MARKET SAVVY : SAVVY CONFIDENTIAL: A Briefing for Investors : ECNs Could Thrive, but They’re Vulnerable

Fast-growing electronic trading systems could seize more than 50% of Nasdaq volume within two years but may prove to be a “short-lived phenomenon” if Nasdaq and the New York Stock Exchange ever go completely electronic and change some of the ways they now trade stocks, according to a study to be released today.

The nine trading systems, known formally as electronic communications networks, or ECNs, have emerged in the last two years to threaten the dominance of the established stock markets. The systems, which match buy and sell orders, let investors bypass the two big markets, especially Nasdaq, and now claim about 30% of volume on that market.

ECNs’ swift growth has prompted the major markets to consider selling shares to the public, in part to raise capital to potentially buy electronic challengers.

The biggest ECNs, Instinet and Island, which together control 70% of ECN market share, should continue to thrive in the next few years, according to the report by Meridien Research of Newton, Mass. However, the industry is likely to consolidate quickly, and ECNs could “find themselves out of business overnight” if the two stock markets implement more direct trading between buyers and sellers, the report said. In effect, the major markets would likely trade stocks in much the way the ECNs do now, thus eliminating the need for the electronic systems, the study said.

“If Nasdaq goes to a fully electronic system, the ECNs would see the volume sucked away from them,” said Octavio Marenzi, Meridien’s head of electronic financial services, who wrote the study.

It’s unclear, however, whether the Nasdaq and NYSE will ever remake themselves in the radical ways the study appears to envision. For example, to blunt ECNs, Nasdaq would have to adopt a highly controversial “limit-order book,” an automated price-matching system that would work much the way ECNs do now, thus making them obsolete. And on the NYSE, a move toward fully electronic trading would slowly do away with the “specialist” system that has been ingrained in the NYSE since its inception, Marenzi said.