The OTC Market Has a New Fix for Perennial Problem
Nasdaq, after years of criticism over its scattershot openings and closings, will soon start and end its days with an electronic call auction.
The new system, dubbed Nasdaq Cross, is being built in response to charges from regulators, traders, index providers and academics that Nasdaq's openings and closings produce too many prices, making it impossible to ascertain the true open or close.
Nasdaq Cross will bunch as many orders as possible to produce a price that more adequately reflects supply and demand in a security. The technology, which first will be used to determine Nasdaq's closing price, is scheduled to debut in the first quarter. Then, it is scheduled to be used in the second quarter to calculate the opening price.
"The industry needs a central facility where all the orders can come together in a price discovery process that is truly reflective of the market," said Adena Friedman, Nasdaq's executive vice president in charge of data products.
Nasdaq originally intended to apply the technology to its helter-skelter opening, but quickly changed its plans following a major slap in the face from Standard & Poor's. The indexing giant announced it would stop using Nasdaq's closing prices in the construction of its S&P 500 index and, for a trial period, use those prices from the American Stock Exchange.
The switch could result in large swaths of Nasdaq order flow migrating to the Amex at the close, especially from index traders. That would be a big boost for the Amex's Nasdaq program, which is struggling to win flow.
That the Amex trades a negligible amount of Nasdaq shares was apparently less of a concern for S&P than the methodology of its closing process. Like the New York Stock Exchange, the Amex closes (and opens) with a call auction. The auctions are not electronic, but are handled manually by specialists as is most order flow on the floor-based boards.
A call auction of the sort used by the exchanges brings together all buying and selling interest in a security to derive a single price. Because the auction typically involves a substantial portion of the day's share volume, the resultant price is considered the best indicator of the value of the security at that point in time. The price is said to have "cleared the market."
Nasdaq, on the other hand, does not derive its opening and closing prices by bunching orders. It simply takes the first and last prints of the day, respectively. And, until recently, the trades that led to those prints might have occurred on either Nasdaq's SuperMontage system, the ADF or any of the UTP exchanges.
That policy changed slightly this June-for the closing, at any rate. In a bid to impose order on the chaos, Nasdaq christened the NOCP, or Nasdaq Official Closing Price. Henceforth, only trades done on SuperMontage would be considered eligible as the Nasdaq closing price. Nasdaq will designate an official opening price in January, according to Friedman.
Single Trade
Still, both the opening and closing prices are based only on a single trade. That trade could be for as few as 100 shares. And with potentially millions of shares changing hands in the first and final minutes of the trading day, that single trade may bear no resemblance to any theoretical clearing price. That's been the chief criticism which Nasdaq is trying to address with the Nasdaq Cross.
"We want to make sure it is a convergence of orders," Friedman said. "So, that it is clearly a reflection of where the market is rather than picking something that happened at 9:30 or 4:00."
If Nasdaq succeeds in launching its cross, it will be the last major stock market to do so. In addition to the manual opening and closing auctions conducted by the New York and American exchanges, all of the world's major markets use electronic crosses at some point in their trading days.
That includes the primary exchanges of France, Canada, Japan, and Germany. Even the dealer-dominated London Stock Exchange uses an electronic call to open trading. Nasdaq studied the major crosses, Friedman said, but is not basing its cross on any one system. The tremendous amount of order flow coursing through the world's second largest stock market dictates an individual approach, she notes.
Nasdaq has been besieged by calls to reform its opening process for much of the past three or four years. In May 2000, then SEC chairman Arthur Levitt wrote a letter to Frank Zarb, then head of the NASD, demanding action on creating a "unified opening procedure."
Buyside traders have routinely complained of the needle-in-a-haystack difficulty of identifying the price likely to become the official opening. Their job has been made harder as Nasdaq market makers increasingly shy away from guaranteeing opening and closing prices.
