July 14, 1998
Nasdaq's NODES Could Transform the Market
by Louis Corrigan ([email protected])
Nasdaq's NODES Proposal: A Product of Recent History
The National Association of Securities Dealers (NASD), the parent of the Nasdaq, has proposed a New Order Delivery and Execution System (NODES) that could produce significant changes in how the market works. The Securities and Exchange Commission (SEC) is now reviewing commentary on the matter. The proposal promises a more competitive marketplace in which individual investors will get better prices. However, critics charge that NODES may unnecessarily strengthen the hand of Nasdaq's market makers in ways that could foster a less competitive, less liquid market.
For most individual investors, the whole debate will seem terribly arcane given that it deals with market mechanisms that they never see nor consider when trading through their brokers. The most knowledgeable critics of NODES are the day-traders who make a living by hitting the market makers' bid and ask prices through the Small Order Execution System (SOES). Developed in 1984 and fortified following the crash of 1987, SOES is an electronic trading system designed to ensure that small orders can be filled automatically at the inside (or best) price. It solved the problem of market makers simply not answering their phones when they didn't want to trade. NODES would do away with SOES by collapsing it into a new, more integrated system.
While members of the Electronic Traders Association (ETA) have made compelling cases against some Nasdaq rule changes in the past, these traders ultimately represent merely a countervailing force to the market makers, who have lobbied hard to protect their privileged position within the system. In other words, the day traders view of what is best for the market may not necessarily represent what is best for individual investors. Indeed, some academics have argued that professional day-traders using SOES have actually cost average investors hundreds of millions of dollars.
NODES represents, in part, a continued attempt by Nasdaq to clean up its act in the wake of the massive 1996 Justice Department investigation that found market makers had fixed prices by maintaining artificially wide spreads between bid and ask quotes. The wider the spread, the more room market makers have to profit from individual investors by selling high and buying low. In the aftermath of this collusion case, major Wall Street houses have ponied up over a billion dollars in fines. Indeed, copies of the class action settlement were recently mailed out to anyone who invested in a Nasdaq stock between May 1, 1989 and July 17, 1996.
At the same time, however, NODES represents another attempt by Nasdaq to strengthen the hand of market makers vis a vis the day-traders, whom Nasdaq generally looks upon as "SOES bandits," abusing a system originally designed to expedite orders placed by average investors. In other words, Nasdaq is looking to protect the interests of its own members at the same time it tries to make the market more competitive.
What makes this issue even more complex is that the current Nasdaq system has come under serious competitive pressure in recent years from independently owned electronic communications networks (ECNs). These networks are essentially electronic limit order books where buyers and sellers meet to negotiate trades among themselves independent of any middleman market maker. ECNs make their money by charging a set fee (typically about 1.5 cents per share) for being the market rather than making it. The dominant ECNs are Reuters' Instinet (which claimed 69% of the ECN market as of February) and Island (20% market share). Yet a number of smaller players such as Bloomberg Tradebook (B-Trade), Attain, and Archipelago have sprung up in the past few years. ECNs claim about a quarter of the overall trading in Nasdaq-listed shares.
Market makers can trade through the ECNs. In some cases, they even post more competitive prices to the ECNs than the ones they display directly through SelectNet, Nasdaq's principal electronic order routing system where market makers and other order-entry firms negotiate securities transactions. The implementation of the SEC's Order Handling Rules on January 20, 1997 required market makers to display customer limit orders in their own quotations while also establishing SelectNet as the overall market's link to these ECNs. In practice, then, a market maker's best quote may be his own or a customer's limit order, but it must now be posted directly to the SelectNet system or to an ECN that disseminates it to the broad market via SelectNet. As a result, the main Nasdaq quote montage already integrates limit orders from individual and institutional investors when those orders are the best available overall.
Rationalizing the System
This sounds confusing, and it is. Such overlapping yet competitive systems create opportunities for all active players to game the trading one way or another. One of Nasdaq's major concerns involves cases where a market maker's published quote price is "hit" simultaneously by orders from two different sources, for example, via SOES and SelectNet.
