) Trends and Threats In 1986 London Stock Exchange introduced a screen-based quotation system (SEAQ) Daily volume (in $Billion) LSE NYSE Big Bang

Attachment 1 - Automation of Trading posts Post Information displays Flat panel display screen Point-of-sale workstation Wireless data system

Attachment 2 - The network effect # of firms Sales of largest q1 Sales of second q2 Sales of third q3 Profits of largest p1 Profits of second firm p2 Profits of third firm p3 1 0.6666 - 0.2222 2 0.6357 0.2428 0.1726 0.0294 3 0.6340 0.2326 0.0888 0.17007 0.0231 0.00035 Source: The impact of the Internet on financial markets - Nicholas Economides