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November 1, 2001

ETFs' Alternative Dream

By Jamie Selway

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  • ETFs' Alternative Dream
  • Page 2

Exchange-traded funds, or ETFs, are electronic naturals.'

They are, in brief, incredibly liquid securities that do not need a lot of human handling. That's why traders are increasingly choosing electronic alternatives for ETF transactions while the American Stock Exchange and the New York Stock Exchange engage in a heated battle for ETF market share.

The competition is not surprising. The prices for ETFs are derived from the prices of component stocks, much like index futures and options. The added liquidity of the cash and derivatives markets puts ETFs among the most liquid equities. ETF pricing occurs at electronic speed, as computers process component market data to update quotes.

Floor Brokers

Why would you expect ETFs to trade on a floor? A good question, especially at a time when the buyside and the sellside complain about the frequency of pennying,' the floor-based practice of stepping ahead of standing orders by one cent.

One answer is that the floor is an incomparable aggregator of liquidity, complete with floor brokers that stand ready to provide a high quality, high touch' execution. So an institutional investor looking to buy 200,000 QQQs, an individual with an odd lot, or a computer implementing a black box' trading strategy, will find the same service provided within the floor's friendly confines.

Historically, it's been much harder to operate an alternative market - such as an ECN - in listed securities than in OTC securities. But recent changes that integrate the Nasdaq InterMarket in the National Market System (formerly known as the third market') makes it much easier.

Using InterMarket, ECNs and upstairs dealers post quotes and print trades. Vendors display these quotes to the public. Alternate venues can set the best price for an ETF, which is in direct competition with the floor community. InterMarket quotes are accessible via ITS and afford trade-through protection. In other words, if the floor trades at an inferior price without filling the better Intermarket quote via ITS, it risks regulatory action.

InterMarket, similar in design to Nasdaq's marketplace for OTC names, is a collection of block positioners, ECNs, and other ATSs. Each participant competes for order flow, each with its own business model.

Upstairs dealers provide capital commitment for sizeable orders, wholesalers service online retail flow, and ECNs offer a true agency auction as an alternative to the managed - and overly complex -floor-based auction. As with ETF pricing, computers are better at calculating simple price-time priority than humans - particularly human interlopers with large trading accounts.

When The Wall Street Journal reported on the NYSE's first day of ETF trading on July 31, many were surprised to learn that InterMarket, not the AMEX or NYSE, carried the day with 41 percent of QQQ market share. That was not an exception. In fact, in the most liquid ETFs, InterMarket's share has grown throughout 2001, while quoted spreads have compressed.