Nasdaq has been working all year to create a single price opening process. The original plan was to apply the Cross to the opening in the first quarter and to the close in the second. Nasdaq believed the launch of the NOCP program drastically reduced the amount of time market participants had to report their last trades. The NOCP plan would lessen the concerns of the index suppliers and traders over the closing process.
The S&P/Amex accord was a rude awakening. "Standard & Poor's has concluded that there are substantial concerns among its index clients about the reliability of closing prices on dealer markets such as Nasdaq," S&P said in a statement.
Friedman counters that the S&P 500 is just one index that includes Nasdaq stocks, pointing to the Russell 2000, the Dow Jones averages, and the Nasdaq 100 as competitor products. Nevertheless, Nasdaq reversed course.
For its part, the American Stock Exchange is ecstatic. With the ability to set a security's closing price, a specialist will be able to guarantee it to his customers, explained Brett Redfearn, the Amex's senior vice president of business strategy. That means index traders looking for guaranteed market-on-close executions will direct their orders to Amex specialists.
However, success for the Amex program means resolving a chicken-and-egg dilemma. To prove to S&P that the Amex can produce a meaningful closing price, it must attract enough liquidity. To attract enough liquidity, it must convince index players it can produce a meaningful closing price.
Redfearn is optimistic. "I expect a fairly significant transfer of liquidity around the close that will make it a very meaningful closing price," he said. Redfearn adds that he's spoken with a number of index traders who've said they want a guaranteed close. "And if you are the guaranteed S&P closing price,'" he mimics the traders, " you will get the order.' This is a significant boost to the Nasdaq trading program."
The pilot, to include 12 Nasdaq stocks, is scheduled to begin the first of December and continue through early next year. Redfearn says the remaining 62 Nasdaq stocks in the S&P 500 will be added next year.
Chicken and Egg
The Amex's chicken-and-egg quandary is not trivial. Most external trading in Nasdaq stocks is done on SuperMontage at the opening and close. "We are quite dominant at the opening and the close," said Nasdaq's Friedman. "Our market share peaks at those times. We want to take advantage of the fact that we already have that dominant position at those two times and create a better opening and close."
Kicking off the Cross in service of a single price close is actually more sensible than starting with a single price open, Friedman adds. It is easier, she says, to segue out of continuous electronic trading than it is to segue into it. That's because Nasdaq, unlike the two primary exchanges, does not have the luxury of holding up the opening of its stocks.
When there are imbalances between buy and sell orders, specialists on both the New York and the American exchanges can delay opening their stocks until they resolve the imbalances. Nasdaq, on the other hand, starts trading at 9:30 come hell or high water. It does not hold up trading.
Therefore, dealing with imbalances at the end of the day, while not a piece of cake, is a better way for Nasdaq to get its feet wet in the unfamiliar world of electronic call auction trading, Friedman believes.
The Sketch
Nasdaq is still hammering out the details, but here's a rough sketch on how the Nasdaq Cross will function at the close. Market-on-close (MOC) orders and limit-on-close (LOC) orders will be accepted by the system up to a predetermined time. That may be 3:50 p.m., according to Friedman. Such orders can be corrected and moved around, but not past 3:50.
At 3:50, Nasdaq will start publishing both an "imbalance indicator," or the difference between buy volume and sell volume, and an estimate of the closing price. The data will be broadcast to traders every 30 seconds to start and then more frequently as the minute hand approaches four o'clock.
After 3:50, Nasdaq will accept so-called "imbalance only" orders, or those orders that offset any imbalance. It will not accept more orders than necessary. It will source orders from SuperMontage to correct an imbalance. The IO orders will only execute at the close if they help offset an imbalance.
"So we have this ten-minute window where we are trying to make sure we create as much of a balance as possible leading into the close," said Friedman. The Cross itself goes off immediately at 4:00.
Nasdaq will guarantee all MOC orders and those LOC that are subject to price improvement, Friedman says. Nasdaq will not guarantee any LOC orders if the closing price is at or worse than the LOC price. "We will try to fill it if it is at the closing price," Friedman explained. "But we will only guarantee it if there is price improvement." Also, Nasdaq will not guarantee any IO orders.
