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February 1, 1998

Next Nasdaq's Winners?

By Daniel G. Weaver

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In contrast, the New York Stock Exchange and the American Stock Exchange provide sufficient incentives for a large amount of market orders to be directed to them for execution against their limit-order books.

Although brokers can direct market orders to one of the regional exchanges or to Nasdaq (in payment-for-order-flow or internalization arrangements), many do not direct orders this way. Price improvement is the reason the NYSE and the AMEX continue to control the lion's share of trading in their listed stocks.

Studies have shown that more than 25 percent of the orders sent to the NYSE execute inside the current quote. Brokers like to report price improvement to their customers, so they have an incentive to direct market orders to the national exchanges. This provides the flow of market orders necessary to make the NYSE and the AMEX limit-order books successful. (Regional exchanges provide some opportunity for price improvement, though a far greater opportunity exists on national exchanges).

Without system-wide time-priority rules and the chance for price improvement, there is no incentive to send Nasdaq market orders to the limit-order facility. And without the flow of market orders, Nasdaq retail limit-order traders quoting at the same price as dealers will see their orders go unexecuted. That is, unless the market moves against them, in which case dealers will move their quotes and limit-order traders will see their orders executed at the worst possible times.

This provides a disincentive for retail traders to submit limit orders. Without the flow of market orders to interact with, the proposed Nasdaq limit-order facility will fail.

At press time, Nasdaq announced an agreement in principal with OptiMark Technologies to allow access to OptiMark from Nasdaq on a commission basis. The preliminary plans are to allow Nasdaq's limit-order facility to take part in OptiMark matches.

Given the wide spreads on many Nasdaq stocks, it is highly probable that matches will typically occur inside the spread. Therefore, limit-order traders quoting at the same prices as dealers will be no better off under the agreement.

However, the agreement with OptiMark clearly shows that Nasdaq is beginning to realize the magnitude of revenues it can gain from commissions versus spreads. Nasdaq should consider system-wide priority rules for all trades. While the primary-priority rule should be based on price, the secondary rule does not have to be based on time.

For example, the secondary-priority rules on the Toronto Stock Exchange are designed so that each member with orders on the book is guaranteed at least a partial fill. An order exceeding the size of the first quote at a given price is shared among all quote participants on an equal-allocation basis, up to some level (2,000 shares). Any remaining amount is allocated on a prorata basis.

Nasdaq should remember the lesson it learned in 1983 when it fought hard to prevent contemporaneous trade reporting. Recall that then-NASD President Gordon Macklin met with the SEC six months after the NASD was forced to accept the rule for a small group of stocks, and asked that all of its stocks be subject to the rule.

It turns out that change was good for business, because volumes and profits increased after the rule change. I believe the same would be true if Nasdaq created a level playing field and allowed limit orders a chance to be executed.

Daniel G. Weaver is an associate finance professor at Baruch College in New York and an expert on market microstructure.