50 Broad Street
Since its inception, Island has consistently identified and capitalized on emerging industry trends by offering market professionals greater access to the market, increased transparency, stronger technological services, and lower transaction costs. Island's proprietary technology is the centerpiece of its success in meeting these goals. Island's technology automates traditionally labor-intensive securities transactions, connects Island to its subscribers, and allows Island to monitor and analyze system performance and subscriber behavior on a real-time basis.
The Island ECN, Inc. is an Electronic Communications Network (ECN), a computerized marketplace that automatically matches buyers and sellers of stocks and other securities. Island executed trades in 53.7 in 2000, and in 2001 traded more than 350 million shares a day on average. Since December 2001 it has led all other ECNs in trades in Nasdaq shares. A fundamental principle of Island ECN is that trading information should not be the domain of a privileged few insiders. Consequently, all buy and sell limit orders as well as all trades executed on Island are displayed instantaneously in its online order book, which can be viewed by anyone with an Internet browser. Only member dealers are able to trade shares on Island, however. By early 2002, Island had more than 700 subscribers. Island's trading day, which extends from 7:00 am Eastern Time until 8:00 pm Eastern Time every business day, is one of the longest in the industry. Among the services Island offers are IslandNET, a complete Island connectivity package that includes hardware, order management software, and 24-hour-a-day connection monitoring in case of power outages. Inlet offers subscribers access to pricing data, order history, and other trade information. Island ECN is a private corporation owned by an investment group that includes Bain Capital and TA Associates.
The founding of Island ECN was a direct result of the upheaval in the Nasdaq markets in the late 1980s. Following the stock market crash of 1987, two new systems--small order execution system (SOES) and SelectNet, an electronic network--were introduced in Nasdaq. One result of the system was that trades of 500 shares or less were to the Nasdaq market maker with the best price and then executed automatically. A group of traders, called SOES bandits, arose in response to the system's unequaled speed and took advantage of it to reap quick profits trading small amounts of stock. The founders of Island developed some of the first trading software for SOES bandits.
The most important early figure was Joshua Levine. A Carnegie Mellon University dropout with a penchant for turtles, Levine moved to New York in the early 1990s where he began working with Jeffrey Citron, one of the founders of Datek Online, an online trading firm. The Watcher, one of Levine's early systems for Datek, provided traders with a way to plug directly into SOES. Levine's next development grew out of his observation of a peculiar situation: Some electronic trades were not being made, trades in which the buy and sell prices did not match because one person wanted to buy a stock for more than another wanted to sell. Levine's new system resolved the anomalous situation by enabling customers to trade stock with each other without going through traditional Nasdaq market makers. The system became the backbone of The Island ECN, Inc., which was founded by Levine and Datek Online cofounder Jeffrey Citron in 1996.
A New Way to Trade in the Late 1990s
The system Levine created for Island was a masterpiece of efficiency and simplicity. Unlike the New York Stock Exchange or Nasdaq, where brokers worked through human "specialists" or "market makers" to buy or sell stock, Island's system was completely electronic--there was no middleman. When a member broker wanted to buy shares, he entered the stock, the quantity, and the price into Island's online order book. If there was a matching order to sell in the book, the trade was automatically executed. The only restrictions were that Island handled only limit orders of 500 shares or less of stocks listed on Nasdaq. Further, only Island's member brokers could trade on the system; others had to make trades through a member broker. Levine also designed Island to be virtually fail-safe. He did not use a single mainframe that could freeze up in periods of extremely heavy trading. Instead he strung together row upon row of off-the-shelf Dell PCs, each programmed to perform one particular function, for example, to receive orders, match orders, or cancel orders; if one computer shut down, there would be a backup waiting to take over its work.
The Achilles heel of ECNs is their liquidity, in other words, how likely a trade is to be executed on the system. Island was founded as a subsidiary of Datek and in the beginning was used by the parent to execute its own trades. The connection to Datek Online, then one of the most successful day-trading firms on Wall Street, gave Island a huge head start. Datek sent tens of thousands of orders to Island every day, providing the needed liquidity to attract other brokers and even Nasdaq market makers.
A turning point came in 1997 when the Securities and Exchange Commission (SEC) promulgated new order handling rules that required Nasdaq market makers to send on to ECNs any limit orders whose price fell between the market maker's best buy and sell prices. Those ECN prices were displayed on the Nasdaq ticker. "For me to be able to have my orders displayed over the Nasdaq system was an absolute seminal event," Matthew Andresen, the day-trader at Datek who was one of the first to understand the rule's import, told the Dallas Morning News. "It's the difference between trying to sell your house with a sign in the yard or without a sign." The new Securities and Exchange Commission (SEC) rules were so critical to the company's success that Island would later call January 20, 1997--the day the order handling rules went into effect--the firm's real birthday. Island was one of the first ECNs to register with the National Association of Securities Dealers after the new rules were in place. By August 1997 it could announce that it was the first ECN to represent orders for all Nasdaq stocks.
