Are you willing to sacrifice potential price improvement in exchange for lightning-fast speed and reliable executions? That's what investors who are trading the QQQ -- the extremely popular, American Stock Exchange-listed exchange-traded fund (ETF) -- must ask themselves today. Investors who rank speed as their top priority are increasingly routing their QQQ orders to Island, the electronic-communications network that has built its reputation through a rapid-fire matching engine that provides customers with sub-second fills. In contrast, investors who put a premium on finding the absolute best bid or offer for their QQQ orders are often sending their business to Amex -- the specialist-driven market that is home to a collective 107 ETF products.
Logically, you may ask, what venue would appeal to QQQ traders who desire speed and price improvement on an equal basis? Well, as the United States' listed market centers are currently structured, such an execution venue does not exist. Island, which began trading the QQQ around one year ago and is now the largest execution destination for the open-ended mutual fund, does not participate in the Intermarket Trading System -- the trading network that electronically links the Amex, New York Stock Exchange, Nasdaq and six other national securities exchanges.
Each participant in ITS, according to the network's so-called trade-through rule, cannot trade at an inferior price if there is a better price available at another ITS market. But since Island has chosen not to participate in ITS, it is not obligated to seek price improvement at another market when there is a better price available than its best price for the QQQ. Moreover, due to its lack of participation in ITS, Island cannot have its ETF quotes displayed in the National Consolidated Quote System -- the market-data platform that displays the best bids and offers for listed securities from all ITS markets.
Island's voluntary exclusion from ITS is both highly controversial and problematic. The ECN, which recently accounted for 31 percent of the QQQ volume over the course of a full trading week (see chart), is the fastest and most liquid QQQ trading venue. But since it operates a closed ECN that performs no external routing of orders, one thing Island cannot offer investors is the ability to improve upon QQQ prices listed on its order book.
Conversely, the Amex, NYSE and other ITS participants -- including the Archipelago ECN -- are obligated, via the trade-through rule, to either match a better QQQ price available on an away market or send its order to the market with the superior price. Moreover, unlike Island, these ITS market centers display their QQQ quotes on the NCQS, giving every investor with access to the national best bid and offer system the ability to see their prices.
But while Island would like to have its QQQ prices displayed in the NCQS, it cannot because it refuses to participate in ITS -- partly because of its internal-matching business model and partly because ITS could severely impact its speed. Specifically, Island is troubled by a time window tied to the ITS trade-through rule, which gives a market on the receiving end of an ITS order a maximum of 30 seconds to respond to that order.
Noting that "milliseconds count enormously" for the likes of program traders and quantitative traders that trade the QQQ via the ECN's matching engine, Island spokesman Andrew Goldman decries the time window.
"The sorts of people who use Island, given the sophisticated trading models they use, demand immediate executions as quickly as they can get them. Any delay that you introduce or any intermediary factor that you introduce between them and their trade, we think, is an improper role for the marketplace," he says.
However, Brett Redfearn, senior vice president of business strategy and equity order flow at the Amex, retorts that Island's exclusion from the ITS has provided the ECN with unfair advantages in QQQ trading. "This is an issue about what is a level playing field," he says. "If you have two cars in a race, and one of them has to abide by the speed limit and the other one doesn't, then who's going to win?"
Trade-Through Rule: A Speed Inhibitor?
Island, offering its customers a combination of speed and execution reliability, has positioned itself as the front-runner in the QQQ trading race. But why? Well, the Amex's Redfearn says that Island's success can be, at least partially, attributed to the fact that it is "trading through" better prices on a consistent basis, "locking and crossing the QQQ market all day long." However, Goldman says the reasons for Island's quick ascension to the top of the QQQ market run far deeper than the ECN's decision not to join ITS. When Island began trading the QQQ in early 2001, says Goldman, the ECN did not know what to expect, because its refusal to participate in ITS also kept its QQQ quotes out of the NCQS. "It was kind of the equivalent of trying to jump into a fight with your arm tied behind your back and hopping on one leg," he says.
But the fact that the Amex was the dominant QQQ market gave Island the ammunition it needed to build its liquidity. Goldman says that the inefficiencies of the Amex's floor-based, auction-driven environment -- such as the market's inability to offer immediate cancellations of orders -- provided Island with an opening to reel in speed-hungry program and quantitative traders. "Amex did a very good job of serving traditional market participants, but was not a marketplace structured to serve the core Island market participants," he says. "If a quant trader's model all of the sudden changes, and then in milliseconds he has to cancel (his QQQ) orders and resend new ones, that would not work with the Amex, because by the time you reach a specialist on the floor and try to get him to physically cancel an order, it's too late."
QQQ traders, says Goldman, were also attracted to Island's fee structure. "It costs no money to place and no money to cancel an order (in Island) -- there is only a charge if an order is executed," he notes.
That said, there is no denying that Island's speed element is the single biggest draw for QQQ traders. And there is also no question that participants in ITS cannot compete with Island's extremely fast executions, in part because of the trade-through rule that they must adhere to.
"Do you not believe that the American Stock Exchange, if (it) could ignore better bids and offers from away markets, would be able to (offer) faster executions?" Redfearn asks rhetorically. ITS, he admits, is slow, but, by rule, Amex cannot trade through the best QQQ price in the market, and therefore cannot compete on a level playing field with Island for traders who want extraordinarily fast QQQ executions.
