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March 1, 1998

Trading Nasdaq Issues at the CHX: Competitive Edge Is SEC Rules, Trading Costs, Price Improvement

By Michael L. O'Reilly

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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