The Nasdaq Stock Market has made some friends specialists at the Chicago Stock Exchange.
Roused by the biggest structural changes in the history of Nasdaq, the Chicago Stock Exchange (CHX) has reembarked on a pilot program to trade Nasdaq securities under exchange trading rules.
“We think our traders can greatly benefit from the Nasdaq market with the right tools,” said J. Montville Henige, chief financial officer at the CHX. “Nasdaq is a wonderful market to be in these days.”
The specialists, however, were not always as enthusiastic about Nasdaq, potentially the CHX’s biggest competitor after the New York Stock Exchange and the American Stock Exchange.
Some CHX specialists soon felt the original program, started in 1987, was unfairly hindered by Nasdaq itself, where the same securities were traded with the blessing and more importantly the support of the primary market.
At one stage, Nasdaq reportedly pulled the plug on the CHX specialists’ pipeline to SOES, apparently miffed that the specialists could post better bids and offers than market makers, thus drawing order flow away from Nasdaq.
The upside, of course, was that specialists could no longer be picked-off by bandits at retail order-entry firms. Nonetheless, the Nasdaq program languished for most of the past 11 years amid system impracticalities and other difficulties.
But times changed. On Jan. 20, 1997, the Securities and Exchange Commission implemented its order handling rules, which allowed customers and no longer just dealers to set the inside market. Superior prices on private networks, such as Reuter PLC’s Instinet, had to be publicly exposed and customers’ limit orders had to be given priority execution.
“The new rules greatly affected the dealer market, but they didn’t directly impact our over-the-counter trading in Chicago,” said Jack Dempsey, president of Dempsey & Co., a CHX specialist firm participating in the Nasdaq pilot program. “We were effectively following the rules anyway.”
CHX rules always required specialists to reflect customer orders in their quotes, and to automatically update those quotes whenever they improved the market.
Carey Austin, chief operating officer at Melvin Securities Corp., one of the five pilot firms, said that CHX customer orders have always been exposed and given priority over dealer orders. In fact, Austin added, the order handling rules made the Nasdaq market resemble a listed environment.
But the rules may have given CHX specialists an unexpected competitive edge. For a start, the rules level the playing field for the CHX’s Nasdaq customers, giving them an enhanced opportunity to set the inside market.
“We are better able to compete with Nasdaq dealers now,” Dempsey said.
“With Nasdaq rules getting tighter,” Austin added, “finding creative ways of doing business is essential. These rules have put us on even ground.”
What’s more, because the CHX has certain trading-cost advantages over Nasdaq, specialists have not reduced payment for order flow as dramatically as market makers, specialists said.
“The OTC program for Nasdaq stocks has had a small and dedicated following for many years,” Austin said. “Now it’s getting more efficient, and that should make us very competitive.”
All the while, specialists tout the CHX’s ability to provide price improvement on orders.
Nasdaq Approval
In May 1987, the CHX received approval from the SEC to make markets in 25 Nasdaq stocks, allowing customers to hit specialists’ bids and take their offers on a non-mandatory SOES. Although not warmly received by the National Association of Securities Dealers, five CHX specialist firms began trading Nasdaq issues.
Unlisted trading privileges for Nasdaq stocks were later granted to the Boston Stock Exchange and the Philadelphia Stock Exchange, but neither ever utilized the privilege.
At the CHX, Austin noted that specialists routinely cut spreads and drew order flow on SOES from non-market makers. Trades executed at the CHX were noted on the tape as having occurred away from Nasdaq.
Soon, however, Nasdaq reportedly shut off the SOES connection to the CHX, claiming it would be improper to continue access because SOES was not an exchange facility.
As business staggered, three of the five firms in the OTC program dropped out, leaving just Dempsey and Billings & Co.
After the market crash in October 1987, SOES became mandatory for market makers. CHX traders were still denied the SOES connection, but continued to buy and sell securities through Instinet or over the telephone.
Eventually, CHX traders were given access to SelectNet, and their quotes currently appear on the Nasdaq system with the symbol MWSE (for the vestigial Midwest Stock Exchange). To send an order to the CHX, the specialist must be accessed over the telephone, with a floor broker or through MAX, the CHX’s order-routing and execution system.
“We had some lean years when we started, but we stuck it out because we knew it was for the good of the exchange,” said Matt Billings, president of Billings.
Last year, CHX management agreed to recharge the OTC program with marketing dollars and other practical support. Today, five CHX specialist firms make markets in more than 250 of the most active Nasdaq stocks.
“There were incremental increases in stock allotment by the SEC our first ten years, and we had some success,” said Lou Klobuchar Jr., chief executive officer at Dempsey. “But structural impediments never allowed us to push ahead. At least until the order handling rules.”
