For Jerry Putnam, founder and CEO of an electronic stock-trading network called Archipelago Holdings, the big test arrived unexpectedly last November 28. Putnam was just wrapping up a meeting in New York when his BlackBerry flashed an email from headquarters: “Check out what’s going on with Enron.” Standard & Poor’s had announced that it was down-grading Enron’s bonds to junk status, sending the stock of the once-mighty company into a death spiral.
When a company’s shares crater, it’s up to the New York Stock Exchange specialist responsible for trading the stock to “catch the falling knife” — to buy into the selling. The Standard & Poor’s announcement unleashed a stampede to dump Enron, forcing the Big Board to declare an order imbalance and halt trading of Enron and other related stocks. The knife was just too sharp for the overwhelmed specialist to catch.
The knife wasn’t too sharp for Putnam’s operation. As Enron sell orders blinked across its computer screens, Archipelago kept at it. Finally, after a 29-minute blackout, the Big Board resumed trading. For Putnam, those 29 minutes were a defining moment. Archipelago and the other electronic marketplaces traded more than 10 million shares of Enron. That put the lie to criticism that the electronic-trading markets, which lack the NYSE’s 210-year history, can’t safeguard markets in stressful times. “This was a tragedy for Enron and an embarrassment for the Exchange, but it was proof of concept for us,” Putnam says. “Enron collapsed, but on our system, it collapsed in an orderly fashion. Meanwhile, the New York Stock Exchange’s systems overloaded. Big deal. In the end, nobody missed them.”
Putnam says this without a trace of the hubris that fueled so many young companies just a few years ago. He knows that Archipelago isn’t about to topple a Goliath like the NYSE. But for Archipelago to win, he argues, the Exchange and Nasdaq don’t have to lose. He is creating an alternative to the established powers — a system that is forcing stock markets to radically change the way they operate. It’s a simple fact that more and more volume is moving to electronic platforms. Putnam says that in five years, “there will be a significant electronic stock exchange in the United States, similar to those in London and Paris.” He leaves no doubt that Archipelago will lead the charge.
Putnam himself offers lessons on how innovators in every industry need to operate today. He is overflowing with bold ideas and big ambitions, but he doesn’t act like a wild-eyed business revolutionary. At the level of strategy, he thinks outside the box. But when it comes to the messy, high-stakes work of making change, he has learned how to innovate inside the box.
A Whole New Way to Trade
Jerry Putnam is the face of Wall Street’s future. He helped create a new class of trading systems, known as electronic-communications networks (ECNs), which use computers to match bids and offers. Because of their ability to match trades in milliseconds and cut into dealers’ spreads, ECNs are now widely used by online brokerages, market makers, and institutional investors, putting pressure on the established exchanges.
Archipelago is not the largest electronic network. (Instinet and Island share that distinction.) But it is the fastest growing. And late last year, it became the largest in terms of total share volume, although a large portion of its volume is routed to other markets. Like the other top-tier electronic networks, Archipelago has sparked a rush to get a piece of the action among those who will lose big if they are left behind. That’s why Putnam’s challenger brand is being funded by some of Wall Street’s power players. Archipelago has raised about $300 million from the likes of mutual-fund manager American Century, CNBC, E*Trade, Goldman Sachs, and Merrill Lynch.
But Putnam isn’t content just to build a trading network. He is building a national electronic stock exchange. In March, he launched the first totally open, fully electronic exchange when he allied Archipelago with the San Francisco-based Pacific Exchange. The result, dubbed the Archipelago Exchange (ArcaEx), is publishing its limit-order book on the Internet (the first exchange to do so), listing stocks on its own, and attempting to lure blue chips away from other exchanges.
In effect, Archipelago is mounting what could be the biggest challenge to Nasdaq since that market was itself the fiery up-and-comer some 30 years ago. But Nasdaq is fighting back. It plans to launch its own computer-driven “ECN killer,” the SuperMontage trading system. Even the mighty Big Board, which in the past 12 months has seen the electronic venues nearly double their share volume in NYSE-listed stocks (albeit from 3.3% to 6.1%), is rolling out its own electronic-trading initiatives. This April, in a big break from its history of paper-based trading, the Exchange unveiled NYSE Direct+, a computer-driven system that executes limit orders in seconds.
Market watchers liken the revolution on Wall Street to the breakup of AT&T. Just as no one foresaw the wave of innovation that followed the dissolution of Ma Bell, no one can be sure how the changes on Wall Street will play out. That said, one thing is clear: Wall Street’s market structure is up for grabs. “We are living in phenomenal times,” says Greg Smith, author of a recent J.P. Morgan Chase report on ECNs. “The Exchange’s dominance is slowly eroding. As a group, ECNs have reached a critical mass that will not be displaced.”
