Taking a snapshot across the Nasdaq landscape, Ed Coughlin, head of Nasdaq trading at Bernard L. Madoff Investment Securities LLC, has software that scans the various market centers - such as SuperMontage, the Alternate Display Facility (ADF), the Cincinnati Stock Exchange and Archipelago.
Today, because of the competing pools of liquidity, Nasdaq stocks are quoted and traded on different venues, such as SuperMontage - Nasdaq's trading platform used by market makers and some electronic-communications networks (ECNs); including Bloomberg TradeBook, Brut, Attain and NexTrade. Instinet - the largest ECN - posts its bids and offers and prints its trades on the ADF (an ECN-requested quote- and trade-display facility, operated by The National Association of Securities Dealers, that serves as an alternative to SuperMontage). Island, though it merged with Instinet, posts its quotes and prints via the Cincinnati Stock Exchange. Finally, Archipelago, which is transitioning into an exchange, will run its own order book outside of SuperMontage, but is in discussions with Nasdaq to have a link into the system.
Against this landscape, Coughlin monitors all competing venues. Then, all of a sudden, a red X appears next to a symbol or the quote flickers. Coughlin looks down and notices that Cisco is locked: someone has posted an order on Instinet to sell Cisco at $13.55, while market makers on SuperMontage are offering to buy Cisco at $13.55, but the orders can't interact because the systems aren't linked. One reason for this is that Instinet quotes its bids and offers on ADF and is not a participant in SuperMontage. While Instinet, if it can't match orders internally, does route out to SuperMontage and other ECNs, SuperMontage does not route orders outside its system.
It's a phenomenon most frustrating to traders known as locked and crossed markets, where, for a brief moment, perhaps only one second, quote screens flicker, signifying that a trade cannot occur.
A locked market occurs when the bid, or price to buy, say $20, is the same as the offer to sell at $20, thus a trade cannot take place because there is no spread. However, under most circumstances, internal rules and algorithms auto-execute such trades to avoid locking the markets. But across unlinked systems, such as ADF and SuperMontage, locks occur when matching bids and offers can't interact.
Typically, a crossed market occurs when the bid is higher than the offer - say the best bid in the National Market System is $50, and the best offer is at $45. Again, most trading venues have internal safeguards that ensure crossed markets can't happen, but across markets they can and do occur.
Locked and crossed markets are a problem, say market makers. "It's confusion," says Coughlin. "Is it a stale quote, (or) is it a real quote? It definitely affects price discovery," he adds. "There's pretty much an unfairness going on." says Coughlin, explaining that customers may not receive the best price when a lock or cross occurs.
WHY ARE LOCKS & CROSSES ON THE RISE?
The answer is simple: access fees. Here's an example. On March 31, JPMorgan was bidding $24 for Yahoo in SuperMontage, a customer of Instinet had posted a bid of $24 for the stock on Instinet's system while a customer on Archipelago was offering $24 for Yahoo. Archipelago's customer could have executed the order by hitting JPMorgan's bid on SuperMontage or the bid on Instinet, says Coughlin, but it didn't. One possible reason is that Archipelago's customer didn't want to pay an access fee to SuperMontage or Instinet, so they chose to become a liquidity provider by placing the sell order on Archipelago, which locks the market.
The impact is that, "It looks like it's creating a disorderly market to investors and institutions," says Miranda Mizen, senior analyst with TowerGroup.
Prior to SuperMontage launching in October, this did not happen because the ECNs were all participating in Nasdaq, and they were subject to the same rule that required the market makers to execute against all posted orders before they lock or cross a market, says a Nasdaq official who requested anonymity.
Now that ECNs are operating independently, locks and crosses are happening in the largest, most widely traded stocks, like Cisco and IBM, where ECNs are major players.
For example, Microsoft is one of the top-10 locked and crossed stocks, says Chris Nagy, head of trading at Ameritrade, who sends orders to market makers on SuperMontage and ECNs on behalf of retail investors. He notes Microsoft was locked 25 percent of the entire trading day on Dec. 2, according to a Feb. 4 Nasdaq study, which examined trading on SuperMontage and the rest of the Nasdaq market.
