J.P. Morgan & Co. said Thursday that it had agreed to acquire a 20% interest in Archipelago, one of a new breed of networks that is bringing rapid change to securities trading processes.
The dollar amount to be invested in Archipelago Holdings LLC of Chicago was not disclosed. The Morgan investment would follow similar ones by Goldman Sachs Group and E-Trade Group, indicating the high level of interest in such electronic communications networks, or ECNs, from the investment banking community.
J.P. Morgan has a history of participating in trading and clearing infrastructures and sees its involvement in Archipelago as part of an effort "to pull a fragmented marketplace together," said Robert C. Gasser, the New York banking company's head of U.S. equity trading.
Archipelago was one of the first four ECNs to gain Securities and Exchange Commission approval in January 1997, and such entities now account for 30% of Nasdaq activity.
They pose a challenge to traditional trade-execution methods by bypassing the market makers who profit from pricing spreads.
In competition with other ECNs-the largest are the Reuters Group subsidiary Instinet and Island ECN Inc.-Archipelago touts its execution capabilities and says it is the only one with major investors from both the institutional and retail financial service sectors. It said its average daily volume has more than doubled since December.
J.P. Morgan regards Archipelago as offering the best execution for clients in terms of price, speed, and size of orders, said Mr. Gasser.
In the same technological vein, Morgan announced earlier this week that it and PricewaterhouseCoopers had developed and launched a protocol to support derivatives trading over the Internet. Morgan also had a pioneering role in developing and spreading its methodology for measuring market risk, known as RiskMetrics.
The explosion of technology has caused the equity marketplace to become fragmented, Mr. Gasser said. The "velocity and volume" supported by the Internet, in addition to free information delivery and seamless communication, "have made it impossible for humans to intermediate the way they used to."
As fast as they are growing, ECNs face challenges in displacing the old way of doing things. One of these is creating liquidity, said James Marks, electronic commerce analyst at Deutsche Bank Alex. Brown. ECNs work best with high-volume stocks that can quickly find matches for executing orders, he said.
When market makers are present as intermediaries, they can create liquidity by taking a long or short position in a stock before a match is found. For less liquid stocks, electronic order-matching systems would be forced to route the order away from an ECN to a human.
Mr. Marks said that, compared with Instinet or Island, Archipelago does not have the volume to generate sufficient liquidity.
He wondered why Morgan and its investment management affiliate American Century Cos., which will be contributing a fourth of the 20% stake, chose Archipelago. He called the move "highly speculative."
Mr. Gasser said Archipelago was chosen for its open architecture that allows for communication outside of the ECN. He contended that this lets it tap liquidity from other sources, including other ECNs like Instinet.
J.P. Morgan's agreement with Archipelago follows one it announced in May to invest in a United Kingdom ECN, Tradepoint Financial Networks PLC. Morgan and Archipelago were part of a consortium-also including Instinet, Morgan Stanley Dean Witter & Co., and Warburg Dillon Read-planning to acquire a majority interest in Tradepoint.
The derivatives protocol it announced this week-Financial Products Markup Language, or FPML-would provide an "electronic definition" that could mark the start of a new era of Internet-based derivatives dealing, said Philippe Khuong-Huu, head of credit derivatives and interest rate derivatives trading.
Mr. Khuong-Huu said Morgan developed FPML, which uses XML, or eXtensible Markup Language, to fill a gap it recognized in the derivatives market, where outstanding contracts have a notional value of $40 trillion.
Unlike the foreign exchange and government bond markets, which let counterparties transact electronically, derivatives trading and settlement processes "seem to be in the stone age," he said.
Morgan appears to be following the path it successfully took in making RiskMetrics an industry standard. Once it had developed risk software applications using its methodology, the company spun off that division as a separate software company.
It now plans to develop software applications for FPML that would enable derivatives trading over the Web.
