How the beer company that created the first Internet IPO is shaking up the stock market.
POW! On a long plane flight the idea hit me fast and hard. The Internet. Why not use cyberspace, the fabulous new medium of universal communication, to do an IPO? Why not distribute our prospectus to the people who already support our company's product, Wit Beer? Just put it out there in the ether, announce that we're doing a stock offering, and let anybody who is interested download the prospectus and check it out at their leisure. For free.
This idea of an Internet IPO all started with a microbrewery. After toiling away for five years as a securities attorney at Manhattan-based Cravath, Swaine & Moore, I started Spring Street Brewing Company, with the narrow goal of bringing witbier, a unique style of Belgian wheat beer, to the United States. We launched Wit Beer on Memorial Day, 1993, in New York City and the Hamptons. Overnight, hundreds of bars and restaurants started serving our product. But ultimate success required more capital than I could get out of friends and supporters.
Originally my idea was to use the Internet to help meet our company's capital needs. And that it did. But over the last couple of years, I've come to realize that we can change how other companies raise capital and trade stocks.
Back in New York after that fateful flight, Tim Klem, my invaluable right-hand man, and I spent a long weekend separately searching the Web to assess the marketing prospects for Spring Street stock in cyberspace. When we got together on Monday morning, we were more excited than ever, for we had both come to a simple but powerful conclusion: the profile of the typical Web surfer and the profile of the typical potential Wit customer were one and the same. In short, our customers were us: young, well-educated, Internet-generation males with a penchant for surfing cyberspace and for drinking gourmet beer - often at the same time. It made perfect sense to use the Internet to get the word out to these guys that we were offering our stock for sale.
The next step was to create a Web site. We didn't need anything fancy; in fact, "fancy" would have been the wrong way to go. Instead, we created a simple collage of photographs: Wit labels, the product itself, pictures of the master brewers. We put up a narrative telling witbier's history and the story of the founding of Wit. The stock offering was described in a separate section that more or less replicated the postcards and posters we were trying to distribute.
"Public Stock Offering," this section proclaimed. "Spring Street Brewing Company Inc., American microbrewer of classic Belgian-recipe beer, including Wit and New Amber Wit, announces the public offering of up to 2,702,700 shares of common stock at $1.85 per share. Minimum purchase 150 shares."
Instead of asking potential investors to phone an 800-number, this section offered a button - a hyperlink to another site where the prospectus was replicated as a wordprocessing document. That meant that all the would-be investor had to do was click on the button to view the prospectus, download it, and print it. The printed version included a subscription agreement; anyone who wanted to buy Wit stock could fill it out and send it to us - with a check.
The Web site was an absolutely straightforward and perfectly simple statement of our offering. It was also cheap. Apart from renting the site for perhaps US$200 a month, we incurred no expenses for printing, mailing, or toll-free calls, and we paid not one penny in commissions to investment bankers, underwriters, or securities lawyers. Two hundred bucks a month is not too much to pay to reach, potentially, the entire planet - subject to securities regulations, of course.
Speaking of securities regulations, it seemed a good idea, given an earlier brush with the SEC, to run the idea past them. So I called Ralph Norman, our local examiner.
"You want to do what?" Norman's first response was cautious.
"The Internet," I told him. "The World Wide Web."
"You had better slow down," said Norman. "Hold off. Let me look into this first. I'll call you back."
I had to sweat it out for only a few hours. Norman, it turns out, was an AOL subscriber and liked browsing the Internet himself. What's more, he liked my idea of using cyberspace to sell stock, and he gave me full credit for proposing it. So the phone call that came later that day had good news. As it was, Norman informed me, the SEC nearly a year earlier had issued a press release that effectively gave approval to the electronic delivery of official documents - including prospectuses. Norman didn't think there would be any trouble in proceeding with the digital offering as long as the format of the documents on the Web mirrored the paper version of the papers that had been filed offline.
A few days later, on February 6, 1995, the SEC formally qualified our offering documents. It was the go-ahead to start selling shares.
Spring Street Brewing Company issued a triumphant press release announcing that the world's first Internet public stock offering was open for business. However, this wasn't a true IPO so much as a novel hybrid: a public offering of illiquid stock - a venture-capital offering for the ordinary investor, with no secondary trading on public markets like the New York Stock Exchange or Nasdaq.