The new Nasdaq close will start with only the most liquid securities. That, Friedman says, makes it less likely that an imbalance will last for very long. "We believe the market will fill in those gaps," the exec noted.
Friedman is vague on details of the guarantee. At the exchanges, it is the specialists that actually guarantee the fills. Nasdaq is not signing any contracts with market makers requiring them to offset any imbalances. "That is their role," Freidman said. "And, for instance, if they miss the window, if they get an order at 3:55, it is their job to guarantee that."
On-close orders derive mostly from index traders employed by mutual funds which base their daily net asset values on the day's closing prices. Index traders need to transact as closely as possible to the actual closing price to avoid losing money. It was their frustration in capturing the close that prompted them to push S&P to reevaluate Nasdaq's numbers.
Beat a Path
On-open orders derive mostly from retail accounts and derivatives traders. Derivatives traders use market-on-open (MOO) orders and limit-on-open (LOO) orders chiefly on the quarterly "triple witching days" when index contracts expire. As with indexers at the close, Redfearn expects derivatives traders to beat a path to the Amex's door at the opening.
Nasdaq's new single price opening may or may not launch in the second quarter. Friedman is reluctant to set a date. However, Nasdaq's chief executive, Bob Greifeld, told the crowd at this year's Security Traders Association annual convention to expect a second quarter launch.
Whatever the case, the methodology of the open is similar to that of the close. All MOO and LOO orders must be in by a pre-set time (maybe 9:15 or 9:20) after which Nasdaq will broadcast the imbalance.
Because Nasdaq's continuous market must begin at 9:30 sharp, the cross must go off without a hitch. The fear is that it won't. "The challenge is making sure that [the cross] happens right at 9:30," Friedman said. "And that you give enough notice so that people will understand what will happen at 9:30. You don't want to feel you have a major imbalance."
Both crosses will be voluntary. That means market makers are not required to throw any orders into the hopper. The Nasdaq Cross will not dis-intermediate their services.
Traders appear mostly sanguine. Though some are not overjoyed with the idea of layering another agency mechanism onto the once largely dealer-driven marketplace, traders seem open to the change.
"I am looking forward to it," said Andy Madoff, in charge of Nasdaq trading at Bernard L. Madoff Investment Securities. "The Nasdaq market has gotten tremendously efficient. [The opening] is one of the few remaining holes in the Nasdaq market structure. It will be a pleasure to have that in place."
Madoff, whose family wholesaling business trades mostly retail orders, finds it difficult to guarantee his broker dealer customers the opening price. "There is no way to participate on any sort of agreed upon benchmark of what constitutes the opening today. For me to be able to guarantee my customers the opening price, I want to be able to participate in a trade at that price."
At least one buyside trader is cautiously optimistic. "Many institutions tend not to trade at the open," said Holly Stark of Kern Capital Management, "because the Nasdaq opening has been a bit amorphous. This is an important step for Nasdaq to take to make the opening a much cleaner and more easily understood process." Because Nasdaq has so many competing market makers, a buyside trader can never be certain which one can supply the true opening price, Stark explains.
Gaming System
Gaming is traders' biggest concern. Some are worried that gamers will create imbalances at the last second, cancel the order and then trade profitably once the market opens.
One trader asks: "If you put in 100,000 for sale, market-on-open. And it looks like you've got a match at a price. And with 30 seconds to go, you pull that order out. And then turn around and buy stock on the open because the 100,000 shares has pushed the price point down. Is that legal?"
That can't happen at the New York or the Amex because the specialists can hold up trading. Nasdaq must start at 9:30.
Friedman won't rule out the possibility of bad behavior, but says Nasdaq is studying all the potential gaming scenarios as part of the design process. "With the IO orders, we're looking at a period of two minutes before the open and two minutes before the close when you can't cancel," Friedman said. "Of course, it is impossible to predict behavior once we put it out. But our surveillance department will be watching closely."
