Cincinnati Stock Exchange. One of the interesting things thathappened when Nasdaq decided to become an exchange, was that it openedup the question, ‘what is an exchange’? It used to be that, with an exchange,executions take place inside the facilities of the given exchange market.Historically, Nasdaq was essentially an association. Hence, it could be botha market center and a printing facility. That is, it could print – not execute –all of the ECN trades, as well as the trades of Knight and the otherwholesalers that were executing in their own systems.As Nasdaq moved to become an exchange, the question then arose, ‘Canyou be both an exchange and a printing facility,60 more or less?’ Nasdaq hasbeen going down that road. Now the other exchanges also have to answerthe same question. If you can be an exchange and a printing facility at thesame time, we would want to get into the printing facility business as well.The Cincinnati Exchange made the first step by going to Island and saying,‘we can be a printing facility,’ and we will share the revenue. Cincinnatishares something like 80% of its tape revenue with Island in this particularsituation.But this raises real issues with exchanges. Exchanges use tape revenue tofund much of their regulatory programs. If tape revenue is siphoned awayby non-listing markets through tape sharing deals, how will primary marketsfund their regulatory programs? How do exchanges operate? If you are anSRO and have to do all of the things that SROs have to do, can you do themif this game is being played with printing facilities?60
Printing Facility means that there is an option to print the ECN trades in the marketsystems.
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FREUND: What is your answer to that?REDFEARN: I do not know how this one will play out. If it turns outthat you can be an exchange and a printing facility, then Island could play allof the exchanges off against each other until they have virtually 100% of thetape revenue. This is because all of the exchanges will also sign up to beprinting facilities because of the economic value inherent in printing trades.At that point, if Island has not become an exchange, it might as well forgetabout its filing for exchange status. Island will have received all of thebenefits of being an exchange, without having to go through the trouble ofactually becoming (or being) an exchange.If it turns out that you can’t be both an exchange and a printing facility,Nasdaq may want to think about its desire to become an exchange. It willlose an awful lot of tape revenue if it can’t be a printing facility for all of theexecutions that take place outside of its exchange marketplace, which wouldprobably be limited to SuperMontage. This gets back to something Imentioned earlier about regulatory harmonization. You really have to ask,what is an exchange? What are the rules that exchanges abide by, and whatis it that ECNs can do to play in that space? Should Island be able to get allof the benefits of tape revenue without having a regulatory program andwithout actually being an exchange just because they have cut a good tapesharing deal or deals?The second point I would like to make here is in response to the assertionthat the QQQs or ETFs can be used as an example that suggests that listedflow will migrate to ECNs as it has in the Nasdaq world. It is true that asubstantial amount of QQQ volume trades in Island. The question is, ‘Is thisan indicator of what’s to come for listed equities or something particular toETFs?’ I believe it is the latter. In particular, ETFs are quite distinct fromequities in how they are priced. Exchange Traded Funds are priced based onfutures and based upon NAVs61 of underlying baskets. Consequently, theprice discovery function is fundamentally different from equities. So thesuggestion that the Island QQQ story is an indicator of what’s to come withyour typical listed stock is flawed. Island has tried to make some inroadsinto the listed market where it ignores the ITS rules, yet it has no successgaining substantial market share in listed equities.FREUND: We will address the regulatory issue. First, let me ask youthis question. You are about to start a new facility for trading Nasdaqstocks. But there is a catch 22 problem in the securities markets business.The market that has the order flow is the best market, and institutionalinvestors have a fiduciary obligation to send their order flow to the best61
NAV is the acronym for Net Asset Value.
