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July 31, 2000

SuperSOES Not So Super - Nasdaq Goes Back to the Drawing Board

By Peter Chapman

Nasdaq's postponementof its SuperSOES, the third delay since April, will allow it to retool a major part of the trading system. Back in April an expanded SOES was earmarked to replace SelectNet as the principal inter-dealer trading system.

Now Nasdaq is redesigning the timer that regulates the frequency at which a market maker at the inside will receive automatic executions against SuperSOES. The system's debut is now slated for the fourth quarter.

The original plan aimed to give market makers five seconds to change their markets between executions. Nasdaq now plans to add a "dial" to the timer. That would set the trading intervals at different lengths for different types of stocks.

Quotes or orders for heavily traded stocks will be taken out faster than every five seconds. Stocks like might trade every two seconds, according to Dan Franks, senior vice president, market operations at Nasdaq. Quotes or orders for less active stocks will be taken out at intervals greater than five seconds.

Nasdaq plans to classify all the stocks in its National Market System (those that will be traded first against SuperSOES) based on their trading patterns. "Microsoft trades a whole lot differently than the local bank stocks which are also in the NMS," Franks said.

New issues are also a concern. An IPO may need to trade quickly on its first day, but less so a month later if its volume plummets. A dial would allow Nasdaq to adjust the execution frequency from, say, two seconds to seven seconds.

Nasdaq made the decision to go back to the lab after listening to comments and suggestions from constituents that include the Knight Trading Group and the Security Traders Association. Dealers said liquidating positions could take too long if trades occurred only every five seconds. That would put them at a disadvantage if prices moved against them in the meantime.

As an example, a market maker, offering 4,000 shares at the inside, would have to wait over three minutes to sell the entire lot if the SOES executions arrived in 40 sequential 100-share lots.

Now, a market maker can sell out such a position quickly because multiple SelectNet messages can take the offer simultaneously. SuperSOES executions will queue up and occur one-by-one in time priority.

Franks added that a lengthy execution could encourage gaming. An order entry firm, for example, could "hold" the market by hitting a market maker's bid for 4,000 shares with 40 100-share SOES executions. Meanwhile, the seller could take a short position in a derivative of the stock. That would turn profitable on completion of the SOES executions and the subsequent drop in the price of the underlying equity. The inside price typically declines after the market maker buys stock because the market maker usually lowers his bid.

"It's like an airport with only one runway," said Michael Dorsey, Knight's chief counsel. "Everything goes into the SOES pipeline. This could cause more problems than it solves."

Knight applauds Nasdaq's rejiggering as a step in the right direction. But it wants to explore the possibility of being SOESed by multiple parties simultaneously as happens with SelectNet.

"I don't know if the problem is solved by knocking [the interval] down from five seconds to two," Dorsey said.

Franks concedes that SuperSOES is not a perfect system. It's intended as only the first phase in the complete redesign of Nasdaq trading that will ultimately result in the Supermontage. Part of the goal is to eliminate the capacity constraints inherent in SelectNet.

"It's an interim step so I don't think it has to be perfect," he said. "But we'd like to make it a lot better than it is."