Traders who want to act as their own specialists now have their chance.
An alternative trading system called Elephant eXpress is making it possible for traders to access the National Market System (NMS) via a link with the limit order book of the all-electronic Cincinnati Stock Exchange. Traders can post their own quotes in the Consolidated Quotation System and trade directly with bona fide specialists and third market dealers over the Intermarket Trading System.
A group of hedge funds and day traders has been using the system for the past year.
Traders no longer need to delegate the handling of their orders to an individual who may not have their best interests at heart, says co-creator David Sher.
"We give our customers the ability to interact with the market as if they were specialists," said Sher, president of ElephantX dotcom, the small New York-based agency brokerage which owns the ATS. "Changing, updating or canceling orders is instantaneous."
The ATS is the brainchild of David and his twin brother Robert Sher, both ex-hedge fund managers themselves. Age 38, the brothers founded ElephantX in May 1999, after running Lafayette Capital Management from 1997 to 2000. Their largest single investor is Bear Stearns, formerly Lafayette Capital's prime broker and, once David Sher's employer.
The big broker also supplies about half of ElephantX's institutional client base from the ranks of Bear Stearn's clearing customers. The customers access the service through Bear Trade, Bear Stearns' proprietary order routing network.
In total, ElephantX's institutional customers number nearly 100. Most are basket-trading hedge funds, although the brothers count four of the top program traders on the New York Stock Exchange as customers.
Day traders are also signing up and the firm is actively pursuing deals with such direct access organizations as Track Data and Neovest.
Fast on the draw, such traders like the fact that they can cancel their orders instantly and auto-ex against other CSE specialists.
Here's how it works: An order placed on the system is eligible for execution against other orders in the ATS. If the order also happens to be the best quote in the ATS, it becomes the best quote on the limit order book. The order then becomes executable by all specialists at the Cincinnati. If the order represents the best quote at the Cincinnati, it becomes the Cincinnati's quote in the CQS. It then becomes executable by all specialists and third market dealers in the country over the ITS.
Traders can use Elephant eXpress to take out the quotations of other specialists over the ITS, but few want to, according to Sher.
Problems Solved
Sher says the service solves two problems. First, traders can be certain their best-of-market orders will be reflected in the national quote immediately. Often, he says, a specialist will delay posting a customer's order. Or, he will simply update his own quote rather than post the better-priced order. He might improve the price by a penny, but, in either case, the customer's order is not displayed.
Second, and perhaps most crucial, direct control over their orders means traders can cancel hundreds of them in an instant. Often, a basket trader will send out cancellation instructions to specialists at the two primary exchanges, wait precious seconds, but still get filled on many of the orders. That occurs most frequently during turbulent market conditions.
The brothers say the idea for Elephant eXpress was borne of their frustrations at Lafayette Capital.
Often facing big losses when news or market shifts hit in the middle of a trade, they scrambled to cancel their orders in time.
Exchange rules, though, give a specialist 90 seconds to act once he gets an order. He is under no obligation to do anything immediately. It may actually be profitable for him to execute the order.
"By giving the specialist time to fiddle with your order," Sher said, "you essentially grant him a call option on the order."
Sher notes that much of the time the market is reasonably balanced between buy and sell orders, giving the specialist no particular advantage. It is only when news is reported or an imbalance occurs that he has an edge. "Then, the fact that he has this order that he can sit with for awhile is very valuable," Sher added.
At Lafayette, the brothers strove to effect neutral strategies. They would buy the stocks in one sector, for example, and simultaneously sell those of another. But they often found themselves taking large intra-day bets. Orders on one side would go unfilled or, despite instructions to cancel, filled.
The service is most valuable when trading stocks with wide spreads, according to Sher. Traders who want to narrow a 10-cent, 20-cent or 30-cent spread – of which there are many for stocks below the top 100 names -face competition from the specialist if they send their orders to the Big Board, according to Sher. It is very easy for him to hide the trader's order by improving his quote by one cent.
"That's where you need the ability to step in front of the specialist," Sher said. "If he pennies up on you, you can penny up on him. You just change your quote. It's a different game when you're interacting with him as an equal."
Committing Capital
Traders who use the system do face at least one restriction. The maximum order size is capped at 25,000 shares. That way, if a trade goes bad the risk to Elephant is mitigated. As a pure agency broker, Elephant has no interest in committing capital.
Most trades occur against other eXpress subscribers or Cincinnati specialists. The Cincinnati is popular with traders looking for fast executions because it is the only exchange to offer automatic executions.
Sher claims executions total between zero and two million shares per day. If that's true, ElephantX's trades can account for a sizable portion of the CSE's order flow. In recent months, the bourse has traded between seven million and 15 million listed shares per day.
ElephantX's specialist unit, also named Elephant eXpress, is authorized to trade about 700 stocks. That includes all of the names in the S&P 500 index, a favorite of basket traders. Most are large-cap. "We know from running a statistical arbitrage hedge fund which stocks people will model," Robert Sher said.
The roster includes both listed and Nasdaq names. The CSE, like all regional exchanges, is slowly starting to offer Nasdaq trading. David Sher noted ElephantX is one of the few CSE specialists trading Nasdaq stocks, though.
The charge to trade is a half-cent per share. With volume, it drops to a quarter-cent. That compares to a DOT rate of nine-tenths of a cent, according to Sher.
There is no extra charge for orders considered premium' by the Big Board. Specialists there charge more to handle short sales, limit orders that sit for more than five minutes, and cancel/replace orders.
More Competition
The NYSE is not the only competition. Archipelago, one of the biggest ECNs, has offered direct access to the NMS since July 2000 through its participation in Nasdaq's InterMarket. It claims its listed executions run at about 12 million shares per day. It also just received approval to convert to a stock exchange in partnership with the Pacific Exchange.
The Island ECN is also seeking access to the NMS. It has petitioned the Securities and Exchange Commission to become a stock exchange and is also in talks with the Cincinnati Stock Exchange to become a specialist. And, despite being shut out from the NMS, it has taken a sizable chunk of the business in trading ETFs, or Exchange-Traded Funds.
The Shers are undaunted. "It's a niche," said David Sher. "It's a program trading niche."