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market. And, as long as they send that order flow to the best market, itremains the best market. So, how can order flow be attracted into the newfacility?REDFEARN: We have a very different approach to what we are offeringin the Nasdaq world. In effect, our model is in recognition of the fact (andthis came up in the earlier discussion) that there is presently a problemdiscovering the price for the size order.We have deeply capitalized specialist firms on the Amex. This isdifferent from what we are seeing at some of the regional stock exchanges.We are talking about Bear Wagner specialists, Performance specialists, andother large firms who will be involved in trading Nasdaq stocks on our floor.What they intend to do is to step up and say, ‘here is where you can price25,000 shares or, depending on the stock, maybe 50,000 shares.’ This iswhere the size price is. It embeds size back into price while at the same timewidening the spread a bit. But if an institution wants to come in and hit sizeat one price in an agency environment, it will be able to do that in ourmarket.Specialists who are involved in this program are also involved in ouroptions business and our derivatives business. So trading strategies onceutilized will link trading of some of the most liquid stocks in Nasdaq to theQ, or to the Q future, or to a related HOLDR product.62 Those are the sortsof strategies that we think will improve the ability to offer size, and toprovide deeper liquidity.SCHENKMAN: Bill, your question has a fundamental assumption that itis all about price. It may indeed be mostly about price. But, as Brett said,best execution is about more than just price. It is about price/size and pricespeed. It is a very personal thing for the investor. You ask any institutionthat needs to buy a block of stock immediately what it is more sensitive to –speed, size, price – or where it will trade. Different institutions will trade indifferent venues. They will go to capital which may cost them more moneyto execute, but will get them an execution within the parameters of thetrading strategy that they consider best execution, in this case speed.To divorce the trading strategy from best execution is bad. It is notrealistic. Once you come to that conclusion, then the destination for tradingbecomes clearer. If you are going for a size execution, and have the luxuryof time, you may choose a crossing network. If you are extremely timesensitive, you may use a broker’s capital. Or if you are going for somethingin between, you may use an ENC, or an alternative trading facility.62
HOLDRS were created by Merrill Lynch and trade on the American Stock Exchange.HOLDRS allow investors to own the common stock or ADRs of specific companies in acertain industry.
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FREUND: That is a good point. Best execution has many dimensions.This will be dealt with further this afternoon by Ananth Madhavan’s panel.MALITZIS: One objective is to actually access the quotes that you seeon the public quote screen. But what is the price you pay to access them?Do you actually get to execute against the quote, at the price and in the sizethat is out there? This is a complicated matter. It is something that isbuzzing around in the industry right now. What happens when all of theother exchanges start trading? What happens if and when ITS stops tradingand there is no inter-market trading system?This issue is coming to a head. Just because there are routing systems toget to the quotes today, doesn’t mean that the practitioners are happy. Theyhave to pay to join these services at a time when everyone is costconscience. People look at the issue of fragmentation, the issue of bestexecution, and the prices they have to pay to access these quotes. As theydo, they gravitate to the most liquid, most efficient markets.FREUND: Do you think that SuperMontage will be that market?MALITZIS: Yes.FREUND: Before we get to the audience (and I will allow enough timefor that), let me explore another aspect of what we have been talking about –the harmonization of regulation. The term rolls off the tongue, but I do notquite know what it means. Could you clarify what kind of harmonizationyou want? It is sometimes called a level playing field. What is that?REDFEARN: Absolutely. We are in an environment now where, if youlook at the rules on the listed markets, the rules on the Nasdaq market, and atthe rules for ECNs, you see three different sets. There are three differentcompetitive playing fields. For example, in the listed markets, we have ITSrules that the exchanges and Archipelago must abide by. There is a tradethrough rule63 in the listed markets. You cannot trade-through a better pricein another market. If you do, you are going to get a call, and you will haveto make good on the better price. The trade-through rule really drives thedynamics of how different markets trade and interact with one another. Therule does not exist in the Nasdaq market.Increasingly, it is being questioned whether there should even be a tradethrough rule in an era when you have institutional size business that mightnot care about what the penny wide, hundred shares or even thousand sharesup market is. Maybe somebody wants to pay a few cents more (or receive afew cents less) to get 25,000 shares done. In Nasdaq, you can do this. In thelisted world, it is different. You have to run ‘walk the book’ beforeexecuting against a size price. With respect to the ECNs, Island does not63
The Trade-Through Disclosure Rule (Rule 11Ac1-7) would eliminate the requirement thata broker-dealer disclose to its customer when a trade-through has occurred.
