Tom Taulli is the author of "Investing in IPOs" (Bloomberg Personal Bookshelf). The book can be purchased at Amazon.com by clicking here. You can reach him at tom@taulli.com

If you like what we do here, please click on our sponsor's banner. Thanks!

Under a buttonwood tree in 1792, 24 brokers founded the New York Stock Exchange. By centralizing the market, they created liquidity. Also, to discourage divisiveness, commissions were fixed, creating a lucrative monopoly. The market worked on an outcry auction system, in which brokers called out bid and ask prices.

Until about 30 years, the system worked well. But then the world began to undergo epochal changes: inflation, the rise of institutions, currency instability, and technology. More and more, the NYSE began to look like a quaint relic of the past. In the next few years, you can expect stock exchanges to undergo more radical change. The reason is obvious: the Internet.

Why Stock Markets?

The purpose of a stock exchange is to provide liquidity. On a stock exchange, buyers can readily purchase a security, and sellers can readily sell them without suffering a big change in the value of the security. Stock is a strange type of "good." Whereas a typical good is bought and then consumed, a stock is bought and sold and bought again, endlessly. By centralizing their actions on an exchange, buyers and sellers reduce their search costs, resulting in efficiency. Moreover, information is better distributed between buyers and sellers. But in the computer age, a stock exchange doesn't have to be centralized physically. This has been proven by the Nasdaq.

The stock exchange mechanism has been wonderfully successful. By issuing stock on exchanges, companies have been able to raise capital for a myriad of industries: railroads, telephone systems, microchips, software, cell phones, and, of course, Internet ventures.

Markets can be wild. There have been crashes and manias. There have also been manipulations. But despite all this, a stock exchange is the ideal system for raising capital. There are several new models that may make the stock exchange even more effective. Let's take a look:

OptiMark

OptiMark is one of the most ambitious innovations in the age of digital stock markets. The visionary behind OptiMark, Bill Lupien, is a former chairman of Instinet, as well as a specialist and governor of the Pacific Exchange (PCX), where he built the world's first automated trading system in 1969. The OptiMark exchange is located on a 1,000-acre ranch in Colorado once owned by Western novelist Louis L'Amour.

OptiMark has raised more than $150 million in venture capital from such powerhouses as Dow Jones, General Atlantic Partners, and Goldman Sachs. OptiMark intends to solve a major problem for institutions: market impact. Here's how market impact works: If an institution wants to sell 1 million shares of XYZ Corp., it won't place the order all at once, but over a period of time, so as not to disturb the market for that stock. Academic studies have shown market impacts can increase the cost of a trade as much as 10 times. Instead of executing a trade in the traditional two-dimensional approach (price x volume), OptiMark allows for three-dimensional trading. That is, a trader can give the system a more well-rounded trading profile. For example, a trader may have a profile that indicates a willingness to sell 200,000 shares at $51.50 and so on.

The profile is submitted into the OptiMark system, which uses supercomputers and patented fuzzy logic to optimize the trade, which takes an average of 1.5 seconds. The process is done in complete secrecy, preventing market impact. OptiMark's technology may have more diverse applications for the airline and concert ticket markets, or really, anything else that is bought and sold.

Electronic Communiciations Network

An electronic communications network is an alternative trading system. Essentially, an ECN is a computer-based trading network that efficiently matches buy and sell orders for Nasdaq stocks.

The leading ECN is Island. When you put an order through Island, the computer checks to see if there is a match. If not, the trade is routed to the Nasdaq. Island is scaleable. For example, on Sept. 1, 1998, a day of extremely high trading volume, Island held up despite handling more than 430,000 orders.

Unlike Optimark, an ECN relies on the concept of visibility. The more people see your stock quote, the better chance you will get a good price. In fact, ETrade and Goldman Sachs recently announced they acquired 25 percent of Archipelago, which operates an existing ECN. There are now nine ECNs, which collectively account for 22 percent of transactional volume on the Nasdaq.

The Direct Stock Market

The purpose of the Direct Stock Market is to provide a stock exchange for microcap public companies, a market that is very inefficient.

According to the National Association of Securities Dealers, there are about 12,000 public companies listed on the over-the-counter bulletin board or pink sheets. The trading volume for the OTC BB is about 57 million shares a day. Direct Stock Market is in the process of securing a "no action" letter from the Securities and Exchange Commission, which is equivalent to approval of its market activities. However, if the Direct Stock Market becomes an ECN for a registered broker dealer, then the "no action" letter is not required. This was the case with Charles Schwab with its relationship with CompuServe and America Online.

Conclusion

On Tuesday, former Robertson Stephens chairman Sanford Robertson announced a new virtual investment bank called EOffering (ETrade bought a 28 percent stake in the bank). Although EOffering didn't say whether it would create an online stock market, it's a good possibility. There are also rumors that William Hambrecht of Hambrecht & Quist is thinking of building a virtual investment bank and perhaps a stock market, as well.

And finally, there is Wit Capital, which has plans to leverage its virtual investment bank into a stock market.

Another prospect is NetStock Direct (http://www.netstock.com), which lets investors purchase company shares directly. I wrote a column about NetStock last week.

All this activity should provide more liquidity and access for individual investors to IPOs and other investment opportunities.

For comments/questions, contact Tom Taulli at ttaulli@bpia.com.

Commercial: Readers interested in IPOs may want to check out The Investor's Guide To New Issues: How To Profit From Initial Public Offerings, available in our bookstore.