Though locked markets don't last long, they occur frequently, says Nagy. "Since the price can change and flicker many times (every second), if you're waiting to get an execution and you can't get it automatically, therein lies your problem," says Nagy.
Those suffering the most are Nasdaq market makers who execute retail order flow and retail investors who may not receive the best price. This can cause auto-execution systems used by market makers to halt. If the bid and offer are the same, these systems assume the quote is stale or incorrect. If Nasdaq market makers auto-execution systems shut down, the market makers have to manually execute the orders which significantly slows trading.
"When markets are locked, pricing tends to be confusing at that point, automated executions tend to halt, and you've got a somewhat dysfunctional marketplace," says Nagy.
Robin Jackson, senior vice president of electronic trading at Schwab Capital Markets, says, "Our contention is more the accessibility of the locked and crossed market. ... The bids and offers that are locking and crossing the market are, in a sense, held up in the plumbing," Jackson says.
Tom Matchett, vice president in charge of automated trading at Schwab Capital Markets, adds that in order to have a fair market, "We're looking at all the members of the marketplace playing on a level field."
A FRAGMENTED MARKET
There really isn't a locked and crossed market problem," says Sang Lee, manager of the securities and investments group at Celent Communications. "The problem is we now have multiple venues for trading Nasdaq stocks. Because of that, and because certain venues for trading Nasdaq stocks are not as quick or directly connected with SuperMontage, that's where we see a problem with locked and crossed markets."
Nasdaq's own report on the introduction of SuperMontage supports this view: "When locks and crosses occur, they are a direct result of non-linked market centers that have chosen both not be represented in the SuperMontage and not to route to the market center with the best available price."
TowerGroup's Mizen traces the cause of locked and crossed markets to fragmentation and the fact that the three biggest contenders - Instinet, Island and Archipelago - "are operating independently. It's exacerbated by the fact that SuperMontage only has 20 percent of Nasdaq-trading volume, Instinet/Island has 30 percent and Arca (Archipelago) has 14 percent market share," she says.
Although Nasdaq also levies access fees for SuperMontage, some are blaming ECNs for encouraging their customers to lock and cross markets by paying rebates for posting limit orders and charging access fees to the liquidity takers.
"I think it would be better if this aspect of trading was out of the market and if, instead, people were buying and selling stocks for more fundamental reasons," says Dean Furbush, executive vice president, Nasdaq Transaction Services. Furbush heads up Nasdaq's SuperMontage project and has brought the matter to the Securities and Exchange Commission.
He says that locks and crosses never occur in SuperMontage, because the trading system executes orders in one-tenth of a second and can execute every marketable order. "What Nasdaq did with SuperMontage was raise the bar so much so that people don't expect locked and crossed markets, because we don't have them," says Furbush. The locked-and-crossed situation "refers to the relationship between SuperMontage and entities that are outside it," he says.
LIQUIDITY REBATES AND ACCESS FEES
Of concern to Nasdaq officials, as well as market makers, is the underlying economics that are motivating traders to lock and cross markets across SuperMontage and the other ECNs.
"There's an awful lot of very interesting economics here," says Larry Harris, chief economist with the SEC, who notes that locks and crosses have increased substantially since the ADF started in July. Others trace the increase in frequency to the launch of SuperMontage on Oct. 16 and Instinet beginning to post its quotes on ADF in October.
"Both Instinet and SuperMontage and many other ECN systems have a pricing system that depends on whether you initiate a trade or you offer liquidity," explains Harris.
Here's how it works: When someone submits a resting order - a limit order or quote -that gets executed, the trader typically gets 2 mil (millicents) per share as a liquidity rebate (the same as two-tenths of a cent, or 20 cents per 100-share trade). But, if a trader submits a market order to initiate a trade with a standing or resting order, they have to pay 3 mil.
