OTC Brokers and Electronic Communication Networks

The Electronic Energy Broker Model

There are three essential elements of any business transaction: Content, Clients, and Connectivity. This model is even more relevant to the Exchange industry and its offspring, the Broking industry.

• Content – people need what the Exchange has to sell, namely hedging and speculative tools.
• Clients – captive clients are even better, which near monopolies like Exchanges have.
• Connectivity – this is technology; phones, IMs, ASPs, and Web Based Platforms.

Liquidity Creates Liquidity

All brokers possess these 3Cs in some form. Their Content is the markets they show clients. Their Clients are not captive, but every broker has one or two on which it can count. An improvement in their Content (markets) gets more Clients, and vice-versa. This Content-Client feedback loop can create a self-sustained liquidity cycle that is hard to beat.

There are a couple problems with its reliability however. For one; clients blow up, move on, retire, or simply get eclipsed by a competitor. For another; Brokers are essentially independent contractors hanging their hats where ever the best deal is. The problem is people. You cannot systematize or scale them. and that is why a brokerage firm without technology is worth historically 2x revenues.

Connectivity and the Network Effect.

It is the 3rd “C” that changes an business’s trajectory. Improve how your client connects with the content, and your business breaks out of its cyclical nature and becomes a growth stock.

Good technology creates its own self-sustained liquidity cycle in the form of a Network Effect. Once a Network reaches critical mass, it becomes a must-have tool for market participants. Obvious examples are Telephone and Instant Messaging.

Can a broker afford to be without either of these?

In the Energy Broking business new connective technology is being implemented right now. Just because it isn’t being used by everyone doesn’t mean it won’t be someday. We all didn’t wake up one day and en masse decide to use IMs to transact business. The same is true with Electronic Communication Networks (ECNs). It will take a while for the tipping point to be reached within these networks. But ECNs will eventually break up the more fragile Content-Client based networks. The degree to which an individual ECN reduces communication friction and facilitates transactions will determine if it succeeds.

And electronic incumbency is the hardest network to break.

Branded for Potential

As a part of its increased oversight in the Exempt Commercial Market (ECM) space, the CFTC has required ECMs to register with it. Pay close attention to the electronic ECMs. Those with order flow have the potential to become a regulated dark-pool, in essence an exchange. The ones without order-flow, just old technology in a year or two.

Here are a few electronic ECMs listed without further comment alphabetically:

• Chemconnect
• HoustonStreet Exchange
• ICAP (3 systems)
• ICE
• International Maritime Exchange
• Natural Gas Exchange
• NetThru Put
• Parity Energy
• Spectron Live
• TFS Energy
• TradeSpark

We’ll try to take a look at some of these in the coming weeks.