On the first day of the offering, Tim and I busied ourselves preparing a direct mailing to our existing database - which included, among others, the 6,000 callers who had seen our 800-number published in a USA Today article on the offering. We had the leisure to get every word right; there was not a single nibble for the Internet announcement.
The following day, however, a reporter from The Wall Street Journal picked up on it and invited himself to the office. Two days later, the paper published his article. It was fantastic. The Journal reporter detailed our use of the Internet, and other articles soon confirmed that ours was the first-ever Internet IPO.
Every day after that at around noon, the mail arrived at our office with a pile of envelopes containing checks and subscription agreements. Some of the check writers lived in states that had not cleared our stock offering, so we immediately returned their checks - to the tune of tens of thousands of dollars in all. But most of the mail we received was entirely legitimate. Not surprisingly, beer enthusiasts predominated, some from as far away as South Africa, Iceland, even the Far East. When you see a guy in Reykjavìk investing $277.50 for stock in a beer he's never seen or tasted, you get a sense of that egalitarian Internet psychology kicking in.
We set up a bank account for the money and created a database of our stockholders. The database was programmed in such a way that the information was fed immediately to a certificate-printing facility. All we had to do was push a button to print out a stock certificate, which we then sent to the new stockholder.
Although we raised most of the money we sought in the first few weeks of the site's existence - thanks no doubt to the burst of publicity that followed our press release - we kept the site and the offering open for 10 months. By the time we closed it in December 1995, we had sold more than 860,000 shares to 3,500 new stockholders. Our fresh capital totaled $1.6 million - the seeds of a viable marketing and sales initiative, and, although I did not see it at the time, the seeds also of a revolution in the way capital can be raised.
__ Trading places __
Spring Street Brewing Company now had the wherewithal to hire additional staff and undertake marketing initiatives. With our coffers filled, we were finally again free to focus on beer.
Then we began to notice something funny. Even though our stock offering was closed, Web surfers kept logging onto our Wit site and inquiring, via email, where and how they could get ahold of Wit stock. Thousands of Web surfers. Maybe they had read about the offering from one of the postcards or posters we'd printed up and distributed to bars and restaurants, or perhaps they had drunk our beer from one of the bottles labeled with our Web address, or maybe they were just tickled by the notion of buying stock over the Internet. Whatever the reasons, the traffic in would-be stockholders continued apace - for six months, seven months, eight months, ten months after our offering closed. We received an awful lot of messages from people saying how disappointed they were that they could not find our stock.
We were not about to do another stock offering. And, again, the offering we had done had been that interesting little hybrid - a public offering of illiquid stock with no secondary trading. All our buyers understood that. But seeing the ongoing interest in our stock gave me another idea. Maybe we could use the Internet to create a trading mechanism whereby people who wanted to own the stock could buy it from people who already had it, and those who already had stock could sell it.
Such Internet trading, I guessed, would cost us little to engineer. I also reasoned that putting a little trading mechanism up on the Internet could be another pub-lic relations coup. And if a flurry of media interest could ignite a new burst of sales activity for Wit Beer, so much the better.
So I went to the computer section of the nearest bookstore and bought a book on programming in HTML. The plan was simple: We would create a new Web site, called Wit Trade, where buyers and sellers of Spring Street shares could find each other. Wit Trade would be a matchmaker.
To make the matches, we would build a system with two sets of bulletin boards, one for Wit stockholders interested in selling, and one for buyers interested in becoming stockholders. These bulletin boards would be just what the name implies: places to post public messages, to read the messages, and, if you liked, to answer a message by posting your response.
Say you were a buyer interested in purchasing Wit stock. You'd go to the Wit Trade site and link up to the buyers' bulletin board. There, you would type in your name, your email address, the number of shares you wanted to buy, and the price you were willing to pay. Then you had two choices. You could sit back and wait for a seller to respond to your notice, or, if you were a bit more aggressive, you could click onto the sellers' bulletin board. There, would-be sellers of Wit stock would do the reverse of what you did on the buyers' bulletin board. After typing in their name and email address, they would indicate the number of shares they wanted to sell and the price they were asking. If you, the buyer, saw a deal that interested you on the sellers' bulletin board, you would just click on that entry and open an email dialog with the person who had posted the sell offer. Obviously, a would-be seller of Wit stock had the same choice of actions: either post a sell offer and passively await the buyer's call, or click over to the buyers' bulletin board to look for a trade.