Three firms joined Dempsey and Billings in the OTC program after the order handling rules were implemented Global Market Traders, Melvin and Sydan & Co.
“We recognized that the changes to Nasdaq would allow the playing field to be leveled,” said Victor D. Feldman, president of Global Market Traders. “Our customer base wanted us to get into the business for convenience and economy.”
Feldman added that customers felt issues would be less represented by market makers with the new rules. “The OTC market has room for more players,” he said.
The CHX averages about 500,000 shares each day in Nasdaq stocks. (The exchange has SEC approval to trade up to 500 Nasdaq issues.)
Nasdaq Reaction
Today, some Nasdaq market makers are taking a wait-and-see approach to the renewed OTC program. The head of Nasdaq trading at a medium-sized Chicago-based firm said that while the specialists have some advantages over market makers, he wouldn’t consider the CHX a competitor. “The CHX Nasdaq volume is still really small,” the head trader scoffed.
Admittedly, the Nasdaq volume at the CHX is only a small fraction of what major Nasdaq wholesalers trade daily, but the CHX, nevertheless, wins high marks for enthusiasm.
“We’re not trying to take over the world,” said Terence X. Hurley, CHX vice chairman, “but we are letting the public know we are actively competing in the capital markets.”
The CHX did not disclose the identity of its Nasdaq customers. Industry sources, however, said the program is popular with small broker dealers and Internet-based trading firms, though institutional accounts are being courted by the CHX.
To be sure, the CHX may be fighting for its life. The same underlying changes that reshaped Nasdaq may soon reshape the listed markets. Indeed, the SEC’s Concept Release last year hinted that the Intermarket Trading System (ITS) the pipeline supporting the National Market System may one day allow Instinet and other private networks to participate like the listed markets do today.
That, in effect, would dramatically spur competition among investors trading in listed stocks, crumbling the dominance of exchange specialists.
The impact could be massive, since Instinet and other electronic communications networks now part of the price-quote montage protecting and broadcasting small investor price quotes currently handle a much smaller proportion of listed trades compared to Nasdaq business.
Few Exclusive Listings
The 445-seat CHX trades over 4,000 equity issues, more than any other stock exchange in the U.S. More than 90 percent of CHX trades are executed electronically on the MAX trading system, an order-routing system similar to the New York Stock Exchange’s DOT.
The CHX has very few exclusive listings instead trading mostly NYSE and AMEX-listed issues.
Last year, the CHX set a volume record for the third consecutive year, outstripping the NYSE and AMEX in growth rates of share volume.
In 1997, the CHX traded an average of 55 million shares daily, or 5.6 billion shares for the year, up 42.5 percent from 1996. The NYSE traded 133.3 billion shares last year, up 27.4 percent, and the AMEX traded 6.25 billion shares, up only 8.5 percent.
Clearly, its volume pales compared to the Big Board. As a response, some experts think the CHX Nasdaq program should be viewed more a preemptive strike than a dazzling display of marketing genius.
Even so, the CHX may be heartened by one academic study.
Robert Van Ness, a visiting assistant professor of finance at Christian Brothers University in Memphis, has co-authored his third study on the Nasdaq program at the CHX, “Nasdaq and The Chicago Stock Exchange: An Analysis of Multiple-Market Trading.”
With his wife, Bonnie, an assistant professor of finance at Christian Brothers, and Wen-Liang Hsieh, an assistant professor of finance at Tamkang University in Taiwan, Robert Van Ness examined trading over 26 consecutive Thursdays, starting with the first Thursday of 1995, in 97 securities traded on both the CHX and Nasdaq.
Despite capturing only a small amount of market share during the sample period, the researchers found the average trade size on the CHX was only slightly smaller than on Nasdaq. During the sample period, the average CHX trade size was 1,574 shares, while the Nasdaq average size was 1,653 shares.
Analyzing the spread sizes during the study, it was found the effective spread or the difference between the current transaction price and the prevailing ask price for a sale transaction was almost 2.5 cents lower on the CHX. The study also noted that CHX trades are price improved almost 2 cents more than those on Nasdaq.
The still unreleased study concluded that trading costs on the CHX are lower for the dually-listed Nasdaq securities, citing dissimilar market structures. “We were intrigued that the CHX does not attract more order flow,” Robert Van Ness said. “Again and again, we found they kept tighter spreads than Nasdaq dealers.”
The researchers theorized that the CHX program suffered from a lack of investor awareness. “A lot of investors and institutions don’t know the exchange is dealing so many Nasdaq stocks,” Robert Van Ness said.
Indeed, a number of leading institutional traders were largely unaware of the Nasdaq program at the CHX.
“I sent a few orders to Chicago when the OTC program first came out, and it worked out OK,” said a New York-based head trader for a large corporation’s pension fund. “But my usage has been minuscule. I’m not sure how the program’s doing now.”
