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May 31, 2000

Cincinnati's Fight For Survival: Electronic Exchange Sees Future on Nasdaq

By Peter Chapman

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  • Cincinnati's Fight For Survival: Electronic Exchange Sees Future on Nasdaq
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As the rules of the game change in the listed markets the Cincinnati Stock Exchange (CSE) is betting part of its future on Nasdaq.

Sometime this summer the all-electronic bourse will offer trading in the top 100 Nasdaq stocks. In so doing, it hopes to mimic the success of the Chicago Stock Exchange, which trades about 15 million Nasdaq shares per day.

"We've seen the success that Chicago has had," said David Colker, president of the CSE. "By expanding we hope to develop a new product line."

The Plunge

The Cincinnati Stock Exchange - actually it is based in Chicago - is now the fourth of the five regional exchanges approved by the Securities and Exchange Commission to trade Nasdaq names. The Boston and Pacific exchanges also have the authority, but their specialists have yet to take the plunge.

In offering Nasdaq trading, the Cincinnati is reacting partly to two moves made by the SEC that could threaten its franchise.

Last December, the regulator abolished a rule that prohibited third market dealers from trading listed stocks issued before April 1979 over the Intermarket Trading System (ITS) via Nasdaq's Computer Assisted Execution System (CAES). That could dull the appeal of the CSE for third market dealers such as Bernard L. Madoff Investment Securities that operate specialist units on the exchange in order to access the ITS.

Third market firms are permitted to trade listed securities issued after April 1979 over the CAES/ITS link. That's what Madoff does. He only uses the CSE to trade those stocks listed before April 1979.

"Clearly there are decisions down the road as to which marketplace will be the more appropriate venue for us to participate in," said Peter Madoff, a principal at Madoff.

Colker admits the CSE is vulnerable. "Our automated ITS interface will become less valuable as Nasdaq is now capable of trading all stocks in ITS," he said.

Rule 390

The biggest blow to Cincinnati's franchise could be last month's approval by the SEC of the New York Stock Exchange's proposed rescission of its infamous Rule 390. Pressured by the SEC, the NYSE voted to chuck the decades-old rule. The rule prohibited internalization of order flow by its members and limited their principal trading to a regulated stock exchange.

Rule 390 had long been Cincinnati's raison d'etre. Six of its twelve specialists are units of large retail brokers. Unable to execute orders in-house, these organizations use their posts on the Cincinnati to fill certain small orders. It is cheaper than sending them to the NYSE.

The CSE setup ensures that these orders are not intercepted by competitors. Although ostensibly a market of competing specialists, the CSE's "time priority modification" rule allows one specialist to trade ahead of, or before, another. That way, an order is guaranteed to be filled by the order-sender's own specialist unit even if another specialist posted his quote first.

CSE rules do prohibit a dealer from trading ahead of public limit orders at the exchange. But, in practice, limit orders are few as they are discouraged on the Cincinnati, sources say.