Having made the match, Wit Trade would step back and leave it to buyer and seller to negotiate a deal. They might do this entirely online, on our system or via email, or they might go offline to the telephone or fax machine or even a personal meeting - preferably in a tavern over Wit beers. If buyer and seller agreed to do a trade, we would step back in to provide online what we called a form of offer and acceptance - really a contract through which the participants would bind themselves to the transaction. The offer and acceptance form laid out the terms of the agreement and could be emailed back and forth. Once both buyer and seller had accepted the offer, they essentially had a legal obligation to buy or sell Wit stock at a particular price.
At this point, Wit Trade would act as clearing agent for the transaction. Our aim was to protect buyers from sellers and sellers from buyers, to serve as a firewall of security for both participants in the deal by becoming middlemen. The buyer would send his check to us, Wit Trade. We would then deposit it and wait for it to clear. Meanwhile, the seller would have sent us his or her stock certificate, duly endorsed. We would hold onto the certificate until the buyer's check had cleared through the bank. Once that happened, we would issue a new stock certificate to the buyer, send the money to the seller, and toss the old stock certificate in the archives. Everybody would be happy. Buyer and seller would be happy with their deal, happy with one another, and happy with Wit Beer, which was providing this investor-friendly service free of charge.
An essential part of the service was the company financial information we decided to put online. The reasons were obvious. That Web surfer who had read something somewhere about Wit Beer stock was not going to buy the stock solely on the basis of a vaguely remembered newspaper story or word of mouth from a fellow beer drinker in a bar. He or she would need something more than that - hard facts and figures at the very least. Typically, an interested buyer of an obscure, small company's stock calls or writes the company and asks for a copy of the financials. That's flattering, but with a mailing running a dollar or two per piece, the costs can mount. In fact, the more interest there is in a company, the more it can cost the company.
Wit Trade solved that dilemma, at least vis-à-vis Internet-savvy investors. With a click of the mouse, anybody could sign on to Wit Trade and, at no cost, view our financial reports. I mean all of it: not just the prospectus, but the annual reports audited by our accountants at Arthur Andersen, up-to-date quarterly financial reports, even press releases about new activities and developments. Potential investors could not just access this information, they could download it, print it out, and export the information to spreadsheets, where they could massage the data any which way they liked.
The plan was to launch Wit Trade on March 1, 1996, a Friday. We would give the launch a lavish send-off with a party scheduled for Thursday night, Leap Year's February 29, at the Internet Café in the East Village. Our press release heralded Wit Trade as the first-ever digital stock trading mechanism, described the mechanism in detail, and invited journalists to come to the Internet Café party and have the first look at a live demonstration of how it would operate.
The press response was fantastic. In addition to a hundred-plus print journalists, three television news crews showed up to film the event. Within hours of launching the system, tens of thousands of people had visited the Wit Trade site and looked at our materials. The bulletin boards hummed with names and offers. It was a highly celebratory weekend for all of us at Spring Street.
Monday morning at about 11, the phone rang in the office. The caller was a staff lawyer at the SEC. Could Mr. Klein please stand by for a conference call that afternoon? The commission would like to discuss the matter of Wit Trade.
Uh-oh.
__ The SEC face-off __
The conference call got under way at three that afternoon. The first 15 minutes of the call were taken up with introductions. I stated my name, and so did the SEC lawyers - I stopped counting at 11. There was the chief of corporation finance and the chief legal counsel. The head of stock exchange regulation, the head of clearing firm regulation, the head of market regulation, and the head of broker-dealer registration. Supporting the chiefs and heads were countless deputies, assistants, and deputy assistants.
For the next two hours and 45 minutes, I tried frantically to transcribe the blizzard of questions precipitated by this veritable synod of attorneys. They needed answers to the questions, they said, in order to determine whether they were right in thinking that Wit Trade had no business doing what it was doing. Occasionally, when I was able to get a word in edgewise, I argued that Wit Trade was simply a convenient, low-cost way to promote a beer company and facilitate fair trading in its stock. That was a legal objective, I asserted, essentially no different from the kinds of things small public companies do every day to enhance liquidity in their shares. The use of the Internet, I suggested, was a logistical matter that only made it more likely that our efforts would work. What seemed a sensible argument in my head began to sound like a desperate protestation of innocence when I said it out loud.
