A full-blown dispute has emerged between traders and electronic communications networks (ECNs). At issue is the transaction or access fee, charged each time a market maker hits the bid or takes the offer on a stock an ECN is publicly quoting on Nasdaq.
Many market makers complain that these fees should not be charged, in part because ECN orders are similar in one respect to the quotes posted on Nasdaq by market makers. They are all part of the Nasdaq price-quote montage.
Consequently, many market makers, from the largest to the smallest, are refusing to pay access fees on orders executed as a result of ECN price quotes on Nasdaq. ECNs, in turn, are now refusing to accept orders preferenced by some of the brokers withholding access payments.
Compete Publicly
Market maker quotes and ECN customer orders compete publicly each day on Nasdaq. Some of the best known ECNs are Reuters Holding's Instinet and Bloomberg Tradebook. ECNs frequently stand alone at the inside price. In some securities, in fact, ECN orders outnumber market-maker quotes. That is likely to become more common as firms reduce their market-making commitments and new ECNs enter the market.
In addition to the access fees charged at up to one and a half cents per share as well as the ECN's posted stock prices, traders incur Nasdaq's one-cent fee whenever their trades with ECNs are transmitted over SelectNet. ECN customers on the other side of the trade are often charged a similar ECN fee, but are not charged a Nasdaq fee.
Market makers, on the other hand, do not charge an access fee. Nor do they pass along the ECN fees, which can add up quickly, to their customers. As market makers see it, the ECNs should be collecting fees only from their customers, who are getting the benefit of executions on their anonymous orders. Without regulatory guidelines, many market makers, as mentioned earlier, are withholding payments to ECNs. These tactics have resulted in several legal and regulatory issues noted herewith:
*Breach of agreement lawsuits.
ECNs are allowed by the Securities and Exchange Commission to charge a reasonable fee to non-subscribers for accessing an ECN. An ECN, which is responsible for communicating its fee structure, may require that non-customers enter contractual agreements on the payment of access fees. Furthermore, the SEC has informally told ECNs that they may refuse to trade with any entity that does not pay its fees.
The first of probably many lawsuits was recently filed by Montvale, N.J.-based All-Tech Investment Group, operator of the ECN ATTN, against a large Jersey City-based Nasdaq wholesaler.
*Heightened NASD scrutiny for unnecessarily locking or crossing markets.
A locked or crossed market occurs when the publicly-displayed inside bid and offer prices are identical or inverted (e.g., an inside bid priced at 10 1/2, and an inside offer priced at 10 1/2 or 10 3/8). A market maker is more likely to enter a locking or crossing quote when it is denied access to an ECN's inside market in order to attract trading interest. While failure to pay an ECN its fees may not be a regulatory issue, the increased incidence of locked or crossed markets is a market-integrity issue.
*Best-execution violations.
This could occur if traders are unable to obtain the best Nasdaq price available.
Interestingly, the National Association of Securities Dealers does not seem concerned that ECNs, which are registered broker dealers, may be failing to provide best execution when they do not fill their customer orders.
*Disruption of trading operations.
Instead of several seconds to execute an order, a trader who is denied access to an ECN may take the time to either call around to get execution at the inside price or enter a locking or crossing order.
ECNs were approved by the SEC under the terms of the order handling rules to operate trade-matching systems through a SelectNet linkage to Nasdaq. When the two-tiered market ended in January 1997 with implementation of the SEC's order handling rules, there were four SEC-approved ECNs. Now there are eight. A ninth ECN is awaiting final regulatory approval.
ECNs transmit their best customer and subscriber orders to Nasdaq and accept preferenced SelectNet orders from third parties. ECN orders can also be accessed by telephone, while subscribers have direct access to ECNs via dedicated terminals and PC-based modems.
The SEC and the NASD are aware of the current controversy between market makers and ECNs, and are considering rule proposals that may resolve the situation.
One rule proposal, a copy of which was obtained by Traders Magazine, would prohibit ECNs from refusing "to deal with any person who attempts to access the quote of the [ECN] when one or more [ECN] is responsible for the inside quote, on the basis that such person has not paid or will not pay any charge or fee that is in addition to the publicly-quoted price of the [ECN]."
Meanwhile, regulators are keeping a noticeably low profile. It is too early to draw conclusions about their ultimate decision. Nevertheless, Richard Lindsey of the SEC's Division of Market Regulation, informed attendees at a recent Securities Industry Association conference that the SEC looks favorably on the NASD proposal.
An NASD spokesman, however, declined to comment, noting the sensitive nature of the issue.
Times Change
Less than two years ago, many of these same Nasdaq market makers wholeheartedly subscribed to Instinet and paid its transaction fees. Instinet provided anonymity and participation in a two-tiered Nasdaq market: the public quote montage and the better-priced Instinet subscribers' market. Market makers were allowed to attract trading interest at prices inside the Nasdaq public market spread without adjusting their quotes. For Instinet and Nasdaq market makers, it was a "win-win" situation.
Currently, however, the combination of dramatically reduced spreads, significant NASD fines and ECN fees may be just too much for Nasdaq market makers and traders to countenance. And the burden of ECN fees can only worsen as more ECNs enter the market.
Firms may continue to pay the ECNs' fees for accessing their price quotes on Nasdaq. If so, these market makers will have uninterrupted access to all inside markets.
Firms that withhold payments, however, can expect to be denied access to ECN orders. When this occurs, the best advice I can offer is this: market makers must be able to demonstrate that they attempted to access the ECNs prior to entering a quote that effectively locks or crosses the market.
Howard L. Haykin, CPA, is president of Compliance Solutions, a New York-based specialist in regulatory compliance for NASD broker dealers and SEC investment advisers.