Another head trader at a large, private New York-based institution said she occasionally sends Nasdaq orders to the CHX, but is unsure exactly how the orders are executed.
To increase consumer awareness among retail and institutional customers, the CHX launched its first television advertising campaign last year, created by the Chicago-based Weiser Group. The spots ran on cable networks CNBC and CNNfn, and Chicago superstation WGN. The goal was to make the CHX look positively different from other exchanges, and to present a solid image to issuers.
Proud History
The image makeover may be necessary as the CHX scrambles to find a place in a fast-changing trading environment. Back in the early days, life had other possibilities.
The CHX opened in 1882 with a strong concentration of regional issues, boosted by the booming railroad industry. In 1949, the CHX began a series of mergers with stock exchanges in Cleveland, Minneapolis, New Orleans and St. Louis to form the Midwest Stock Exchange. Although it was always domiciled in Chicago, the exchange did not revert to its original name until 1993.
Business at the CHX changed over the years, as exclusive listings dwindled and specialists began to trade more Big Board and AMEX issues.
Today, of the more than 4,000 CHX stocks, less than 30 are exclusive listings. The CHX trades 80 percent of NYSE issues, and more than 90 percent of AMEX issues.
The exchange executes virtually all of its institutional and retail orders electronically in MAX. Linked to 100 brokerage firms in the U.S., the MAX system aims to provide automatic executions at the best price available in the ITS.
Small orders sent by a member firm through MAX are routed to the designated specialists. Most of those orders are automatically executed within system parameters. If the specialist does not execute the order, it is automatically displayed. Large block orders from institutional customers can be executed in MAX, or sent to a floor broker for execution or display with the specialists.
A CHX rule requires specialists to honor the best bid or offer in the ITS for all orders entered in MAX. Additionally, a price-improvement algorithm was created to improve the spread from the last sale under certain guidelines. Nearly 50 percent of orders receive an improved price from the last sale in the primary market usually a sixteenth or an eighth.
Institutions and dealers sometimes select the CHX to cross large blocks of stock instead of crossing the block order on the NYSE (to avoid, for instance, having to break-up orders among several floor brokers, and therefore incur higher trading costs). Provided that the CHX specialist does not have a customer order at his quote, the specialist steps aside and allows the two sides of the trade to cross cleanly.
The CHX began an extra session in 1996, and last year averaged 540,000 shares each day between 4 p.m. and 4:30 p.m. (Eastern Standard Time). A spokeswoman for the CHX said it had no plans for a pre-opening session, but did not rule it out. “We’ll do whatever it takes to remain competitive,” she said.
BRASS and Beyond
On the operations side, the CHX will soon launch a new electronic trading system for their OTC program from Weehawken N.J.-based Automated Securities Clearance Corp., the makers of BRASS.
“We wanted to provide our specialists with a competitive advantage through the best technology available to compete with Nasdaq market makers,” Henige said.
Klobuchar said the new system set to be launched later this year will allow all BRASS users to access the CHX system. “With BRASS’ access to over 70 percent of Nasdaq order flow, we will be able to piggyback on their ability to keep up with changes in the industry,” Klobuchar added.
The new system customized to fit CHX rules will link directly with MAX, eliminating the manual entry of orders by the OTC specialists. “MAX is great for listed trading,” said Dan Curran, a managing director at Sydan. “But it has no link to SelectNet or Instinet for OTC trades. We get stuck manually inputting our orders.”
MAX orders for OTC stocks will be routed directly to the specialist BRASS system for execution. Orders from other BRASS users will be routed into MAX, and then sent to the specialist BRASS system, with links to Nasdaq liquidity sources.
“Implementing BRASS is a CHX initiative,” Austin said. “Management has organized all vendor dealings around our best interests. They have committed themselves to the success of the program.”
Because exchange trading rules do not allow specialists to compete in stocks, like multiple market makers on Nasdaq, the only competition of sorts is over new OTC issues. When a member seeks the allocation of a Nasdaq stock, that member petitions the CHX. If more than one specialist seeks the same issue, the case is heard before a committee of non-CHX members that then allocate the stock.
But with more than 200 Nasdaq stocks still available under the pilot program, internal competition is minimal.
“By definition, the CHX firms have to work together to build a better marketplace,” Dempsey said. “We all have a vested interest in seat prices here.”
The firms in the OTC program want to push up the number of Nasdaq stocks traded to 500 after the implementation of BRASS, hopefully with the participation of more specialists.
“With 500 of the most active Nasdaq stocks, the CHX program will have one of the largest books in the business,” Klobuchar said. “This is a marketplace growing dramatically, and there’s room for other players.”