What's more, the argument scored no points with the SEC legal team. As they vied with one another to suggest regulations Wit Trade might possibly be violating, they seemed also to be labeling our actions as not just imprudent but impudent as well. The tone from many of the lawyers was one of astonishment at best, annoyance at worst, that a tiny beer company was causing all this hullabaloo in the first place.
On the imprudent front, what concerned the SEC lawyers was the possibility that Wit Trade might in some way, shape, or form constitute a brokerage house or stock exchange. If that were the case, we would be required to register as a broker subject to formidable capital requirements, as well as to a variety of legal conditions, provisions, and stipulations. The SEC lawyers also voiced a concern that the highly public, easily accessible Web page on which bids and orders were posted could be vulnerable to manipulation by some unscrupulous Web surfer.
But while the lawyers were crisply precise when it came to noting the problems Wit Trade had surfaced, they were uncharacteristically taciturn when it came to volunteering any solutions. At six in the evening, I finally asked: "What do you want me to do?" The convocation of attorneys gave a unanimous three-word answer:
"We don't know."
By a kind of unhappy default, it was thus agreed that Wit Trade, however slight its chances for ultimately surviving regulatory scrutiny, could continue to operate for a day or two while the SEC continued to study the matter.
Three days later, there was another three-hour conference call - with only six lawyers this time, but with the same results as had been achieved with twice that number. The SEC was still "studying the matter." Its lawyers were not prepared to tell me what was wrong with Wit Trade. In fact, they were not prepared to tell me whether anything was wrong with Wit Trade. In the kind of deliberate circumlocution I had myself mastered as a lawyer at Cravath, Swaine & Moore, they hedged, prevaricated, came down squarely in the middle, and took up a seated position right smack-dab on the fence. They simply did not know what to tell me. This business of the Internet was new to them. The innovation of Wit Trade was new to them. There were no precedents. What's more, the whole situation carriedthe unmistakable odor of "high tech," something foreign, untested, unexplored, and therefore, to some extent, unintelligible.
But while they studied the matter, while they tentatively probed at the edge of what might potentially be a whole new field for the agency's scrutiny, they did have some advice for me. In effect, their message was that I should shut down Wit Trade while they applied themselves to finding and defining the crime I would be committing if I did not shut down Wit Trade.
I confess that I got pretty hot under the collar at this point. It was fine for the SEC lawyers to debate abstractions; they had all the time in the world. But if I shut down, my entire experiment in creating liquidity for Spring Street's shareholders would be in trouble. I could deal with specific allegations of violations of statutory regulations - if we had broken a law, we had broken a law. But "Just stop what you're doing" did not strike me as fair or sensible regulatory intervention.
My argument to this effect fell on deaf ears. In fact, the lawyers told me I should consider myself lucky. "You don't realize," they said, "that people don't usually get legal advice from the SEC." What was their legal advice? That I should hire lawyers who specialized in dealing with the SEC. I knew all about such lawyers. For example, I knew that it would cost hundreds of thousands of dollars to retain them to argue my case. This was not a viable option.
"Are you ordering me to shut down Wit Trade?" I asked. "Not really," came the reply. So I didn't. "We'll get back to you," the lawyers said, "by week's end." There was a strong implication that I should be prepared for unfavorable news.
One thing was absolutely certain: I did not want to fight the SEC. It had power, time, and virtually limitless resources. I couldn't go up against it.
Gloom descended on the Spring Street office. To think that our lovely little experiment might come unglued because of an SEC ruling was a depressing thought. Sure, our investors weren't expecting liquidity; they already knew Spring Street shares couldn't be traded on the public market. But trading between Spring Street shareholders would, at the very least, create moderate liquidity for our shareholders. Nevertheless, the idea for Wit Trade had come at wit's end; I could not imagine that I would be lucky enough to have another brainstorm if this one got shot out from under me.
The air of melancholy hung heavy all day following that second, heated conference call. We sweated it out till late in the afternoon, when the phone rang with another call from the SEC. This time, however, the caller was Steven Wallman, one of the five commissioners of the SEC, each appointed directly by the president of the United States.
Before his appointment, Wallman, like most SEC commissioners, had been a partner in the securities practice of a major law firm - in his case, the prestigious Washington firm Covington & Burling. Unlike any other SEC commissioner, however, Wallman's previous life included a stint as a techie, a student of computer science as an undergraduate at MIT. So when Wallman noticed the staff activity over Wit Trade, he decided to take a personal interest in the matter. His personal interest would change my life.
