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Robert Sales
Robert Sales
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ADF Looks to Bypass ITS For Listed Equities

The National Association of Securities Dealers' Alternative Display Facility hopes to offer ECNs a way around the Intermarket Trading System, but hurdles remain.

The NASD's Alternative Display Facility is hoping to build its listed-equities business by offering participants a way around the Intermarket Trading System.

Today, every market trading listed stocks in the United States is subject to the rules governing the Intermarket Trading System - an outdated dealing platform that electronically links together the New York Stock Exchange, American Stock Exchange, Nasdaq Stock Market and six other regional-equity exchanges. Of course, since those exchanges have to adhere to Intermarket Trading System rules, brokerage firms - and the investors they represent - must follow regulations that sometimes hinder the quality of NYSE- and Amex-listed stock executions.

But what if there was a place where you could go to post your listed quote, and have it displayed to everyone in the Intermarket Trading System community, without having to actually participate in the ITS? That, in a nutshell, is the listed-equities strategy the National Association of Securities Dealers Alternative Display Facility is pursuing.

The Securities and Exchange Commission mandated the creation of the Alternative Display Facility, a quote-display and trade-printing facility, in 2001 - in large part to provide an alternative for electronic-communications networks that did not want to post their over-the-counter bids and offers on Nasdaq's SuperMontage network. But while the NASD has had little success convincing ECNs to display their Nasdaq quotes in its facility, the Alternative Display Facility has the potential to build a successful listed-equities business.

Steven Joachim, senior vice president of market operations and information services at the NASD, says that the Alternative Display Facility is going to try to attain listed-equities success by offering its participants an option for avoiding the Intermarket Trading System. The most common complaint about the Intermarket Trading System centers around its so-called trade-through rule, which states that ITS members cannot trade a stock at an inferior price if there is a better price available at an away market. In other words, for example, if a stock is being traded at the NYSE, but the Amex is offering a better price for that same stock, the order must be sent to the Amex, in accordance with the trade-through rule.

Though the rule was initially designed to ensure that investors get the absolute best prices for their listed orders, it can sometimes hinder the speed of executions. In fact, a time window integrated into the rule gives a market on the receiving end of an Intermarket Trading System order a maximum of 30 seconds to respond - an eternity for extremely fast-moving traders.

To accommodate potential Alternative Display Facility participants that did not want to be subject to the trade-through rule, or any other Intermarket Trading System regulations, the NASD - earlier this year - incorporated anti-ITS language into the listed-stock rules it created for the facility.

"What we (said) in our rules ... was that ADF participants, at their option, could choose to trade through ITS, or trade outside of ITS. If they decided to trade through ITS, they'd be subject to all ITS rules, including the trade-through rule. But if an ADF participant decided it wanted to opt out of ITS, they could trade with other ADF participants without being subject to ITS rules," says Joachim.

Unfortunately, he says, when the Alternative Display Facility applied for membership in the Intermarket Trading System, the ITS operating committee shot it down, mainly because it was not in favor of the NASD's "optional ITS" component. "There were some exchanges that believed that if this option was going to be provided to ADF members, than it should also be provided to all ITS-member (exchanges)," he says.

Subsequently, the NASD sent its optional Intermarket Trading System proposal, along with the rest of its rules for the Alternative Display Facility, to the SEC for review. The commission has yet to rule on the "optional-ITS issue," says Joachim, and the Alternative Display Facility's listed-equities business has consequently yet to get off the ground. The SEC did not respond to calls seeking comment.

But when the commission rules on the optional-Intermarket Trading System proposal, and the Alternative Display Facility finally launches its listed-equities business, Instinet may be one of the first firms in line to display its NYSE and Amex quotes in the NASD's facility.

Instinet - the global-agency-brokerage firm that owns and operates the largest ECN - has already agreed to post its Nasdaq bids and offers in the Alternative Display Facility. In fact, as of mid-October, Instinet remained the only firm committed to displaying its Nasdaq prices in the alternative to SuperMontage.

However, just because Instinet has hopped on board the Alternative Display Facility's bandwagon for over-the-counter securities doesn't necessarily mean it will follow the same path for listed stocks. An Instinet spokesman says that the ECN's participation in the Alternative Display Facility, for listed stocks, is a "reasonable thing to assume," but not a certainty.

The NASD's desire to avoid the Intermarket Trading System, he says, is "completely understandable," because the Alternative Display Facility is strictly a quote-display and trade-printing facility that is not involved in executions.

However, he also says that if the SEC were to grant the Alternative Display Facility an exemption from the Intermarket Trading System, it could put a heavier burden on ADF participants. "The SEC might say that anyone who is a participant in ADF may have to take on ITS trade-through obligations. In other words, if Instinet were to quote in the ADF for listed issues, we (may) have an obligation to follow the rules of the ITS," says the spokesman.

If the Alternative Display Facility can get a favorable ruling on the Intermarket Trading System, without shifting the burden of responsibility to its participants, it may also be able to recruit Island - the second-largest ECN. Island actually finalized a merger with Instinet, its one-time rival, on Sept. 20, but it will take some time before the ECNs can integrate the disparate businesses.

Just as Instinet shunned SuperMontage, Island also decided to post its Nasdaq quotes in an alternate facility. However, in lieu of choosing the Alternative Display Facility, Island selected the Cincinnati Stock Exchange as the venue for displaying its Nasdaq prices. But if Island can post its quotes for listed stocks in the Alternative Display Facility without having to adhere to the Intermarket Trading System's trade-through rule, it may eventually decide to display its NYSE- and Amex-stock prices in the NASD's facility.

Island has had excellent success trading the QQQ, the most popular exchange-traded fund listed at the Amex, without becoming a member of the Intermarket Trading System. In fact, since Island is not an exchange, it can trade the QQQ - an open-ended mutual fund, not a single stock - while totally ignoring the trade-through rule. But not participating in Intermarket Trading System is problematic for Island, which regularly accounts for more than a third of the volume of the QQQ, because it cannot advertise its QQQ prices to everyone in the listed-exchange community.

Through the Intermarket Trading System, Island could get a connection to the National Consolidated Quote System - the market-data platform that displays the best bids and offers for listed stocks to all Intermarket Trading System participants. But while the Intermarket Trading System would provide Island with a vehicle for advertising its QQQ prices to a broad range of firms, it would also force the ECN to adhere to the trade-through rule. And since Island's market model is built largely on speed and internal matching, it has decided that it can't afford to comply with a rule that could leave its customers' orders hanging for up to 30 seconds.


ADF Timeline

The SEC is still reviewing ADF's rules and market structure for listed equities, including its ITS proposal. It remains unclear when the ADF will begin posting quotes for NYSE and Amex stocks.

July 2002
SEC grants the ADF permission to post quotes for Nasdaq stocks, on a pilot basis. But the facility's listed-equities business remains in limbo.

Q1 2002
ADF is denied membership in the Intermarket Trading System, partly because it has written rules that allows its listed-equities participants to ignore the ITS. ADF subsequently sends its rules and ITS proposal to the SEC for review.

Jan. 2001
SEC approves Nasdaq's SuperMontage proposal, on the condition that the NASD builds an alternative-display facility.

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