Electronic equity market swings for the fences

This article originally was published Jan. 28, 2007. Bats Global Markets Inc. launched its initial public offering on its own stock exchange Friday, April 15, 2016.

Four months ago, Dave Cummings’ business model was left for dead. Today, his Kansas City company handles 10 percent of all trades in Nasdaq stocks.

By year’s end, Cummings expects that 1 billion shares a day will change hands at Bats Trading Inc., his upstart equity market in upstairs offices at the Briarcliff Village shopping center.

It is a lofty goal, and outsiders have found reason to doubt that Bats’ recent growth will be sustainable.

But Cummings – a Park Hill High School computer geek turned commodities trader turned entrepreneur – remains determined to compete with the big boys, the Nasdaq Stock Market and the New York Stock Exchange.

Bats Trading is fighting to secure its place in the rapidly restructuring U.S. financial markets. The company is one of many innovative high-tech trading venues grappling for position far removed from industry headlines about mergers between large U.S. and European stock exchanges.

One measure of Cummings’ focus is that Bats Trading will lose $5 million in January to get more business through the door. That’s acceptable for now, because Cummings has raised more than $30 million by selling interests in Bats to various brokerage firms.

Wall Street analyst Robert Rutschow said Bats Trading’s chances of success aren’t great, but they aren’t zero either.

“It’s kind of crazy, but he might just do it,” Rutschow said.

A knack for trading

Cummings, 37, did not follow a linear career path into the securities business.

He grew up in Weatherby Lake and, he says, mostly “messed with computers” in high school. He studied computer and electrical engineering at Purdue University and became a low-level programmer at Cerner Corp., a medical software company.

Yet Cummings had a fascination with stocks. Reading The Wall Street Journal in college, he wondered what made stock prices go up and down and, more importantly, how to profit from that.

In 1995, he left Cerner and interviewed to become a stockbroker in Kansas City. Instead of offering a job, the branch manager told Cummings he’d make the worst stockbroker in the world. What he should do is trade.

Cummings joined the trading pits at the Kansas City Board of Trade, chasing wheat prices and the Value Line stock index.

Then Cummings found a way to merge his two interests.

“I had this idea I could put programming and trading together and build a trading robot that would make markets like a pit trader, except with a computer instead of a human being,” Cummings said.

His company, Tradebot Systems Inc. in North Kansas City, started trading futures, but switched to stocks because profits looked bigger.

Now, The Wall Street Journal is writing about Cummings.

A front-page article last month chronicled Tradebot’s decision four years ago to move its computers to New York and New Jersey. Milliseconds count in Tradebot’s computerized world of “algorithmic,” or “black box,” trading. Commands from its rivals’ computers near the exchanges were able to grab trades quicker than Tradebot’s computers in Kansas City, the Journal article explained.

Specialized clientele

Bats Trading opened for business one year ago this weekend.

It is a network of computers where companies like Tradebot do their electronic trading. It caters to broker-dealer firms that fill orders for individual clients, computer trading firms such as Tradebot, mutual funds and other institutional investors, or even their own accounts. It is not your basic Merrill Lynch walk-in retail office.

Technically, Bats is what Wall Streeters call an electronic communications network, or ECN. It’s not an exchange or regulated like one, and Bats reports all its subscribers’ trades to an exchange.

ECNs first emerged in force after a 1997 regulation opened the U.S. equity market that Nasdaq and the NYSE previously held tight. The Nasdaq – itself an electronic stock exchange – lost much of its trading volume to ECNs.

Nasdaq battled back with its checkbook, folding ECNs named Brut, Strike, Island and Instinet into the Nasdaq market. The NYSE followed suit last year and merged with Archipelago, which previously had bought the Redibook ECN.

Wall Street had returned to its days of duopoly, in which most stock trading happened on Nasdaq or at the NYSE.

Cummings says he formed Bats Trading to return competition to equity markets. Bats, which stands for Better Alternative Trading System, has fought for volume partly by undercutting fees at Nasdaq. It expects to offer trading in NYSE-listed stocks starting in February.

As recently as September, however, Boston-based Aité Group dismissed Bats’ chances by declaring ECNs “dead as an innovative business model.”

In light of Bats’ success, Aité senior analyst Brad Bailey promised an update to that four-month-old report on the evolving U.S. equities market.

“What we have in there is almost ancient history. Things are moving quickly,” he said.

At the time, Bats was handling about 50 million shares a day, a small part of Nasdaq’s world of 2 billion shares a day.