"I think what you have done is very interesting," the commissioner said once the introductions were concluded. "And I see no reason why the SEC and Spring Street Brewing cannot find common ground."
Music to my ears.
"While it's true there are people here who think your operation should be stopped cold," the commissioner continued, "there are others who think Wit Trade is an important experiment, the type of entrepreneurial activity that should be encouraged. The agency is not hostile to the technology, to the Internet, or to small companies finding creative ways to raise capital or facilitate trading in their shares. But there are securities laws on the books that have been put there for good reason, and it is our job to make sure they are followed and enforced."
Then came a startling proposition: "If you voluntarily suspend the trading mechanism," Wallman said, "I would like to work with you toward a resolution that would allow you to use the Internet to create a trading environment for your shareholders. Stop the trading system for now and I promise to get back to you with real guidance on how to operate it without violating the federal securities laws."
It was the proverbial offer I couldn't refuse. I thanked Commissioner Wallman as warmly as I knew how and immediately shuttered Wit Trade. I also fired up the mighty Wit publicity machine - i.e., me and my PC - and issued a press release announcing that the SEC had asked us to back off during its review of Wit Trade. Spirits around the office rose at once; action had been taken that could once again put us in the public eye.
We got the release out the next day. The press response that followed was stunning. When it was all over, our story had been told throughout the US and Europe.
Two weeks after Commissioner Wallman's call, the SEC's resolution of the matter came to us over the office fax. We huddled around the machine, trying to read Wit Trade's fate upside down and backward. When we finally ripped the page from the out-tray, it turned out that anyway you looked at it, we had scored a pretty impressive triumph. The SEC's letter opened with such lavish praise for "our nation's financial innovators" - to wit, us - that I positively blushed as I read it. It went on to award us formal permission to resume trading our stock on Wit Trade's electronic bulletin boards - subject to certain modifications, which we agreed to.
Even before the ink was dry on the fax, I sat down to write a press release headlined "SEC Gives Green Light to Digital Stock Trading." In only three weeks, the subject was covered by countless newspapers, magazines, and television programs. It seemed not a day went by that a television crew didn't show up at the Spring Street office. Then came a number of intriguing phone calls from such technology companies as AOL and IBM, from such investment banks as Bear Stearns and Morgan Stanley, and from a number of discount brokerage firms that were themselves exploring Internet trading: E*Trade, Lombard Securities, eBroker.
A lot of these people said they'd like to come by the office, meet with me, and see our technology setup. So I spent a couple of weeks greeting visitors from as far away as Omaha, Nebraska, and, of course, Silicon Valley, California. A lot of them were awfully surprised at what we could do with our simple operation. Most of these companies had invested millions of dollars in sophisticated electronic systems, and here was our little Wit Trade mechanism, created with plain old hypertext markup language at a cost of a few hundred bucks.
Wit Trade, in fact, suddenly appeared to me to be just the tip of the iceberg. Underneath it, a huge opportunity lurked, a unique way of raising capital from individual investors through the Internet, and perhaps, too, a whole new way to trade public stocks. With its simple, static HTML bulletin boards, Wit Trade was all of a sudden looking small, limited. A far more sophisticated, far more consequential idea had captured my imagination.
__ From brewer to banker __
Spring Street's initial public offering had shown that the Internet was the perfect medium through which a small, early-stage enterprise could find and reach potential investors - people knowledgeable about the enterprise's product, and willing to risk a small investment for a potentially high return. The Spring Street experiment had demonstrated that you could do this cheaply, without using underwriters or brokers, and without having to print and mail prospectuses.
Wit Trade had shown that you could use the Internet to provide moderate liquidity. During the first week of March, more than a thousand would-be buyers and at least that many would-be sellers had met over the Internet to buy, sell, and swap Spring Street stock without needing to go through brokers, or deal with dealers, or have a seat on the stock exchange. They saved the fees and commissions, and, by executing trades directly with other investors, they avoided the spreads charged by market-makers and specialists who are the middlemen of every traditional stock market trade.Why couldn't that model work as a trading mechanism for other companies, too?