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abide by the trade-through rule, and does not participate in ITS. The bigdispute that we have had with Island is that Island is an ECN that isoperating in our ETF business but is ignoring the rules that we have to abideby.Somebody commented earlier that people will gravitate to that modelbecause you get an instant execution. Well, if the Amex could in effect givean instant execution and ignore all the quotes and all of the other markets’prices, then we could be a hell of a lot faster. But we have to say, ‘OK,Archipelago’s quote is such and such,’ so we have to outbound routethrough ITS and see if we can get a fill on ITS, or we might have to go to theChicago Stock Exchange. Obviously there is delay involved with this set ofrules.A lot of this speed issue is not so much about execution systems. In fact,we have automatic execution capabilities now that we could put in place.But as long as we are in an ITS environment and have to abide by the tradethrough rule, inevitably it is a completely different structure. It is a differentplaying field.FREUND: I saw Sanjiv shake his head.GUPTA: We all know that, when you send your order to a listedexchange, it takes a bit more than a second or two to hear back. To say thatit is just to look at what Archipelago’s quote is, etc., does not explain the 30seconds of specialist intermediation. This is the fundamental problem thatthe alternative systems are trying to solve for the institutions and anybodyelse who wishes to trade with them. The whole dispute with Island is overthe ITS rules which, in my completely personal opinion, are absurd in thismarketplace. I suspect that within a year they will be gone,64 or else therewill be a choice of whether you want to participate or not.I am not sure that the abolition of ITS would be particularly good for theexchanges. I stand by my earlier comment that ITS makes the marketplacefar less competitive. I am not sure that the exchanges would get that manybenefits out of the elimination of ITS.FREUND: Sanjiv, I keep hearing you say that it takes 30 seconds. Ithink it takes more like 15 seconds. But let us say 15 to 30 seconds. Do youthink that an institution that wants to buy 750,000 shares, as we heard thismorning, cares whether it takes 15 or 30 seconds more when they are tryingto buy a big block?CORMACK: Yes (laughter).64
The rules of the ITS were still in place in early 2003. However, the SEC in late 2002,granted a temporary ‘de minimus’ exemption from the trade-through rule restrictions forthe QQQs and other ETFs, provided the trades occurred within 3 cents of the NationalBest Bid or Offer, or NBBO.
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GUPTA: When you do not know what has happened to your order, thatspells trouble. Here’s an example: You look up at the screen and see a50,000 share offer, so you route your buy order, and try to lift the offer.Then, in the auction, the specialist interacts with the crowd, and you haven’theard back; and still later you haven’t heard back. After 30 seconds, you seethe quote move, and suddenly the specialist’s bid is a penny above your limitprice. And you still haven’t got an execution. This is the penny jumpingphenomena. You want to lift an offer but instead people in the crowd havelifted it in front of you. The bid is higher than your limit order and you’vebeen shut out. In that 30-second process, you didn’t know who you were incompetition with. If you had heard immediately that you were not going toget this 50,000-share trade done, you’d have been able to do somethingpositive about it. Maybe you could have paid a penny higher.These are the problems. If you heard immediately, even if it was arejection, that immediate turnaround would allow you to take advantage ofother pools of liquidity. That is what people want to do now. They want totry something and, if it doesn’t work, they want to re-route.But price improvement does not make sense to a lot of investors. It madesense in a teenie and eighth world, but the concept of price improvement inthis penny environment does not. A lot of institutions would give up priceimprovement for immediacy. We now have a system on New York calledDirect Plus, which gives up price improvement and allows you to access thequote in two seconds. The technology exists. Unfortunately, the NYSElimited that technology to 1,099 shares, with only one order allowed every30 seconds.CORMACK: Every unexecuted order has an option value associatedwith it. The larger the order, and the longer it is out there, the higher theoption value. If I send a 100,000-share order to a system, and if it hangsthere for 30 seconds and I will not be able to get out, I will have given up alot of value. If I can hit Island in a sub-second time frame, the opportunitycost for exposing that order is very low.FREUND: You meant to say Archipelago.CORMACK: I am trying to be neutral (laughter). If I was to hit Islandor Archipelago, and I could execute that sub-second, that is a much betterfill. You know, as a former trader, I am much more comfortable with thatspeed, and there is value there.REDFEARN: I encourage everybody to go to one of the websites whereyou can look at the Rule 11 Ac1-5 execution quality data and the QQQproduct. Look at the data by order size, and look at the speeds going up byorder size. For a lot of orders under 500 shares, or under 1000 shares, youwill see speed. In all the other markets, the execution speeds are going to goup. Certainly for the small orders, because we are handling both institutional
