The tide is turning for Nasdaq, the electronic stock mart that once got whipped so badly by regulation, ECNs and a brutal market, that it seemed close to drowning in a sea of red ink. Now it is back playing in the big leagues again, having signed a deal to acquire INET from Reuters in a $934.5 million transaction for Instinet that had an overall value of $1.9 billion. The deal is expected to take about six months to close.
So, with this giving Nasdaq a market share of perhaps between 65 percent to 75 percent in the trading of its own listed stocks, more bells and whistles and places to cut overlapping services, what does it do for the very foundation stone of this once quixotic marketplace? Wither the Nasdaq market maker?
If you listen to Nasdaq CEO Bob Greifeld tell it, the Nasdaq market maker has never been as important. Greifeld recently spoke of an "all-time high" mutual respect between Nasdaq and the market makers. "Clearly, they are the backbone of the Nasdaq Stock Market," he told Traders Magazine last month. "They have been since its inception, and in this decimal world in which we live, the market makers have done a remarkable job of transforming their business models."
Some of the market marker desks polled for the 2005 Traders Magazine Annual Survey of Nasdaq/OTC Market Makers return the compliment. However, 33 percent feel that Nasdaq management is taking positive steps for the dealer community. The same percent disagreed, while a similar percent had no opinion. Still, the response rate does not reflect the views of a diverse group of trading pros, including dealers, who have in recent weeks privately praised Greifeld.
At the same time, this is a much-changed environment from the days of fractional trading. That's when the term market maker had a precise meaning, a desk that posted two-side continuous quotes, committed capital and made money on the spread. Heavy losses were not uncommon. But it was generally a profitable era for many market makers. Some of that still exists in pockets, especially in the OTC Bulletin Board and Pink Sheets. However, most of the OTC order flow today is coursing through a galaxy of pipelines – algorithmic, direct access, crossing networks, ECNs and other machines. It is difficult to completely quantify how, in fact, most orders are exactly handled. By one rough estimate, some 75 percent of equity order flow today is handled through computerized models. And algorithmic and programmed trades are as pervasive as the VWAP, TWAP and the exotic algo strategies used by institutions.
The past 12 months have accelerated the computerized trend. It opened the way for even more algorithmic trading, squeezing out unprofitable players and others who do not see a viable future, while opening a path for hybrid market models. Computerization has resulted in job losses because of cut-throat competition. Just several weeks ago, deep discounter BrokerageAmerica, a market maker that once set its sights on becoming the leading Nasdaq market maker, pulled the plug. Some pros said it ran out of capital and was also hurt last year by a fire at its technology plant. Its most recent annual Securities and Exchange Commission filing showed it had lost $7.6 million on revenues of $26.9 million for the year ended December 2003. One established player, Schwab Soundview Capital Markets, did not see a future running its own market maker. So Schwab sold its Capital Markets unit late last year to UBS for $265 million, exiting the business of market making. UBS thus became a newly-crowned giant, providing it an extraordinary ability to internalize more order flow. And it dared to compete on the same turf as industry leader Knight Equity Markets.
But some pros say the trend now favors a hybrid model. This model will in part reflect the requirements of the fast markets that can quickly satisfy best execution under the new Reg NMS trade-through, or so-called order protection rule. Merrill Lynch, once a bastion of old-style market making – as well as listed block trading – has entered this new age. "We are investing in automation where it enhances the performance of the firm and the execution outcomes for our clients," Mike Stewart, Merrill's head of global cash equity recently told Traders Magazine.
In the final analysis, this dramatic transformation in the U.S. institutional equity markets has been brought about by the demands of a buyside community hit by the harsh realities of the equities markets. The buyside is trying to reduce transaction costs in a decimalized world, a world where the typical trade size has dropped to 400 shares. The buyside is now in the catbird's seat. It is the era of the low-touch transaction of one cent a share for algorithmic trades while the traditional high-touch trade of capital commitment can be had for the pricier five and six cents price tag. With algorithms, buysiders have a way once again to execute large blocks, albeit in small individual size trades. Overall, respondents to the survey said 50 percent of their firms' equity trades are handled algorithmically. The number of Nasdaq trades in this category is 25 percent. And boy, these are dirt-cheap trades.
"Commission compression is here to stay," Peter Driscoll, a buyside trader with Northern Trust told a conference in New York. "The blended rate of many firms is down to about two-and-a-half cents to three cents. This rate isn't enough to support the sellside infrastructure. So they push us to these algorithmic trading tools."
But this same push from the sellside is in itself a response to the agenda of the powerful buyside community. One buysider said Nasdaq is paying more attention to his group, offering tools, for instance, such as the Experimental Market Information (EMI) via nasdaqtrader.com. So far, this product provides near realtime market data to all comers. However, says this buysider, "the sellside won't like us having this level of access." Buysiders want even more analytical tools so they can monitor costs and weigh up market impact costs. One buysider, for example, tells of how he can weigh up market impact on a "package" of 150 names on the buyside and 150 names on the sellside, with a value of $100 million per side. Electronic tools allow him to run an assessment. Similarly, more transaction cost-analysis tools permit buysiders to measure the performance of individual brokers. That is forcing dealers to pay closer attention to their methodologies in trading.
Some pros on the sellside say that all of this will eventually lead to trouble. Steve Brain, the head of systematic trading at agency broker Instinet, has a warning. Despite assurances from sellside trading firms, he has his doubts that they all maintain a strict Chinese Wall between their proprietary and customer operations. He contends that some sellside desks, which offer cheap algorithmic trades, can't be trusted to protect the anonymity of buyside order flow. These desks, he says, can make bets based on inferences from public data – fueled by this same buyside order flow – on the direction of the market. "Agency brokers can minimize unnecessary trading costs because they cannot commit capital to complete against their clients," he says elsewhere in this month's issue.
Meanwhile, desks that regard themselves as market makers, soldier on. And what an optimistic lot this group is. Some 70 percent see their desks as profit centers; only about 15 percent see their desks as cost centers, the same percentage that see their desks as breakeven operations. Nasdaq today is described as an agency market. However, respondents overall said that some 70 percent of their Nasdaq trades are executed as principal though the individual responses did vary widely.
Nasdaq's planned merger with INET, coming just as this survey was nearing completion, would clearly change the playing field in the OTC market. About 67 percent of respondents said Nasdaq's overall performance today, compared with ECNs and ATSs, was about the same. The integration of INET is likely to sway opinions in Nasdaq's favor, pros say. Greifeld says Instinet has "the leading technology on the planet with response times of 5 milliseconds for incoming orders."
Greifeld noted at a press conference that Reg NMS has "defined the new competitive landscape by calling for all market centers to be mutually accessible."
"With this move we maintain our status as the low-cost provider and at the same time provide increased order interaction for both Nasdaq and exchange listed securities," he added. "We also believe this further enhances our ability to attract new listings." With Nasdaq also hopeful it will soon be approved as a stock exchange by the SEC, Nasdaq market makers must be also hoping some of the glory days will return to the dealer community.