Archipelago, the ECN that is scheduled to morph into an exchange later this year, shares the Amex's frustrations about the reasoning behind Island's choice not to join ITS. Jamie Selway, chief economist at Archipelago, says the ECN started to trade the QQQ in August 2000, after it agreed to participate in the Computer Assisted Execution System, a Nasdaq trading platform that has a built-in interface to ITS. Via CAES/ITS, says Selway, Archipelago also acquired the ability to post its listed quotes on the NCQS.
Of course, as part of ITS, Archipelago -- which trades between three and four million QQQ shares on a good day -- has to adhere to the trade-through rule. But Selway says that Island is "being disingenuous" when it rails about ITS' speed problems. "Island has a very strong opinion about ITS, but has never routed a single ITS order. They're not speaking from experience, they're speaking from speculation," he says. "The reality is that ITS, when (routing an order to) the Cincinnati Stock Exchange, or to another third-market participant, is extremely fast."
Indeed, Selway says, when Archipelago routes an ITS order to the market-making firm Knight-Trimark, the average response time is one second. Cincinnati also is fast, he says, turning around ITS orders in "three seconds or less." The NYSE, on the other hand, takes an average of "16 to 18 seconds" to respond to ITS orders, but offers better opportunities for price improvement, says Selway. Island refuses to participate in ITS, he says, because it simply does not want to route orders outside of its matching engine, even if it only takes the ECN "a half a second to do it."
However, Sang Lee, an analyst covering e-trading at the research and consulting firm Celent Communications, says that it's unrealistic for anyone to expect Island to completely revamp its business model to join ITS. "You can't force them to change, just because other markets can't compete with them," he says. "Island uses a closed model. They don't go out and seek out best possible execution. But that's apparently what their customers want. They don't mind the fact that when they send their order to Island, the order will be executed within that system."
A "Sour" Opinion
Lee also says that for other markets to throw stones at Island is unjust, because different types of investors have varying definitions of best execution. In the case of the Amex, he adds, gripes about Island's regulatory advantages sound like sour grapes. "They can complain all they want. But the thing is, the (QQQ) was theirs to begin with and they lost it. I think there is another way for Amex to try and get that market share back, as opposed to (complaining about) regulation," says Lee.
Citing the fact that the professional traders using Island are closely scrutinizing their profit and loss statements on a daily basis, Goldman agrees that QQQ traders are not concerned about Island's policy prohibiting external order routing. In fact, he says, part of the reason QQQ traders take their business to Island is because of the ECN's internal matching model. If Island were to join ITS, Goldman emphasizes, it could "no longer guarantee" quality executions to its QQQ customers.
Archipelago's Selway retorts that Island is "trivializing" the speed and execution issues by tying all of its concerns to ITS. "The idea that any time you leave your system you're degrading your client, that's just silly," he says. "If Island built a direct interface to Archipelago's (matching engine), for example, they could get (QQQ) trades turned around in 500 milliseconds." Hammering his point home, Selway says that Archipelago has built an electronic interface to Island, and has no problem routing a QQQ order to its competitor -- as long as Island has the best price.
But Lee says that the main reason Archipelago wants Island to route orders directly to its ECN is because Island, currently, has a "hell of a lot more" liquidity than Archipelago. Moreover, he argues that the competitive QQQ landscape is fine just as it is. "Would it be ideal to have all this (QQQ) liquidity interconnected? Yes, of course, but then what happens to competition?" Lee asks rhetorically.
Amex's Redfearn counters that Island would only promote competition if it joined ITS. What's more, he says that by excluding itself from ITS, Island is also potentially cheating average individual investors from getting the best QQQ price. "Let's say there is a buyer on Island who is willing to pay $10 for a stock. And let's say that your grandmother is willing to pay $10.02 for that same stock on the Amex. If all that order flow has now been segmented away from the national market system, your grandmother is not going to be able to sell that stock at her price when she wants to, because (Island) is ignoring her quote," says Redfearn.
Emphasizing that, prior to Island, the Amex fended off QQQ competition from the likes of the NYSE and Archipelago, Redfearn says that the exchange just wants everyone trading the open-ended mutual fund to play by the same rules. However, he also says that it would not be feasible to resolve the Island/Amex dispute by simply eliminating the trade-through rule. Without that rule, he says, the markets would become too fragmented and price discovery would be shattered.
Archipelago's Selway concurs, noting that the death of the trade-through rule could lead to chaos. "If there wasn't a trade-through rule, would the New York Stock Exchange, with its 80 percent market share (in listed securities), respect the prices of other people -- or would they go pull an Island? It might be a scary thing if (the Big Board) pulled an Island," he says.
But one Island official, speaking on the condition of anonymity, says that, regardless of what happens to the trade-through rule, its imperative for the ECN and its rivals to forge some kind of compromise that will give Island the right to publish its QQQ quote in the NCQS. "The existing regulatory structure is costing investors millions of dollars a day. Every day that goes by that we're not part of the national market system, investors are being harmed directly," the source says.
Celent's Lee, meanwhile, says that the SEC could solve the QQQ dilemma via one simple act: the approval of Island's application to become a full-fledged stock exchange. "The ironic thing about Island is that once it became an exchange, it would have to participate in ITS," he concludes.