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and retail business, our speeds are generally slower for the smallest ordersizes. When you get to about 2,000 shares, execution speed numbers flattenout. I can tell you that the effective spreads and the executions you get arebetter on the Amex. If you compare the effective spreads here versus whatyou see on Island, it is almost egregious how far outside of the NBBO quotethe executions are on Island.This gets back to who the participants are. Does a retail investor want togive up ten seconds and pay a penny and a half or two cents more per share?I am not so sure the retail investor does. It might make sense for certainprogram traders or certain professionals who are hedging and want to get offthe hedge right away. But this trade off does not make sense for manyinstitutional traders as well. For larger orders, even in those particularstatistics, the time differentials are not quite as big as those seen in the datafor small orders, if at all.CORMACK: It is about choice. However, because of the trade-throughrule, people do not have that choice. We have to abide by those tradethrough rules because we are an ITS participant. No matter how much thatday trading client of ours wants to pay up two cents to buy those 3000 sharesout there, we cannot do it. I have to send it somewhere else. In Nasdaq, youhave that choice. You can trade-through for speed, the customer has thatchoice. No one is forcing anyone to do it. Let them make the decision.FREUND: Have you heard any agitation to remove that rule?CORMACK: Yes.FREUND: Do you expect that it will happen?CORMACK: It is a very controversial rule. I can see both sides. If Icould buy, for example, a million shares of AOL up two cents through theentire million shares offered on the floor of the New York Stock Exchange, Iwould do it 100 times out of 100. I have exposed too many large orders onthe floor of the NYSE, and too many weird things have happened. Pay uptwo cents to get the job done in a sub-second? I would do that 100 times outof 100. But you cannot do that today with the trade-through rule.REDFEARN: For our Nasdaq strategy, we want no trade-through rule.It makes it easier to do size. You do not have to pay so much attention to a500 share, one cent wide spread. Institutions do not care about that. A onecent spread is not the price for 50,000 shares.Imagine a scenario without any trade-through rule whatsoever. Let’s say,hypothetically, the Amex opened its own ECN, Chicago puts in an ECN, andthen you have an Island ECN. Let’s say that there is no linkage, or not realintegration because everybody could ignore the other markets. What wouldthe price be then? How would that affect price discovery? I mean you couldhave different prices in different markets locking and crossing all day long.That would create another set of issues. Getting past the trade-through rule
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in this environment may not be as easy as one might think. In my view,efficient electronic linkages and arbitrage will reduce the negativeconsequences of fragmentation.CORMACK: Except for the retail investor, I do not think that would bea problem. Arbitrage would take care of those issues. That is what hashappened with Nasdaq. But it comes back to the point about our bifurcatedregulatory structure. Most rules are designed to protect the small individual,the 100-share investor, Aunt Tilley or Uncle Ned with their orders in themarketplace. The rules do not protect the institutions. The institutionsgenerally drive these problems, and they come back to roost for the retailcustomer. That is what happens when markets that are regulated for retailare, at the same time, supplying institutional size investors.At this point, technology has offered institutions a significant amount ofcontrol over their executions. But the 15 seconds that they are leaving theirorders and waiting, is a loss of control. The wait leaves them with lesschoice, with less of an opportunity to take advantage of a different marketsituation. This brings us back again to the bifurcated regulatory structure.This time, the split is between the individual investor and the institutionalinvestor.FREUND: When I asked for your perspectives on the future of marketstructure, one of you said that you expect a separation of retail and wholesaletrading. Can you speak to that?MERRIN: Sure. Wayne, in your latest survey, I think you said that itcosts the institutions on average 46 cents per share?WAYNE WAGNER: The number you want is 46 cents a share for thesearch costs.MERRIN: Right. That is above and beyond what they pay forcommissions, correct? I believe that in your updated iceberg the ratio ofhidden costs to explicit costs is now about 9 to 1. In other words, for everydollar that the institutions pay in commissions, they are paying about 9dollars in other hidden transaction costs. Right? When we first startedLiquidnet, it was a 7 to 1 ratio. Hidden costs, which have increased, were 36cents above and beyond what you were paying in commissions two yearsago.If you add it all up (this is something that I am not going to attribute toWayne), you are talking about over $100 billion a year that goes out of thereturns of these institutions, and into the hands of somebody else. The waythat our markets are structured today, going out and searching for liquiditymeans giving up information.As far as I can see, two major factors move market prices against theinstitutions. Number one is information dissemination. A broker gets anorder and tries to find the natural other side. This should be good for an