The SEC's Firm Quote Rule currently leaves a market maker liable for trading the advertised (or minimum) number of shares at the quoted price. In theory, the threat of multiple liability makes market makers less willing to offer their very best prices. This problem has become more acute in the last year and a half because volume moving through SelectNet has soared (six-fold between October '96 and September '97) so that it now accounts for over 15% of overall Nasdaq volume.
NODES would resolve this problem, in part, by combining the current SelectNet and SOES systems. That is, it would meld an order-driven, negotiated price system where there are no limits to order size with an automatic execution system where each market maker has generally been required to fill a minimum order at his posted quote. NODES would also create a voluntary Limit Order File so that the best-priced limit orders would be displayed in Nasdaq's quote montage as well as in a separate "Top of File" display. This would alleviate the need for each market maker to update his own posted quote when a limit order arrives. All orders in the limit order file could also be viewed by other market participants with the necessary Nasdaq workstations.
The major goal of NODES, then, is to make Nasdaq more order-driven, which in turn will make Nasdaq's market makers more competitive with the ECNs even as the whole market becomes more integrated. Yet in helping Nasdaq function more like its competition by doing away with some of the distinctions, NODES will also have the paradoxical effect of diminishing the responsibilities of market makers while enhancing their privileges. One significant example relates to Nasdaq's Actual Size Rule (ASR), instituted in a pilot program last year.
Prior to the ASR, market makers were required to show 1,000 share minimum quotes for most actively traded issues (500 or 200 shares for others). That means they were obligated to buy or sell at least a 1,000 shares of a stock at their advertised prices. What the ASR pilot did was exempt market makers from this obligation for a select group of 50 stocks, including the ten largest Nasdaq stocks. The program has since been expanded to 150 stocks, and the NASD is now proposing that the actual size rule should apply to all Nasdaq stocks.
Though the proposals are distinct, a number of key features of NODES will only become effective if the SEC approves this ASR extension. Full passage of NODES, then, will mean that market makers will no longer be obligated to fill 1,000 share orders at their posted prices for any stocks. That is, the basic obligation of market makers to provide real liquidity, an obligation underscored by the strengthening of SOES in '87, will essentially be thrown out.
How NODES Will Work
The system would work like this: Market maker quotes, orders from ECNs, orders from exchange specialists with unlisted trading privileges (UTP participants), and orders visible in the Limit Order File (the best customer orders) will be accessible to all Nasdaq order entry firms. These firms can send in customer orders or orders for their own accounts for up to 999,999 shares. Limit orders can be directed to a specific market maker, ECN, or UTP. They can also be undirected. Market orders must be undirected, in which case they will interact with the Limit Order File as well. Orders will have a minimum life of ten seconds.
Market orders of up to 1,000 shares will be executed automatically at the best price, even if the price is offered by an ECN. For example, let's say one firm enters an individual investor's market order to buy 1,000 shares of Buffett Inc. If market maker A is alone at the best price, offering 1,000 shares at $20 a share, the full order will automatically execute at that price with that market maker. If market maker A is only quoting 500 shares at the best price of $20 and an ECN has the next best price with an order to sell 500 share at $20 1/8, then the buy order will go through automatically, hitting the market maker's quote for 500 and the ECN's sell order for 500. If an individual investor's limit order to sell 100 shares at $19 7/8 had been displayed in the Limit Order File, the above undirected trade would have gone off as follows: 100 shares at $19 7/8, 500 shares at $20, and 400 shares at $20 1/8.
By making participants automatically good for their quotes when the order size is below 1,000 shares, the system incorporates some of the functionality of the current SOES system. After filling such orders, market makers and ECNs will have 17 seconds to adjust their quotes before being liable for a new order. On orders above 1,000 shares, however, ECNs and market makers will have some time to decide whether to accept, decline, or do nothing.
On orders of between 1,001 and 5,000 shares, doing nothing after 17 seconds obligates the participant to fill the order (or the partial amount advertised). For example, if an ECN that has displayed an offer of 7,000 shares gets hit with an order for 5,000 shares, no action after 17 seconds leads to a filled order. Had the ECN only offered 4,000 shares, no action would have led to a partial fill. Orders above 5,000 shares work on the same basis but allow the ECN or market maker 32 seconds to act.
Day-Traders Raise Concerns and
the Privileges of Market Makers