Instead of folding, Cummings sold interests in Bats Trading to major Wall Street firms Lehman Bros. and Morgan Stanley, as well as other more specialized players. These companies also brought trading volume to Bats.

By Thanksgiving, volume through Bats’ network doubled to 100 million shares a day.

In mid-December, Cummings announced a plan that rattled markets. Bats would pay companies to trade there.

Bleeding badly

Normally, Bats collects a fee of 26 cents on every 100 shares traded on its system. But it also pays rebates, typically 24 cents per hundred shares.

Subscribers collect rebates when they post offers to buy or sell stocks at specific prices, called limit orders. A market center needs a steady supply of these standing offers to buy or sell. It ensures a liquid market so that any broker-dealer firm with trades to execute will find someone to trade with and at the market price.

Subscribers pay fees when they accept a posted offer to buy or sell, what Bats considers taking liquidity from its network. Because the rebate is smaller than the fee, Bats earns about 2 cents for every 100 shares that change hands through its network.

Cummings’ December announcement was that Bats would slash its fee to 20 cents and boost its rebate to 30. Instead of making 2 cents on 100 shares, Bats would be paying 10 cents per hundred.

Volume soared, averaging 250 million shares a day this month. It also means Bats is spewing red ink to the tune of a quarter million dollars a day.

Cummings promised the sale would last throughout January or until Bats hit 5 billion shares traded. He considers the $5 million loss an investment.

The sale encouraged current Bats subscribers to trade at Bats instead of other venues. It also attracted 11 new subscribers in three weeks, boosting the total to 110, according to a Bats e-mail to subscribers.

The Nasdaq fired back by issuing a “head trader alert,” though the exchange has no regulatory role. The alert said such inverted pricing creates incentives for illegal trades and manipulation. It urged firms to “use caution” when trading with a market that offers inverted pricing.

Rutschow, the Prudential analyst who covers Nasdaq, said he couldn’t recall another such warning out of Nasdaq. To him, it seemed an effort to protect Nasdaq’s volumes.

“It’s a tough business. You do what you can to stay competitive,” Rutschow said.

A Nasdaq official called the alert “urely precautionary,” and not a suggestion that Bats or any other market center condones illegal trades or an effort to protect its volumes.

Fighting the machine

Bats Trading had sent out its own reminders before Nasdaq’s alert, and Cummings jabbed back at Nasdaq.

“Sounds like the Nasdaq propaganda machine is in high gear again, spreading fear, uncertainty and doubt,” his e-mail to subscribers said.

When Bats’ sale ends Wednesday, Cummings will start to find out how much volume will stick around.

Rutschow said some of the January volume is temporary, a boost in algorithmic trading at companies like Tradebot that earned them a lot of rebates. But some also came from Nasdaq, he said.

Cummings said Bats should be able to hang on to half of its January volume boost, saying subscribers came for the price but will stay for Bats’ service and superior systems.

He said Bats needs to maintain about 200 million shares a day to achieve the “critical mass” it needs to compete.

Bats’ strategy is to remain a low-cost market center, and Cummings said it can operate at a loss to do so. Its broker-dealer owners will reap benefits from lower fees at Bats, Nasdaq and the NYSE.

All three markets, however, face competition from other emerging trading venues, including other ECNs with different strategies than Bats.

And the brokerage industry isn’t betting only with Bats. Several Wall Street firms have invested in regional stock exchanges in Philadelphia and Chicago. Others helped bankroll International Securities Exchange Holdings Inc.’s launch of its own electronic stock market last September.

“They’re using a shotgun approach, not being sure how this is going to play out eventually,” Bailey said.

Some of the biggest brokerages are even bypassing exchanges when possible by matching customers’ trades themselves through electronic platforms. Other ventures, such as Liquidnet, run trading platforms to match up large blocks of stock, so institutions can trade with each other.

“It’s not the old ‘Just go to one or two exchanges and get your trades done, ’” Bailey said. “It’s a very complicated environment that’s changing, right now on a monthly basis.”

Bats Trading Inc.

Founder: Dave Cummings, owner of Tradebot Systems Inc.

Investors: Lehman Bros., Morgan Stanley, Credit Suisse, Lime Brokerage, Getco LLC, Wedbush Inc.

Employees: 25

Headquarters: 4151 N. Mulberry Drive, Kansas City, North

Online: www.batstrading.com

This story was originally published April 15, 2016 at 4:35 PM with the headline "Electronic equity market swings for the fences."