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Radical innovation: kansas city takes on wall street

February 20, 2007

The dynamic opening up of markets is challenging the incumbents in ways they never thought possible.

NASDAQ built a reputation as the exchange of the technological boom, with the respective highs and lows that came with the time. It was the sexy alternative to the NYSE.

Now it looks like NASDAQ and the other exchanges are under attack from the most unlikely of locations, Kansas City.

BATS is an alternative exchange based in Kansas City and run by a hyper-smart and aggressive 37-year old, Dave Cummings.

The exchange has come from nowhere and with limited start-up investment, in just a year, to take on the mighty NASDAQ.

It has now attracted attention and investment from blue-chip houses including; Morgan Stanley, Credit Suisse and Lehman Brothers.

BATS has an ambition to become the third largest equity market in the US and to conduct a billion daily trades.

Cummings created BATS in the Summer of 2005, when he saw a massive gap open up in electronic exchanges as NYSE purchased Archipelago and NASDQ acquired Instinet.

He was driven by a fear that the exchanges would raise their fees; Cummings saw consolidation as a threat to his trading business, a fear also shared by the leading investment banks.

“When all those got taken out, we saw that the desire to innovate and do things differently just wasn’t there. We felt we could play that role and play it well.”

Dave Cummings

Like other electronic exchanges, BATS matches buyers and sellers for a small fee.

BATS is catering to a huge need that’s come from the rise of algorithmic trading, a phenomenon that’s impacting global financial markets; it currently accounts for 40% of all trades on the London Stock Exchange. Goldman Sachs predicts that it will reach 60% by 2008, with obvious implications for human traders.

While algorithms have been used for some time, especially by hedge funds, new strategies are being employed around speed. For example, both Dow Jones & Co and Reuters now both release news in computer-readable formats specifically for algorithms.

Algorithms work fast and frequently generating a volume bonanza for all exchanges. Total US daily trading volume is averaging 6 billion in 2007 and is forecast to rise to 8 billion in 2008.

Despite the huge opportunity, BATS needed to get its name out there, so it has has to be marketing itself; blasting out emails to key traders on Wall Street and quickly got a response from the heads of both NYSE and NASDAQ. This email list has now grown to 1,000 traders and influencers.

In January 2007, BATS went even further, paying traders to switch from NASDAQ. The tactic seemed to work, by the end of January, BATS was handling 13% of the volume of NASDAQ-listed stocks.

The model is obviously based on acquiring a huge volume of trades; fees are far lower than any other system. It charges customers who lift orders from its system 26 cents per 100 shares but offers a rebate of 24 cents to those posting.

The BATS revolution hasn’t gone un-noticed.

“The success at BATS during its first year has been noteworthy and is even more impressive given how little it has cost the company to establish a meaningful market position. We believe the company’s flexibility and innovation will continue putting pressure on the exchanges.”

Raymond James

The entire BATS system was built for less than $2m and the company has spent no more than $14m all in. It’s also attracting new capital faster than it can spend it.

BATS has now set its sights on the NYSE where it will be able to make even more inroads into trading of NYSE-listed shares because its trading platform is faster than the NYSE’s hybrid platform that’s a cross between electronic trading and that of the old-fashioned floor.

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