Origins of a Challenger
Its business is stock trading, but at its heart, Archipelago is a technology shop. Its headquarters, in an office tower in downtown Chicago, is glitz free. Unlike at the Exchange, no paper litters the floor; no shouted bids fill the air. At Archipelago, the work of electronically matching buy and sell orders occurs out of sight, in a high-security server farm that takes up two entire floors.
On a Monday morning in early March, about 30 staffers crowded into a standard-issue meeting room. Seated at the head of the conference table, outfitted in a preppy Ralph Lauren polo shirt and white khakis, a youthful-looking Putnam could easily have been mistaken for a rank-and-file employee (which he has been on more than one occasion). Surrounding him were Archipelago’s tech-team leaders, black belts in the complex, arcane world of markets software.
Measured in the split-second rhythms of stock trading, Putnam’s experience melding high tech with high finance extends over several lifetimes — all the way back to the mid-1980s. As a rookie institutional broker at options trader Walsh, Greenwood & Co., Putnam got a close-up look at how a breakthrough technology could yield big commission dollars.
Walsh, Greenwood had developed the first PC-based options-quotation system, called the Shark, which enabled users to build real-time graphs and analytics from trading data. Demand grew so high that Putnam soon found himself selling the Shark to institutional investors. “I saw how Wall Street was evolving, and I saw how the PC was evolving,” he says. “Then someone came along and wrote a program to help Wall Street leverage the PC. I knew that it would change the way we did business.”
After the market crashed in 1987, Putnam left Walsh, Greenwood and drifted through four securities firms in six years, chafing under the bureaucracy. He hit rock bottom in 1993, when Prudential fired him. The company accused him of making an unauthorized trade on behalf of a client and later dropped an arbitration case against him when it failed to substantiate the allegation. By then, it was too late. Putnam’s tenure on Wall Street was over. “I figured I could screw up by myself just as easily as I could with someone helping me,” he says. “So I decided to start my own company.”
He launched an online broker-dealer to serve institutional traders and rapid-fire day traders. Tellingly, he named it Terra Nova. He was bound for the new world of electronic trading. Right around the time that he was starting the new company, Putnam met Stuart Townsend, who, with his wife, MarrGwen, was running Townsend Analytics Ltd., a software-development company for financial markets. The Townsends are relatively unknown outside the exotic world of markets software, but within that world, they are highly respected. They were impressed with Putnam’s ability to spot market opportunities for new technology. And Putnam was bowled over by Stuart Townsend’s revolutionary piece of software called RealTick — the first-ever Windows-based real-time quotation system. Terra Nova quickly entered into a partnership with Townsend Analytics to sell RealTick to institutional traders.
“But things really became interesting when Stuart taught RealTick how to trade,” recalls Putnam. Townsend wrote an algorithm that enabled traders to view live bids and offers and get immediate access to Nasdaq to execute trades. Putnam and the Townsends marketed the souped-up RealTick to “SOES bandits” — day traders and momentum traders who exploited the inefficiencies of Nasdaq’s Small Order Execution System. “These guys would fire orders at Nasdaq market makers who were slow to move prices, and the market makers would have to fill the order through SOES,” says Townsend. “Then they’d turn around and sell the order to people who had already adjusted their prices. They made a lot of money from dealers who were unprepared for the efficiencies of the electronic marketplace.”
Make no mistake: Speed is not a priority for every trader. For institutional investors such as retail mutual funds, it’s more important to find deep liquidity and to get that big block order filled in one transaction, no matter how long it takes. But RealTick’s ability to pick off slow-moving market makers pushed Putnam and the Townsends to seize quickly on the lesson that the speed of computer-driven trading systems would radically change the way investors did business with markets.
Innovation by the Book
Putnam is a Wall Street maverick. But he’s no reckless rule breaker. A favorite tactic is to learn the rules of Wall Street intimately and use them to his advantage. That’s how he launched Archipelago.
In 1996, trying to make a go of his business, Putnam read a 1,000-page tome that spelled out new order-handling rules from the SEC. The rule set was handed down after a two-year investigation into claims that Nasdaq dealers kept the spreads between stock prices artificially high. One outcome of the SEC edict was that it allowed electronic networks to link directly to Nasdaq and let market makers access limit-order books through Nasdaq systems. Putnam realized what that meant: An electronic network could fully integrate its systems into Nasdaq, display its quotes, and have those quotes accessed. The ruling could make his outfit a player.
The SEC knew that the three existing, private electronic-trading systems — Bloomberg Tradebook, Instinet, and Island — would apply to become ECNs. “But the SEC never expected to hear from a startup in Chicago,” says Putnam. “I told them we’d be ready when the rules went into effect in January 1997. I don’t think they realized that they had created a new industry.”