So, exchanges and ECNs are earning 30 cents per 100 shares and they're paying out 20 cents - the difference is 10 cents per 100 shares, which they use to run their systems, explains Harris.
One of the reasons the ECNs do this is because each ECN wants to have limit orders. "They pay the liquidity rebate to get the limit order and then that gets them more liquidity in the system, and that attracts the market orders," says Harris.
INCENTIVES & MOTIVATORS
Access fees and liquidity rebates are becoming the primary motivation for executing trades, contend sources. "For the most part, it's all revenue driven," says Coughlin. "People are looking to be the provider of liquidity versus the taker of liquidity."
The standard charge is known as "3-2" (30 cents for accessing liquidity and 20 cents for providing liquidity) - "It's the fees that most exchanges and ECNs charge traders for accessing their quotes and orders," says Harris.
Furthermore, Harris contends, "There's a huge transparency problem" being created by the fees. When markets are locked, Harris explains, "The quoted bid/ask spread is zero, but the true spread is half a cent." This is because the liquidity rebate of 2 mil plus the access fee of 3 mil adds up to five mil (five-tenths of a cent), which is the same as half a cent.
Because of the access fees and liquidity rebates, critics say that participants - especially customers of the two leading ECNs Instinet and Island - are deliberately locking and crossing markets rather than hitting the bid or offer in SuperMontage where they would have to pay a so-called access fee.
According to Nasdaq's Feb. 4 report, ADF (where Instinet quotes)initiated 56.2 percent of the lock/cross events occurring in all stocks from Dec. 2 through Dec. 6, whereas Cincinnati/Island initiated 23.7 percent, Nasdaq/SuperMontage 15 percent and Amex 4.2 percent.
What's more, several sources say that Instinet and Island often lock each other, because while Instinet routes out to SuperMontage and other ECNs, Island does not.
To illustrate how the liquidity-rebate game works, Furbush says suppose that the best bid was coming out of Merrill Lynch at $20 on Nasdaq. "You could say, 'Great, I'll go sell into this bid.' If I do that, because I'm a market order hitting a limit order, I'm going to have to pay 3 mils or 30 cents per 100 shares traded on top of $20. Instead, I'm just going to put a $20 offer on Instinet or Island."
"Who cares (if) it locks the market for a little bit, but now someone else is going to have to lift me and I'm going to get the 20 cents. In so far as that is driving these locked and crossed markets, we think it's not helpful," says the Nasdaq executive.
Andrew Goldman, executive vice president, global marketing and communications at Instinet Corp., admits that locks and crosses are occurring but contends they are not a problem.
"It is definitely occurring. I would challenge the fundamental proposition that somehow this is detrimental to investor's interests. At the heart of a locked or crossed market is the proposition that you are narrowing the spreads that are being offered to investors," says Goldman.
However, a Nasdaq official says, "We're told that some ECNs are intentionally locking the markets to require the market makers to take out their locking or crossing quotes and when they do this, they have to pay an access fees." The Nasdaq official adds, "The market-making firms have complained that the ECNs are basically extorting ECN-access fees (because market makers) have to make an effort to take out those locked and crossed markets for purposes of best-execution obligations."
In response to the view that traders are deliberating locking and crossing markets to profit from liquidity rebates, Instinet's Goldman says, "Why (customers of Instinet) are sending certain orders, it's a difficult rationale to figure out given the diverse number of trading strategies people employ and the reasons they use our marketplace." He continues, "We think it has more to do with the liquidity, the speed, the certainty of execution and the value-added brokerage service that we offer."
Meanwhile, market makers are locked in a battle over paying access fees to ECNs.
The basis for the unfairness, explains Coughlin, is that market makers can't charge an ECN a fee for accessing a quote, whereas ECNs can. "If I'm bidding $20 for stock and another ECN (customer) is locking me at $20, I now have to pay a fee to buy stock. That (party) should have sold stock to me at $20 before locking the market," he says. "Is it fair that Island can charge a fee to me and the market makers can't?" he asks.