For if there was a single theme that had emerged over the past few weeks, standing out like a bright red thread in a tapestry of pale gray, it was this: An increasingly large community of investors and entrepreneurs wanted to escape stock brokers and investment bankers and all the other intermediaries and barrier-builders. They wanted the kind of direct access to one another and to information that they were accustomed to getting and had come to expect from the Internet. They wanted to be wired to investment possibilities and investors - online, in real-time.
Why not apply what had worked for Spring Street to a wider canvas? That idea was churning in my mind in the latter part of March 1996. What I was contemplating was nothing less than an investment bank and brokerage firm that would arrange stock offerings and facilitate stock trading on the Web. Sure, there would be a fee for the service, a few cents for each share traded. But it would provide a whole new set of cost savings to the individual investor that would far outweigh comparable fees charged by traditional brokerage houses.
This company would let early-stage companies and noninstitutional investors meet directly, on their own level playing field in cyberspace, thus creating a model for capital formation more efficient than any that existed to date.
The company would develop a digital stock market in which sellers and buyers would interact directly. For retail investors who resented being excluded from the old-boy network that distributes the best stocks to wealthy individuals and institutions, my putative company offered an unprecedented opportunity for an equal shot at initial public offerings. That alone could attract a large pool of prospective investors to the new online investment community.
The company would be called Wit Capital (which can be found, by the way, at www.witcapital.com/).
__ Stock 101 __
That was the theory. However, in practice stock trading was a world about which I knew virtually nothing, despite having spent five years as a securities lawyer.
As had been the case with beer, the first item on the agenda was education. We started with the basics, with the investors who want to buy or sell securities. To do that, the investors place orders through brokers. The brokers are agents who earn commissions in exchange for routing their customers' orders to a marketplace.
There are two types of marketplaces for stock trading in the United States, and the way an order is executed depends on the type of marketplace - whether a stock exchange, like the New York Stock Exchange, or a dealer market, like Nasdaq.
In the New York Stock Exchange, the broker routes all the orders relating to a particular stock to a specialist. Specialists are people assigned to particular securities or categories of security. They then attempt to match the orders routed to them by brokers - a buy order with a sell order. If no such match is readily available, the specialist will trade against his or her own account, acting as principal in the transaction.
In Nasdaq, the order can be routed by a broker to any one of the securities firms that regularly trades in the security. These firms, which also buy or sell shares as principals, are called market-makers.
Both specialists and market-makers charge for shares traded through them. This charge, called the "spread," is the difference between the bid price for which specialists and market-makers offer to buy the stock and the ask price they set to sell the stock. They're entitled to this spread, or so they say by way of justification, as reward for their role in guaranteeing a stable ongoing market in the security. They do this by trading the security for their own account against any broker's orders, whether the price of the shares is moving up or down, and whatever the demand. It means that the investor, you and I, can be certain that our buy or sell orders in that stock will always be executed at once.
If the stock is very liquid and is trading back and forth fast and furiously, the spread will be small, perhaps even as small as an eighth or even a sixteenth of a point (or dollar) on each share; if trading is sluggish, as it is for the vast majority of Nasdaq issues, the spread will be large - often as wide as 50 cents on every share, and sometimes as wide as $2.
That is the basic brokerage business. It has been a good business for centuries, so it is no wonder that brokers, dealers, specialists, and market-makers have been at best wary and at worst resistant to any radical changes. Brokers have discouraged, and occasionally attempted to sabotage, every technological innovation that threatened to alter the way in which stocks were traded. It's not surprising. Such changes, they feared - perhaps rightly - would threaten the supremacy of the brokerage firms that were founded on and flourished within the existing system.
But like the genie that could not be put back in the bottle, technology over the past 20 years managed to create a variety of computer-based trading systems that essentially cut out the specialists and market-makers. It did this by connecting buyers and sell-ers of stocks directly; it thus made possible transactions "within" or "between" the spread. In fact, for institutional traders, electronic trading systems with names like Instinet, Posit, and AZX accounted for nearly 20 percent of the daily volume on the major stock markets over the last decade.
