In 1997, Jerry Putnam spotted an obscure business opportunity in the stock market that a lot of investment banks -- to say nothing of individual entrepreneurs -- missed. The Securities & Exchange Commission had issued new rules to require market makers -- who hold inventories of certain stocks so there's always a ready market for them -- to publicly display their best prices for each issue.

The SEC was particularly concerned that NASDAQ market makers were offering better quotes via private trading systems or electronic communications networks (ECN), which cater mainly to institutional investors, than they were to the general public. Amid sweeping changes in trading technology and the booming market, Putnam saw a new business opportunity for the ECNs -- and a chance for newcomers to get into the market. The SEC said that market makers could fulfill their disclosure obligations if the ECNs made their best quotes publicly available on NASDAQ. But the rule change also paved the way for the ECNs to make all the prices they carried -- some of which were better than those listed on NASDAQ -- visible to the public, making the ECNs attractive alternatives for investors. Putnam, who ran an electronic brokerage at the time, decided to start a lower cost ECN aimed at a broad range of investors. "I thought it would be a huge benefit for investors and for brokerage firms," Putnam says.

Within a few months, Putnam launched Archipelago Holdings Inc. in Chicago to compete in that market. Two years later, Archipelago has annual revenues of $20 million. It turned a profit in its first six months and has drawn significant investment from Goldman Sachs and E*Trade Group, the largest online broker. (The investment bank also owns 10% of Brute, another ECN).

TECH TRADING. Putnam's success reflects the usual mix of pluck and luck -- and a change in stock investing. Technology has taken control of the guts of the business -- trading -- out of the hands of the giant investment banks and made it possible for tiny, agile companies to become contenders. Not that the banks are taking the challenge lying down -- as witnessed by Putnam's new partners. But that has also proved an opportunity for Putnam, giving him heavyweight backing to face future consolidation in the still-changing market.

What is an ECN? Think of it as a private trading system open to subscribers that eliminates the human intermediaries involved in a typical stock transaction -- and the fees they charge for their services. In a traditional market such as the New York Stock Exchange, customers place an order to buy or sell a stock with a broker, who calls in the order to his company's floor broker at the exchange, who executes it through a market maker called a specialist. Shares are bought at the lowest price available and sold at the highest.

On an ECN, buyers and sellers post their orders in the system, which automatically matches them. The ECNs earn a fee from each trade. Putnam says fees for 100 shares of IBM Corp., for example, would be about $15 on Archipelago -- but more than $100 at a full-service brokerage.

The ECNs have been making inroads on conventional markets for some time. Indeed, 20% of the trades in NASDAQ-listed stocks and 4% of trades in shares listed on all exchanges are done on the ECNs. And the SEC says the recent rule change may drive more business to them. Archipelago's own growth suggests that. On its first trading day, 1,000 shares of Dell Computer Corp. changed hands. "We did one trade and turned it off," Putnam recalls. Now, Archipelago handles about 25 million shares a day. Of course, that's not about to put the NYSE out of business. But the phenomenon is clearly a challenge to traditional exchanges.

To date, there are nine ECNs. Officially, they are registered as broker-dealers. The SEC, which is concerned that a proliferation of unregulated private exchanges will hurt investors, views them as markets. So it is now requiring them to declare themselves as broker-dealers or register as markets. Becoming a market, however, is a challenge that Archipelago says it's willing to embrace. Later this year, it plans to register as a virtual securities exchange. At that point, the big technical challenge it will face will be connecting with all other securities exchanges.

DOG-EAT-DOG BIZ. As a small company, Archipelago's success is all the more remarkable because the ECN market -- like many Internet businesses -- is a dog-eat-dog, low-margin business that needs heavy volume to prosper. Not only does it take considerable technical and financial resources to keep such systems running, but it's likely that there will be a shakeout in the already crowded field.

Reuters' Instinet, a favorite of institutional investors, has about 69% of the ECN market. Second place belongs to fast-growing Island, owned by Datek Holdings, with a 20% share that includes a large following among retail traders. According to BancBoston Robertson Stephens & Co., Archipelago shares the remaining 11% of the market with Redibook, owned by Speer Leeds & Kellogg, Bloomberg Financial Markets' Tradebook, and several more recent additions.

So what's the outlook for Archipelago and bold upstarts of its ilk? The picture is mixed. According to Gary Craft, senior analyst at BancBoston Robertson Stevens in San Francisco, "Instinet is losing market share because of underinvesting and overpricing, and it is losing to players like Brute, Island, and Archipelago." Still, Goldman Sachs and E*Trade's investments in Archipelago and Brute show that the strong hands won't placidly let a bunch of nimble midgets displace them.

Putnam expects consolidation: "I think in the end, there will be three or four [ECNs]. And out of that, one or two new stock exchanges will emerge." Putnam plans to run one of them. He's certainly equipped for the struggle. Once he spotted his opportunity, it took him a mere eight weeks to set up his business. In 1994, Putnam founded Terra Nova Trading Inc., an electronic broker-dealer that's now Archipelago's biggest client. Still, setting up an alternative trading network was a mammoth undertaking, says Putnam, requiring hundreds of computers and proprietary software that would let his system interact with those of NASDAQ and other ECNs.

At least for now, that open architecture gives Archipelago advantages over competitors Instinet and Island, which don't tap other ECNs' listings if an order can't be filled internally. (Archipelago pays a commission if it completes a trade on another ECN.) "We did not have this notion that we would internalize our order flow," says Putnam. "We looked at it and said, 'This is a best-execution model.' We get paid when a customer does a trade, so we should do everything we can to have a trade happen. And if that means sending an order to another ECN or sending it to a NASDAQ market maker, all we cared about was where is the best price available."

Open architecture won't be enough to distinguish Archipelago long term, however. "As it stands now, the whole idea of openness is an industrywide phenomenon," says BancBoston's Craft. Putnam concedes the point. But he contends that so far no one has successfully imitated their system.

Instinet, which trades 142 million shares a day, says it executes 75% of its trades within its own network, with the remainder flowing out to NASDAQ. "We have a huge pool of internal liquidity," says Harlan Flint, senior vice-president of strategic marketing for Instinet.

Who uses Archipelago? Today, it has about 6,000 regular customers, of whom 60% are institutional investors -- primarily broker-dealers and mutual-fund portfolio managers. Less than 5% are market makers, says Putnam -- mainly because the ECNs compete with market makers. The remaining 40% are retail investors, including day traders.

The linkups with Goldman Sachs and E*Trade, which agreed to take 25% each of the company, are part of Putnam's plan to play in the big leagues. Neither E*Trade nor Goldman will comment, but Putnam says those deals will also help broaden Archipelago's customer base. Through Goldman, Archipelago hopes to gain access to more institutional investors. Through E*Trade, he hopes to reach more retail investors. In the wake of those deals, "I don't feel like a small business," he adds. But Putnam says starting small has taught him to stay focused on his core strength of applying technology to trading.

In 1999, says Putnam, he wants to triple the number of shares Archipelago trades each day. With the Internet revolutionizing trading, customers "are going to hit a button and their orders are going to interact directly with the market," he says. And if Putnam has his way, those orders will flow through Archipelago.

By Jeremy Quittner in New York
jeremy_quittner@businessweek.com