New Leadership in 1998
In mid-1998, Jeffrey Citron and Joshua Levine stepped aside and named the canny Andresen as Island's president. When Andresen took over Island had four employees, a handful of customers, and no marketing. But soon, under Andresen's leadership, Island started to really thrive. By autumn 1999 the firm had 40 employees and had set a record, trading 6.6 billion shares in a single quarter. Around that time James Marks, an analyst at Credit Suisse First Boston, told Future Banker that he considered Island the only ECN with enough liquidity to be taken seriously. Andresen put a series of new plans in the works. The company began talking about inaugurating a 24-hour trading day. It also hoped to attract a larger share of institutional traders, such as mutual funds, although most observers thought that would be a difficult goal to achieve--the average deal on Island involved 300 shares, while institutions traded hundreds of thousands, or even millions of shares regularly.
Island in 1999: The First For-Profit Securities Exchange?
In June 1999, Island made what was perhaps its most significant (if in February 2002, still unrealized) move: It was the first ECN to apply to the SEC to become a national securities exchange, under new rules released by the Commission. If approved, the application for exchange status would put Island on the same level as the New York Stock Exchange (NYSE) and Nasdaq. It would bring Island numerous advantages: The firm would be able to trade stock listed on the NYSE. It could earn millions in revenues every year from the sale of its market data, as the NYSE and Nasdaq do. Furthermore, as an exchange it would qualify for participation in national market systems, such as ITS, which would give a powerful boost to Island's liquidity.
Some believed Island was not up to the challenge of becoming an independent securities exchange. They maintained the firm would be required to regulate itself and its members, it would have to put rules in place to prevent fraudulent practices, and it would need a trained regulatory staff approved by the SEC to perform its duties, all of which would be complicated and expensive. Island countered that its completely electronic form would make regulatory oversight much easier than that of a traditional exchange--it was completely transparent with a permanent audit trail for regulators. In January 1999, to aid its exchange application, Island named Cameron Dovi Smith general counsel. Smith, a former attorney with the SEC's division of market regulation, was hired to manage the legal end of the firm's exchange application, which was formally made in April 1999. At the same time, the company retained two attorneys, who also had SEC experience, from a Washington, D.C. law firm. Not content to put all of its eggs in one basket, Island explored other paths to exchange status. In summer 1999 it negotiated buying into the Pacific Stock Exchange (PCX), a deal that came to naught. Ties with PCX would eventually be forged first by Archipelago, a competing ECN, which would also be the very first ECN to become a securities exchange.
In September 1999, Island introduced 12-hour trading, beginning at 8:00 am and running until 8:00 pm Eastern Time. Island, which previously opened its trading day at 9:00 am, had noticed that trading early in the day was strong, with 20 percent of its trades occurring between 9:00 and 10:15. By the year's end, the numbers were bearing out the decision. Trades early and late in the day grew from about a million a day in June 1999 to around 15 million a day in January 2000, with average order and execution size climbing as well.
Introduction of Decimalization in 2000
In April 2000 Island announced that it would list prices in its online book in decimal form as well as the traditional fractions. The move was, in part, a reaction to the SEC's indefinite postponement of a July 3 deadline to switch the entire securities marketplace to decimal pricing. The National Association of Securities Dealers (NASD) announced a month earlier that it would be unable to meet the July deadline. Island hoped its move would catalyze the market. Indeed, it elicited reactions that ranged from praise to denunciation. Instinet, the oldest ECN, sent a letter to Congress demanding a rapid switchover to decimals. Some of Island's own customers, however, considered the change irresponsible and felt that it would lead to confusion and instability. Andresen defended the move, pointing out that Island already traded in increments smaller than one-sixteenth of a point and was required to round off quotation information before it was submitted to Nasdaq. Those trades never caused system problems or confusion among investors.
The move to decimals met with approval on Capitol Hill. Legislators, in general, favored a prompt change to decimals. Island's move won the company points in Congress and was expected to aid the firm's application to become an exchange. Andresen had already begun making regular trips to Washington to lobby Congress to encourage changes in the way securities markets were structured. For example, public pressure by Island helped encourage NYSE in October 1999 to rescind Rule 390, which prohibited members from trading significant quantities of stock off the trading floor. As a result, in April 2000 Island began dealing in NYSE issues.
In an October 2000 letter to the SEC, Island formally called for an end to the Commission's "trade through disclosure" rule. The rule required exchanges to execute orders at the best price available. In practice this meant orders had to be forwarded to the market with the best price--which might no longer have the stock by the time an order arrived. Island argued that investors should be informed of better prices but also allowed to buy at a higher price--at an ECN, for example--if they chose. "Knowing in a millisecond whether or not you got your trade executed--and knowing with absolute certainty--can sometimes be the single most important thing for an investor to know," Andresen argued in Securities Industry News.
It was not easy for Congress and the SEC to brush off such calls. Island ECN's remarkable success indicated that it had its finger on the pulse of the future. By mid-1999 its had 256 subscribers. At a time when ECNs were accounting for some 40 percent of all Nasdaq trades, the two leading ECNs, Island and Instinet, accounted for 87 percent of ECN trades. In 1999 Island reportedly executed trades in about 26 billion shares. In 2000 it would double that execution rate and boast nearly 400 subscribers. Island forged a number of strategic agreements in mid-2000. Ixnet, Inc. agreed in April 2000 to provide the firm with global network connectivity. It signed a deal with the South Korean Uclick Co. to establish the first Korean ECN. It also agreed, first with Unicredito Italiano SpA's TradingLab unit and then with the Spanish ECN Access Europe, to open their electronic networks to each other.