Putnam and his team had just eight weeks to nail the deadline. He suspected that regulators would approve just one new company and then wait until 1998 before permitting other upstarts to follow. That would give him a 12-month jump on the inevitable competition. Fortunately, he already knew two people who could build an ECN in record time: Stuart and MarrGwen Townsend.
It was Stuart Townsend who gave the new network the name Archipelago, a clunky word that sums up a radically new model for executing trades. The SEC’s biggest objection to Putnam’s application was this: Unlike Island and the other networks, Archipelago didn’t have access to a deep pool of liquidity. Putnam said he didn’t need one. His plan was to leverage an open-architecture approach that would link his system not just to one single island of trading but to a group of islands — an “archipelago” — of networks and stock exchanges. If Archipelago couldn’t find the best price on its own order book, it would find it somewhere else, whether that meant going to Nasdaq, the NYSE, the American Stock Exchange (Amex), another market maker, or even another electronic network.
Archipelago’s open-architecture model was a triumph for the democratization of information through technology. It and the other electronic networks cut out dealers and other middlemen, allowing institutional buyers and sellers to post prices directly to each other. As a result, transaction costs tend to be lower than on the exchanges, and executions are faster. Trades on Archipelago’s system are completed in less than a second, while a typical man-made trade on the Exchange can take 16 seconds. “That’s a lifetime in a volatile market,” says Putnam.
Putnam is pushing speed and transparency to another level on ArcaEx, the first U.S. stock exchange to publish an open book that displays every pending limit order. Unlike traditional exchanges, there are no insiders with information advantages on ArcaEx, because prices and share quantities are broadcast to the trading world in real time. Bottom line: There are no insiders with trading advantages. “There’s a reason why it costs millions for a seat on the New York Stock Exchange,” says Putnam. “A seat on the Archipelago Exchange costs nothing, because it’s worth nothing. Everything is transparent.”
On an early morning in March, Putnam and some other executives gathered around a PC and watched as the Archipelago Exchange executed its first trade, on a Pacific Exchange listing called the Thai Fund. Not exactly a heavy-volume security, but that’s the point. The plan is to start small, keep testing the system, and gradually phase in Amex, Nasdaq, and NYSE stocks.
As he watched ArcaEx take its first tentative steps, Putnam says that it felt a little anticlimactic. For a moment, he thought about everything that Archipelago had accomplished since 1996: It had built the exchange. It had the jump on technology. And in those server farms, it had enormous bandwidth. But in a sense, it had taken six years just to get to the starting line of what’s shaping up to be a marathon race for market share.
The NYSE has launched a counterattack with Direct+, proof that the success of the electronic networks has pushed the Big Board to innovate. “The Exchange has huge credibility,” says Adam Townsend, a J.P. Morgan Chase analyst. “If the Exchange can get things right on the technology side, traders will continue to work with it directly. If it can’t, the orders will migrate to the most efficient platform.”
Putnam, meanwhile, is focusing on the challenges that lie ahead: building volume; winning over listings from the other exchanges; and coming up with new products, such as single-stock futures and options. Now is not the time for hunkering down and retrenching. “We have to challenge well-established businesses,” Putnam says. “We have to outsmart them and outthink them. We’re running over quicksand: If we stand still, we’re dead. I’ve surrounded myself with smart people, and I tell them that we have to do the hard stuff. I tell them all the time, ‘We have to think big.’ “
Bill Breen (firstname.lastname@example.org) is a Fast Company senior editor. For more articles on financial-markets innovation, visit our Web archives.
Sidebar: Innovation by the Book: Jerry Putnam’s Plan
Jerry Putnam, founder and CEO of Archipelago Holdings, has three big items on his to-do list — items that will ultimately determine Archipelago’s future.
Get big fast. These days, high-stakes innovation is not a game for pip-squeaks. In March, Archipelago and REDIBook, the fourth- and third-ranked ECNs in terms of volume, completed a merger. The combined entity, which will keep the name Archipelago (Putnam will remain CEO), can already claim trade-execution volumes that nearly match those of Instinet, the top-ranked network. But that’s not enough. “We need to get bigger,” says Putnam. “There are too many players in our industry; we’re all trying to preserve share and grab more. The biggest guy is going to win.”
Have bold ideas, flawless execution. Archipelago already claims the highest concentration of servers in Chicago, and the company expects its server farm to keep growing. “We’re moving from being a broker-dealer who does what it can to keep everything running to being a company that is an integral part of the national market system, with lots of requirements for redundancy and backups,” says Stuart Townsend, Archipelago’s CIO. “At this point, it’s almost like running a nuclear reactor.”
Become the clear alternative. Putnam doesn’t expect to bring down Nasdaq and the NYSE. But he does expect to make Archipelago the most compelling alternative to the big guys: “It’s not like we’re trying to build an online grocery store. There are already tens of millions of investors out there. We just have to win them over.”