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institution because presumably there would be less market impact. So thebroker calls up other institutions, advertises on AutoEx, and/or sends outFIX indications of interest. These are nice gadgets. The problem, accordingto New York Stock Exchange statistics, is that the process I’ve just describedworks only about 30% of the time. That 30% is when the order is crossedupstairs. The other 70% of the time, the procedure works to thedisadvantage of the institution. It only serves to inform everybody else. Itgives the rest of the market the information that there is a large buyer orseller out there.Information dissemination is the first major market mover. Informationstarts the time clock ticking against the institution. Compared to five yearsago, there are now tens of thousands of day traders who make their livingsoff of this information. There has been an explosion of hedge funds. Not allhedge funds are bad, but some hedge funds are, and they too make theirliving off of this information.The other major market mover is size disparity. The average order sizefor institutions is now well over 250,000 shares. At the same time, averageexecution size is 1,100 shares for New York, 800 shares for Nasdaq, and 300shares for the ECNs. Whenever you have that kind of size disparity, therewill be market movement. There is no way to fill that square hole with thatround peg. That is the only way to get orders done in our current marketstructure. Our current market structure is no longer working for institutionalparticipants. Period.The amount of money that these guys are losing every day, every year, istoo much. View it this way. $100 million a year is approximately what theBush tax incentive was (at one time). This dollar sum flows out ofinstitutions every single year. Ultimately it comes out of the little guy. Ifyou can fix that gaping hole, you can tell Bush to relax.The only way to fix that gaping hole is to go outside of the currentmarket structure and establish a market that works for institutions. I canguarantee you the following. If you talk to institutional participants and say,OK, you have a blank sheet of paper, go and design a marketplace, Iguarantee you that they will not design a marketplace with a bunch of peoplerunning around on a trading floor.Once again, what we have might be perfectly fine for retail. But it is notworking for institutions. The NYSE is saying that there is a differentmarketplace for institutions, that they are going to give institutions adifferent quote.65 Perhaps the market makers are going to put up capitalevery time the institutions want to trade. Perhaps that is good. Regardless,65
Merrin was referring to various NYSE systems for offering institutions quote informationdistinct from what is offered to retail customers.
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the market makers are also saying that retail has to be separated fromwholesale.FREUND: Do you see any reason to believe that separation is going tohappen any time soon?MALITZIS: Didn’t the SEC address this in the order handling rules? Inessence, they took a bifurcated market (I would argue that there was awholesale market and a retail market) and merged them into one. That wasmy perception of what the order handling rules did: I could be wrong.MERRIN: Yes, that is correct, but my argument is that this is the wrongapproach. Retail and institutions need two completely different structures.Retail needs price transparency and it needs to know what’s going on outthere. Retail wants to look at a quote system and to enter an order andexecute at the bid or the offer. Institutions don’t want transparency. Theyare not going to agree to put their bid and offer out there for everyone to see.Their trades are so large that the information could move the market. Whatthe SEC did was favor the retail investor by creating greater transparencyand merging retail and institutional in the order handing rules.Consequently, the brokers could not protect the institutions anymore.MALITZIS: Yes, the order handling rules forced the quotes of all marketparticipants – large market participants, ECNs, Nasdaq market makers, etc. –into the public quote stream.MERRIN: A big hidden reserve is the problem. Nobody can regulate it.No one is going to tell all the institutions that they have to show their entirehand. We must realize that there will never be perfect information.The whole random walk theory contemplates perfect information. Anexchange is supposed to be a perfect capitalist environment, right? Forevery buyer there is a seller. The problem is that because institutions holdtheir orders so close to the vest, the supply and demand of the institutions isnot represented on the exchanges. Only retail supply and demand isrepresented. This leads to a tremendous amount of volatility because,ultimately, the institutional demand goes against the retail supply. You arebumping two different sizes together. There has to be volatility. And it isthis volatility that leads to a 47 cents cost per share, on average, every timethese big guys go into the market. Ultimately, it is going to flow back.When the institution is done, price goes back to reflecting the retail supplyand demand. Price finds its natural value based on the set of retail orders.REDFEARN: Given the general principles of supply and demand, somemarket impact is inevitable. This may be a bit sacrilegious but, if there aremore buyers than sellers or more sellers than buyers, prices are bound tomove if you try to get 100,000 or 500,000 shares done. If there is a naturalbuyer on the other side you will get filled. If there is not, where do you gofor liquidity? In this context, many of the institutional services that are