The essence of the unfairness is that market makers have a best-execution obligation. "If someone else is offering at $20 on an ECN, I have a best-execution responsibility to buy stock at $20," says Coughlin. "By adhering to my best-execution responsibility, I end up paying a fee," he adds. For the most part, the market maker absorbs the fee and doesn't pass it onto the customer.
WILL THE SEC ACT?
Market makers and Nasdaq officials say the matter is now for the SEC to decide. "That's the battle right now: Who is winning the battle of market share," says Coughlin. "The SEC is faced with a landscape of ECNs and access fees. One (market center) is free and one (market center) charges," he says.
Several traders claim that access fees are high on SEC Chairman William Donaldson's agenda. But according to an SEC spokesman, "There's nothing pending at the moment. It's an issue of continuing concern to us."
Meanwhile, there are various remedies that have been talked about. "What we've talked to the SEC about is maybe you can't charge an access fee if you locked the market," says Furbush. Coughlin confirms there's a proposal to say if someone locks the market, either charge them or don't pay them (the liquidity rebate).
One of the proposals before the SEC is to reflect access fees in the ECN's quote. "Another solution is to say that all prices would be adjusted by the access fee. To do that, we'd have to trade in sub-penny increments," adds Harris, who suggests that is unlikely.
"The right solution is that we need access to standards and pricing conventions," says Harris. At market-structure hearings that were held last fall, the traders asked repeatedly for pricing standards, he says. "What they meant was when we see a quote for $20, they want that quote to mean $20 and not $20 plus 3 mil. They want: What you see is what you get."
To resolve the issue, TowerGroup's Mizen says, "It will be a combination of regulation, in terms of the SEC ruling, best effort, and maybe remodeling the financial incentives to discourage such behavior."
Market makers are watching. "We are lobbying heavily for equivalent standards amongst execution venues," says Schwab Capital Market's Matchett, adding that he doesn't know whether the course that will be taken is regulatory or good old-fashioned business dealings. "It's already gone from a low chatter to a steady roar and I think it's going to get much louder."
ECN Fees Ring up Tab for Market Makers
Access fees charged by electronic-communications networks (ECNs) are confusing and interfering with market makers trying to deliver best execution, contend critics.
Ed Coughlin, head Nasdaq trader at Bernard L. Madoff Investment Securities LLC, says that if he needs to sell stock for a customer and an ECN is bidding $20, he doesn't get $20 - he gets $20 minus three-tenths of a cent per share or $19.997.
"What's being created here is a lot of confusion, it's unnecessary," says Larry Harris, chief economist for the Securities and Exchange Commission. "Suppose you have a person offering a price of 20 with no access fee and another person is offering a price of 19 with an access fee of nine-tenths of a cent," says Harris. "The system is going to route to the 19 because it's the best price, even though it's one mil (one-tenth of a cent) better than the 20," says the SEC economist. "If the confirmation has to say 19 because of the trade price, then the broker/dealer ends up eating it," adds Harris.
"ECNs can price discriminate, they can charge different things to different people," says Dean Furbush, executive vice president, Nasdaq Transaction Services.
Some ECNs charge more than three millicents (3 mil) or 30 cents per hundred shares-which is the standard access fee for liquidity takers charged by Instinet and Island or by Nasdaq for using SuperMontage. If the order is routed to NexTrade, the market maker has to pay nine-tenths of a dollar or 90 cents per 100 shares, says Coughlin. While that doesn't seem like a lot of money, Coughlin says, "If you tend to access (ECN) quotes with access fees, it adds up fairly quickly." For a 1,000-share-trade, it costs $9 to access the ECN quote. If a discount broker is charging a retail customer $9.95 to enter a trade online, they could also be paying $9 to access that ECN quote. On a $5,000 share order, the fee goes up to $45; on 100,000 shares, that's $900 a day. As a rule, market makers do not pass on the costs to their customers, he says.