Instinet, founded in 1969 and today owned by Reuters PLC, the huge British multinational news and information processing conglomerate, is the biggest of the electronic trading systems for institutional traders. Using networked computers and proprietary software, Instinet offers institutional investors an electronic order book. Trading parties simply enter their orders to buy or sell securities directly into the order book. It means that when the big institutions want to buy or sell stock, they don't call a broker who then calls a specialist or market-maker. They just boot up their desktops and check the order book on the computer screen. If there's a sell order they'd like to take, they click on it and take it. If there's a buy order they find attractive, they click and "hit" it, as the jargon goes. Say Institution A wants to sell 10,000 shares of Intel at $100 a share, and Institution B wants to buy Intel shares at $99. The market price is then set at Bid $99/Sell $100, which means that the market-maker will buy from A at $99 then sell to B at $100, making a $1 spread. In electronic trading, A and B could meet directly at $99.50, cutting out the market-maker and sharing the savings, and paying only a few pennies per share to the broker.
No broker, no dealer, no market-making middleman, no spread. The trade is executed directly between buyer and seller, each of whom pays Instinet a tiny fee per share traded. Today, Instinet alone does more than 15 percent of the daily volume of Nasdaq and the New York Stock Exchange.
Posit, the second-largest electronic trading system, operates differently. As opposed to Instinet's hit-and-take system, Posit uses what is called a crossing mechanism. Institutions enter orders into the Posit system anonymously and without specifying a price. Five times a day, Posit collects the buy and sell orders, then matches or "crosses" them to pair a buyer with a seller. The final trading price is based on the median of the stock's current ask and bid price in its primary market, say the NYSE or Nasdaq.
All this - and more - we learned that summer of study. It was stunning to consider how, when it comes to trading stocks, the huge institutions are very different from you and me. They do not use traditional brokers. They do not pay the same types of commissions. They do not route their orders to traditional marketplaces where the specialists or market-makers impose a spread on every share transacted. They just match directly with other institutional investors within the spread. And the businesses that help them do it have grown huge and rich in the process.
As the hot summer wore on, my idea began to come into focus. Why couldn't we develop something comparable for individual retail investors? Create an electronic trading system that would match buyers and sellers directly, thus cutting out the middleman - disintermediating the intermediary, as the jargon had it - and saving the spread?
The big electronic systems that served the institutional investors were built on proprietary networks and geared only to large block trading. Such a system would be prohibitively expensive to build and inappropriate in any case. No, my idea was to deliver a comparable model to individual investors through the Internet, an open-architecture, low-cost public medium that was perfect for the small-scale transactions that retail investors dealt in.
We hung up a blackboard and did some calculations. How would such a system work, and how would individual investors benefit? The numbers we came up with helped clarify my developing idea. This was something much bigger than Wit Trade, much more than simply providing a modest bulletin board on which shares of obscure beer companies could trade. This was a whole new kind of electronic trading environment, using the Internet as the public backbone, to serve individual investors. In so doing, we would be leveling the playing field for all investors - individual and institutional, zillionaire and common folk.
Chances are, not everybody was going to like the idea.
__ Revenge of the brokers __
Brokers had not the slightest interest in routing their orders to our new trading system. The reasons became obvious the more I learned about the many paths to broker profits built into the existing system.
In addition to commissions, brokers earn a little something extra when they route customer orders to market-makers or specialists. The market-makers pay what is called payment for order flow, or order flow remuneration - a percentage of the profit the market-maker has made in the trade. Call it an incentive payment from the specialist or market-maker, something that keeps the broker sending the order flow their way. Or call it by its rightful name: a kickback. The specialist or market-maker is willing to pay it in exchange for the opportunity to trade against the order.
For example, suppose Joe Smith orders his broker - we'll call her Betty - to sell 1,000 shares of ABC Corporation. There's a range of market-makers to whom Betty might take the sell order. Fred is one of those market-makers. He can buy ABC stock at $10 per share and sell it at $10.25 per share, thus making a quarter-per-share spread on the order. Obviously, Fred wants as many orders to trade ABC stock as he can possibly get. It makes sense, therefore, to offer Betty 2 cents per share in payment for her customers' order flow. Fred still makes 23 cents per share on the deal, so he comes out ahead.
And so does Betty, for whom the spread is not the issue. In fact, the bottom line is that your broker, the agent you have hired to work on your behalf, is not necessarily getting you the best trade possible. She is not necessarily even looking for the best trade possible. She is looking for the market-maker who will give her the best return possible. In fact, your broker's share of the market-maker's profit is more important to her than the commission she gets from you.
In the meantime, you the investor are not getting what you paid for - i.e., a loyal agent dedicated to finding you the best possible execution at the best possible price.