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provided on the floor of the exchange make a lot of sense. People can comedown to the floor, have a floor broker hold or work the order, and feed thatinformation to the market in a gradual, controlled way. This process reducesmarket impact.I would like to also get into the game of throwing out Plexus figures(laughter). We have done some work in the past with Plexus. We havelooked at the pre-trade costs and the overall market impact costs, both in theauction market and in the dealer market. Wayne, tell me if I am wrong here.All of the studies that we have looked at have shown that pre-trade costs andmarket impact overall on the Nasdaq market has been higher because searchcosts are higher in that marketplace. Nobody will put all of his orders in alimit order book.In an environment where there is institutional order flow, there must be away to control information release. A controlled release of informationhelps to serve the institutional community. It reduces their market impact toa certain extent.MALITZIS: This is a great ad for why you should to put your orders inSuperMontage (laughter).I want to touch again on another point – regulatory harmonization. To anextent, there will always be regulatory differences between the exchanges,the ECNs, the over the counter market, and so forth. The Amex can argueabout the trade-through rule, and we can note that there is no short sell rulefor Nasdaq securities. The debates never end. The SEC’s role here is tolook out for the investor, to ensure that there is a baseline level of regulation.At the end of the day, markets must compete on quality. If an investor hashad a bad experience with a particular market, if he has received a printsignificantly outside of the inside quotes, or if his order is treated poorly anda bad execution has been realized, the statistics show that the investor willwalk away from that market. That is what we believe at Nasdaq.We invest a lot in our regulatory infrastructure. We would have adifferent definition of print facility.66 If you put your quote up on Nasdaq,you should have to pay for that regulation. At the end of the day,competition, with regard to both speed of execution and regulation, is goingto win.66
At the time of the conference, Island was quoting its trades on Nasdaq but printing them onthe Cincinnati Stock Exchange. Nasdaq obviously was not pleased for business reasonsbut it cited another concern. ‘Our view is that there should be a nexus between the placeyou quote and report trades, in part because we incur regulatory obligations when a marketparticipant quotes here and uses our facilities,’ Malitzis explained in a note after theconference. The market participant in question, who Malitzis did not identify by name,committed what ‘looked to us like regulatory arbitrage.’
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FREUND: Questions from the audience?ROBERT WOOD67 [From the Floor]: Fragmentation is a synonym forcompetition. Because the regionals were small back in the old days, theycould not give price competition to New York. But a lot of technicalinnovation came from the regionals. For instance, SCOREX68 precededDOT.We know the behavior of monopolists. They never want things tochange. They are not into innovation. They are not into adopting newtechnology, and so forth. The very fact that the ECNs came into existence isa reflection of how inefficient Nasdaq had to have been. Order flow attractsorder flow, and if the Nasdaq marketplace had been efficient, those ECNswould not have had a chance. But the innovations provided by the ECNshave been important. My concern is, if SuperMontage becomes reallysuccessful, how can the ECNs survive in a world of best execution?GUPTA: First of all, you have to realize that SuperMontage basically isan ECN. It takes the elements that the competitive forces of the marketplacehave created over the last four or five years. Nasdaq has created a superECN with regulatory approval that can sort of fashion a marketplace that is avirtual monopoly. I talked about the ADF before. The ADF is thealternative structure that people could choose. But the ADF is havinggrowing pains. It can’t succeed overnight. To launch a whole newmarketplace and a whole new regulation is a tricky business.Once you have that whole new marketplace, as you pointed out, theretends to be inertia. But so long as the choice remains, so long as everyonedoes not have to be a complete flag-waving member of SuperMontage,competitive forces in the marketplace will create new solutions. I do notthink that a centralized marketplace like SuperMontage offers all of thechoice that institutional investors need. Take down the barriers tocompetition, and you will see what you get. It is as simple as that.FREUND: On the other hand, isn’t it true that the New York StockExchange has spent huge sums of money, like $400 million a year, onautomation