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March 1, 2002

Market Structure Massacre?

By Jim Marks

Despite all its inefficiencies,' Nasdaq by 1999 was undoubtedly the greatest success story ever told in the history of exchanges. Coming from a dead start 25 years earlier, Nasdaq had more trading volume that any other equity exchange in the world (though the New York Stock Exchange set its own market capitalization and volume records too). Nasdaq was organized differently than any other major equity market. It was built on a dealer system, instead of a specialist or primary market maker system, which controlled a centralized limit order book. Dealers were motivated to participate in Nasdaq because of the profits they could make employing trading capital. This self-interested dealing, and the profits generated, attracted more capital, fueling, in turn, greater liquidity.

This self-interested aspect of Nasdaq, however, has never received much credit. Instead, it has been seen as part of Nasdaq's inefficiency', and it has been a prime target of structural market reforms over the past five years. The question that now faces Nasdaq and its participating traders is interesting: Will the combination of electronic limit order books and regulatory pressures - forces that are causing narrower spreads - drive out the liquidity-providing capital of dealers chasing short-term trading gains?

Once again, this would be a highly ironic outcome, but the jury is still out. Market making has become much less profitable, but the reasons are not completely clear.

Decimalization and narrower spreads played a role. But, this occurred at the same time that the market's downturn produced a decrease in overall order flow, especially from the retail orders that are highly profitably for market makers. Markets will have to rebound before we can separate the true impact of changes in market structure from temporary changes due to normal fluctuations in market trading volumes and retail order flow.

Nasdaq SuperMontage

The next big change in market structure is coming later this year: Nasdaq's SuperMontage. The primary change gives traders an ability to access greater depth. Instead of limiting market participants to their best bid or offer, SuperMontage will include bids or offers three levels deep from each participant. This should reduce fragmentation in cases where an ECN's or market maker's second-best bid or offer is better than any other participant's bid or offer, and is bypassed in trading because it does not appear on the screen.

In addition to enhancing depth of book, SuperMontage does a better job of integrating quotes with trading capabilities. It introduces some new variations on the way orders are handled. This includes the ability to add to orders without giving up time priority within the limit order book; the ability to execute against price/size priority instead of price/time priority; eliminating locked or crossed markets by automating executions between the orders that lock/cross the market; and the ability to post anonymous (pre-trade) orders. SuperMontage will still allow internalization and preferencing.

Another important aspect of SuperMontage is that, in return for being allowed to step more deeply into the electronic trading pool, Nasdaq must give up its monopoly quote vending business.

As a condition of approval, the Securities and Exchange Commission is requiring the NASD to set up an alternative display facility (ADF) through which other Securities Information Providers (SIPs) can access and distribute quote and trade data.