In December 2000 Island was spun off from its parent Datek Online Holdings Corporation The spin-off was the result of a $700 million investment that gave an investment group that included Bain Capital, TA Associates, Silver Lake Partners, and Advent International a 90 percent interest in both Datek and Island. Earlier investments in the two companies had fallen through because of a Datek subsidiary's alleged involvement in trading violations. Observers believed the spin-off would only help Island by distancing it from Datek's legal problems at a time its application to become a securities exchange was still before the SEC.
By the beginning of 2001 Island boasted a 14.5 percent share of all Nasdaq volume. In January alone the firm traded 7.86 billion shares, a 123 percent increase over the previous January--and that despite the Internet stock crash of late 2000. Island was the second largest ECN behind Instinet and closing quickly on the leader. The SEC had not yet ruled on the firm's exchange application--the Commission was moving slowly on the first application. The downturn in the Nasdaq resulting from the Internet stock collapse was expected to have repercussions for many ECNs--including Island--which drew their strength from day-trading first fueled by Internet speculation. Island was already pursuing a new course, however, wooing Institutional Investors.
On January 3, 2001, Island's computer system proved its worth. The Federal Reserve Board cut its interest rates that day and Nasdaq was flooded with orders as a result. The extremely high volumes caused delays in Nasdaq order executions; Island's system, however, continued to function uninterrupted, handling more than 10,000 orders a minute at one point. Later in the year, Island was able to handle more than 11,000 orders per minute for three hours straight. In Island's history, its computers never experienced a capacity-related shutdown. Only the September 11, 2001 terrorist attacks on the World Trade Center, just blocks from Island's headquarters in lower Manhattan, could force them out of service, if only temporarily. Smoke and soot from the burning towers engulfed Island's building, abruptly clogging the building's air conditioning units. Before long, the company's 2000 computers were dangerously overheated and had to be shut down. A new Island backup data center in Secaucus, New Jersey was within months of completion at the time. Within two days, however, the company had patched together a makeshift network for its subscribers.
Island Becomes a Leader at the Start of the 21st Century
The attacks seemed to have but minimal impact on Island. In the month following the attack, the firm enjoyed an 18.18 percent growth rate. In October 2001 Island passed the American Stock Exchange (AMEX) to become the nation's largest marketplace for trading QQQs, the top 100 shares on Nasdaq. During the third week of October, Island traded more than 129 million QQQ shares, more than 18 million shares more than the AMEX. AMEX had depended on QQQs for a large share of its income. In response, AMEX filed a complaint with the SEC charging Island with violating the SEC's trade-through rule requiring orders to be forwarded to the exchange with the best price. In its defense, Island maintained that 87 percent of its volume came from professional traders whom it would be difficult to cheat. It also reiterated its philosophical stance that the price of an order's execution should not be given more weight than the speed or certainty of its execution. The question was still before the SEC in 2002.
In November 2001 Island's share of Nasdaq trades grew to 23.6 percent, with a share volume of 11.3 percent and a dollar volume of 12.7 percent, enabling it to surpass its longtime rival Instinet as the leading ECN. The surge in Nasdaq volume was seen as a vital boost to Island's hope for exchange status. As Isabelle Clary wrote in Securities Industry News, "If the largest ECN cannot manage to become a stock exchange, the exchange provision in Regulation ATS might as well become mute." Island, meanwhile, forged ahead with the application process, with the hope that the SEC would render a decision by spring 2002.
Island ECN became a member of the Cincinnati Stock Exchange in December 2001. The step was the first in a plan to find an alternative to Nasdaq to publish Island's market data, as required by the SEC. Nasdaq charged Island a fee for every trade reported, whereas Island did not share any of the revenues from Nasdaq's sale of its compiled data. The firm and CSE entered negotiations over a plan under which CSE would rebate up to 75 percent of market data revenues to Island. Island opted not to pursue a merger with CSE of the sort that Archipelago consummated with the Pacific Stock Exchange earlier in the year, a marriage that in October resulted in Archipelago being granted exchange status by the SEC. Membership in the CSE would not interfere with Island's application to become an exchange itself.
In June 2002, Island reached an agreement to be purchased by its chief competitor, Instinet Group Inc. for a deal valued at $508 million in stock. Together, the two companies would represent a significant challenge to its competitors, including Nasdaq. In a press release, an Instinet spokesperson stated: "The acquisition brings together superior trading platforms with a common goal of improving customers' performance by applying innovative technology solutions to equity trading. The combination is complementary on several levels. It is expected to deliver significant synergies as a result of expanded liquidity and cost savings in clearing, technology, facilities and administration."
Principal Competitors: Instinet Group Inc.; Archipelago-RediBook; Brut ECN, LLC; Btrade.Com Inc.
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