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February 1, 1998

Next Nasdaq's Winners?

By Daniel G. Weaver

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  • Next Nasdaq's Winners?

Dealers will certainly be the big winners if Nasdaq's proposed limit-order facility is approved. They would regain priority over customer limit orders and establish a cheaper alternative to Instinet or Bloomberg Tradebook.

Institutional limit-order traders, however, would have a disincentive to use the system, and retail limit-order traders would find that many of their orders would go unfilled unless the market moves against them.

The limit-order facility, the centerpiece of a new integrated order-delivery and execution system, proposed and filed for approval with the Securities and Exchange Commission by the National Association of Securities Dealers, would create a central location where limit orders could be stored and prioritized by price and time. (The system was originally dubbed Next Nasdaq).

Like Instinet, the identity of the trader would not be revealed in the limit-order facility until the trade is executed. Institutions don't want to trade through dealers for fear of being front-run. On the other hand, dealers don't want their identities revealed until they have the chance to unwind positions they have taken.

At the moment, the main users of Instinet are Nasdaq dealers seeking anonymity they cannot obtain elsewhere. Last fall, another dealer market, the London Stock Exchange, instituted a limit-order facility. The evidence thus far indicates that the majority of the volume in that system is generated by dealers who have switched from other dealer-messaging systems.

The same should be more than true about the new Nasdaq facility. While dealers would find the new Nasdaq system a cheaper alternative to Instinet, institutions would probably remain on Instinet because of the Nasdaq system's live-quote rule.

That rule means that orders placed on the new system can't be canceled in the ten seconds following the order's entry. This would act as an effective deterrent to institutional usage of the system. (Note that market-makers' quotes on the current Nasdaq system are not subject to the ten-second rule.)

What about retail limit orders? Nasdaq is a fragmented market without system-wide priority rules. While a dealer cannot trade ahead of a customer limit order he or she holds, the dealer is free nonetheless to trade ahead of customer limit orders held by other dealers or electronic communications networks. Plans for the new Nasdaq facility call for price and time priority inside the facility. However, that is only envisaged for non-directed orders. The market practices of payment for order flow, internalization and preferencing would guarantee that little, if any, order flow would be non-directed. Therefore, the system-wide priority rules will rarely be invoked.

Market participants could direct orders to the new Nasdaq facility or to another dealer. In this case, dealers' best-execution obligations would require that they obtain the best price, not the first best price.

A dealer could direct his order to another dealer offering the same price as the new Nasdaq facility, and his customer would be no worse off than if the order was executed against limit orders in the new facility. Hence, given the practice of payment for order flow, there would be no incentive for market orders to be directed to Nasdaq's limit-order facility.