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Nasdaq offers SuperMontage as a more attractive venue for market makers to conduct their business.

At a recent Nasdaq press briefing held to answer questions about their proposed quote aggregation and execution system called SuperMontage, Nasdaq officials described the securities markets in the U.S. as something magical; not easily defined and less easily replicated. They told of foreign emissaries making pilgrimages to Nasdaq, asking for the key–the secret to how they might develop such a system in their native country.

"The answer," says the Nasdaq official, "is we don't know."

Therein lies the trepidation with authorizing changes in the U.S. securities markets: no one is sure what the effects of any restructuring might be. So when it comes to addressing market fragmentation–the fear that investors' limit orders might be stranded in one, isolated liquidity pool because multiple venues are trading the same stock–the SEC moves very cautiously, lest they should harm a system not completely understood.

The past year has been frought with debate on the issue of market fragmentation as a result of the growing popularity of ECNs–electronic communications networks that provide an alternative to executing a trade over Nasdaq's system. ECNs have garnered a strong foothold, and currently match about 30% of trades that occur in Nasdaq stocks on their own networks. Their allure came from providing features Nasdaq's systems did not. "Nasdaq execution systems were horribly inefficient, they didn't offer you anonymity and there was no ability to use a reserve book–those are three big features. So, the ECNs offered those things and market makers beat a path to their door," says head of Nasdaq trading at Bernard L. Madoff Investment Securities, Andrew Madoff.

Enter SuperMontage, and with it Nasdaq's attempt to offer a more attractive venue for market makers to conduct their business. SuperMonatge would display the top three market quotes, whether posted on an ECN or sent by a market maker, giving investors a depth of book they did not have before. If the SEC approves the proposal, which is quite possible considering Nasdaq has addressed ECN concerns seven times with seven amendments, the ECNs fear their regulator will become their greatest competitor.

That makes some ECNs livid. Though it appears that Nasdaq is only attempting, through the SuperMontage proposal, to enhance the functionality of its system, the ECNs see SuperMontage as an ECN with government-mandated liquidity. The order handling rules instituted a few years ago by the SEC require that all ECNs send their top-of-book quotes (the best bid and ask price on a trading system), to Nasdaq for display. If SuperMontage, in effect, creates an entity where orders are matched, just like ECNs, customers can use a reserve book, just like ECNs and orders are executed efficiently, just like ECNs, how can they survive against a competitor with such guaranteed volume? The answer: If Nasdaq technology does what many familiar with its past systems think it will do ... if it fails.

Nasdaq officials refute charges they are creating a monopolistic environment because, they say, for orders other than top-of-book, placing additional information into SuperMontage is totally voluntary. Nasdaq says it is only trying to improve its current system and provide investors with the best place to find liquidity for their limit orders, the same way that ECNs did when they entered the market. Nasdaq also says that as far as technology is concerned, this time things are going to be different.

One of the major features of Nasdaq's SuperMontage will be the ability for investors to see the top three bids and offers in the market for any given stock. The levels will be viewed as large aggregated chunks of stock showing all the volume available at a given price point. Currently, Nasdaq only shows the top bid and offer from a market maker or ECN. Orders placed into the system will be filled on a strict price/time priority–first come, first serve.

Some people see the three-level depth of book as being a major step in the right direction, while others question the benefit of only seeing three levels in a decimal world. Professor of Finance at the Zicklin School of Business, Baruch College, Robert Schwartz says that seeing a stock offered at $20.00, $20.01 and $20.02 might not provide investors with enough information about what stock is available–the fear being that significant volumes of stock could be sitting undisplayed at $20.03 or higher. "The price dimension concerns me a little bit from the point of view that we are moving to decimals with a penny increment," says Schwartz, "I don't have confidence that that will be more informative than up and down in s'teenths."

SuperMontage proponents see the move to a three-level depth of book as a definite improvement nonetheless. Vice Chairman of Charles Schwab Lon Gorman says, "SuperMontage takes the next step in bringing some depth, which is extremely, extraordinarily important–making depth more broadly available, whether to retail or institutional customers, is invaluable information." With greater depth of book customers have greater choice in their investment decisions, sometimes getting a large chunk of stock moved is more important than getting it done at the best price.

In a separate bottom section of the montage, individual bids and offers in the queue will be listed, some with attribution, some anonymously. Another major selling point of the system is the new ability for market makers to list multiple quotes, giving them the ability to separate out their agency orders from their proprietary trading.

Previously, market makers were only allowed to post one bid and offer in Nasdaq's system and were usually loathe to represent a customer's agency order in their quote. That is because market makers are required to fill orders which are in line with the size and price of a stock they have displayed in the market. A market maker may have no interest in doing business at a price dictated by their customer's personal order. For example, if a market maker's customer wants to sell some stock at $20 but the market maker feels that the stock is worth at least $20.50, they would not want to show the $20 quote under their name and assume responsibility for filling orders at that price.

Considering their disinclination to post such a quote under their name and also taking into account that market makers are required to either fill such an order, display it, or send it to another broker, sending those orders to ECNs seemed the perfect answer to the problem. One Nasdaq official says losing exclusive control over this market niche is why the ECNs are expressing such vocal opposition. "There are about 700 market makers and we are going to give every one of them a chance to display an order directly without going to an ECN, so you have seven anointed systems (ECNs) that can display customers limit orders now and we are going to give the capacity to display to 700 new market making participants," says the Nasdaq official who asked not to be named, "of course they don't want 700 new competitors in that part of their business."

Madoff says, "I can't imagine why I would put a bid in an ECN when I have the ability to put an order in a less expensive Nasdaq system which would probably have a much greater trading volume than any of the individual ECNs."

Additionally, market makers may be tempted to place agency orders into SuperMontage because, by its very nature, the system guarantees best execution, which market makers are required to provide. No longer will market makers face the unpleasant scenario of having their agency orders traded through which happens when a customer's limit order is accidentally skipped over in a volatile market and never filled. With SuperMontage's strict price/time priority, trade-throughs are theoretically impossible.

But just as market makers like Madoff gain something with SuperMontage, so, too, do they lose something, namely, the ability to be preferenced in an average order as the counterparty with whom an investor wants to trade. There are many different reasons investors chose one trading party over another. "Market makers represent many different flavors, some market makers represent greater amounts of liquidity than other market makers so there are all kinds of good reasons why investors choose to trade against certain market makers and those choices are going to be severely limited which we think is bad for the public," says President of the Bloomberg Tradebook ECN Kim Bang.

To firms like Madoff, however, not being preferenced through Nasdaq is inconsequential as most of their order flow arrangements are handled through direct connections with the brokerage firms sending them orders and not by way of any Nasdaq functionality. For ECNs, on the other hand, in addition to losing their niche of displaying market marker's agency orders, losing the ability to preference a market maker for outgoing orders is something their customers may not like at all.

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