You might think order flow payments would be illegal. I did. How could a broker get away with selling her customers' orders? Didn't she have the fiduciary duty to get the customer the best price possible? How could she get a kickback for selecting one market-maker over another, or over a competing execution service?
But when I did some research, I found that order flow payments had been sanctioned by the courts and even embraced by the SEC regulators.
It is an open secret that order flow payments are pervasive in the brokerage industry, and it was obvious as I went from brokerage firm to brokerage firm that the brokers had no intention of giving them up no matter how bad they were for customers. It was naïve and ill-conceived, they said, to expect brokers to forgo that sizable portion of their revenue represented by order flow payments just so they could get their customers better prices! Even the discount brokers, renowned for having aggressively advanced the interests of their customers over the business-as-usual procedures of the large full-service brokerage firms, laughed at our proposition of a digital stock market. Put the interests of customers above the few pennies per share they earned by selling their order flow? Nonsense.
No wonder we ran into a wall at the borders of the brokerage community. We'd get a meeting at yet another firm, demonstrate our technology, describe our plans for the digital stock market, and wait for the invariable question: What happens to order flow? Then, when they heard the answer, we waited for the invariable response to our proposal: No.
Initially, we thought we could appeal to brokers who wanted to get better prices for their customers. But that failed. Now, we would have to create our own brokerage firm. We would have to build a direct relationship to each and every individual investor, then use our digital trading sys-tem to let our customers trade amongst themselves in the new marketplace.
This effort, however, was going to take a bigger team, more technology, and even more capital. (Among the more than 40 investors in Wit Capital would be Wired Ventures, which now holds a minority stake.)
We were well aware, of course, that all around us lots of new brokerage firms were likewise using the Internet and electronic trading. Through these technologies, they were lowering commissions while offering customers cost savings. They were also giving their customers unprecedented access to account information and to news and information services that helped form investment decisions. We decided that Wit Capital would also provide these low-cost brokerage services, news and information, research, and an array of other services and other tools. But Wit would of course go further than that. It would also offer free access to such investment banking products as initial public offerings and venture capital investment opportunities, and, most important, it would provide access to our digital stock market, a place where users could buy and sell stocks with each other, directly, without having to pay commission to a broker. Wit would make its money only off small transaction fees.
__ The future of the stock market __
For most of the last century, the average full-service brokerage firm has earned hundreds of dollars in commission on an average stock trade. Such fees were traditionally seen as appropriate to recompense the firm as a whole for its aggregated experience, expertise, and guidance, as well as for the trade transaction.
Then in the 1970s, a number of so-called discount brokers - Charles Schwab and Fidelity Investments prominent among them - challenged the traditional model of bro-ker commissions. A new model emerged, one that recognized that technology had dramatically reduced the cost of executing a trade. It also recognized that broker advice and expertise might not be as significant or valuable as brokers want investors to believe.
But remember how the big institutions trade stock? They don't call a broker who then calls a specialist or market-maker. Institutional investors just boot up their desktops and check the order book on the computer screen. Then they click their mouses to play hit-and-take or the crossing mechanism market.
No broker, no market-making middleman, no spread, no payment for order flow. The trade is executed directly between buyer and seller, and the electronic trading facility that has made all of this possible takes its tiny fee per share traded.
Until recently, however, it was inconceivable that a similar mechanism could provide similar benefits to individual retail investors.
Enter the Internet and the Web. Instead of the market-makers controlling order flow, the order goes to whoever gives the best price.
If that rattles the cushioned cocoon of complacency in which broker/dealers now thrive and sends them back into the fray of customer-driven market forces, so be it. Perhaps it will propel them back to their first obligation: serving their customers' best interests. And that, in turn, may stir the competitive and creative juices of all the participants in the stock-trading process. This is no small mission - and it's not going to happen all at once.
In March, Wit will begin to offer no-spread direct trading. We will start with a handful of Nasdaqstocks, then add more over time.
Ultimately, I believe, a wholly digital stock market could handle more volume than the traditional market; at that point, it would displace the traditional market.
In the future, the stock market will not revolve around brokers or dealers or specialists. It will not be limited to a physical location, to a trading floor, even to a single central database. The stock market of the future will take place whenever individuals access each other to trade securities. A seat on the stock exchange of tomorrow will be any chair in front of a computer with a modem.
