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March 1, 2002

Market Structure Massacre?

By Jim Marks

SuperMontage's impact, positive or negative, on other market players is not easy to ascertain. A lot of the important developments have occurred via SuperSOES, with subsequent increases in overall Nasdaq participation by ECNs. In this light, SuperMontage represents a better order routing interface rather than a dramatic change to market structure.

ECN Future

As for ECNs, a lot depends on how they interact with SuperMontage. Each ECN can individually decide whether to accept automatic executions from the SuperMontage, or just be an order delivery' ECN with the ability to decline or partially fill an order. The incentive to be just an order delivery ECN will be the protection of their existing liquidity. They will be able to provide customers with their own liquidity while also providing access to Nasdaq's overall liquidity through outbound orders over SuperMontage. Instinet and Island could be expected to pursue this route. ECNs that are more order routers than liquidity centers, like Archipelago or Bloomberg, have a greater incentive to participate directly with SuperMontage, but that is not certain. A critical handicap for SuperMontage is that orders sent to an order-delivery ECN can be allowed to time out after 30 seconds without execution.

This means that sources of order flow have an incentive to go directly to an ECN, where an order will be filled immediately either on that ECN or posted on Nasdaq, rather than through Nasdaq. That's where the trader could discover 30 seconds later, without a clear explanation, that his order has not been executed.

Another wrinkle is that ECNs like Island and Archipelago are applying for exchange status. When and if they get exchange status, they will be required to take automatic executions from SuperMontage. In addition, as UTP (Unlisted Trading Privilege) Exchange participants, the new exchanges will go to the back of the line in terms of priority.

The SuperMontage system will execute against all Nasdaq member orders at the NBBO before executing the UTP order. Both of these features favor Nasdaq over new ECNS that turn into exchanges. It will be interesting to see whether this motivates any ECNs to withdraw their exchange applications.

In the end, existing trading desktop real estate may prove more important than any individual trading features available in SuperMontage. If Nasdaq had done this two years ago, the ranks of ECNs would be much thinner today.

But, it is likely that traders will continue to use Archipelago or Bloomberg as their point of entry into the automated trading facilities for Nasdaq stocks, because they are comfortable with these systems. They know how to use them. SuperMontage does not provide much functionality that is not already embedded in these systems, or will be available as soon as SuperMontage is.

One exception is smart order routing.' There will be little proprietary advantage to smart order routing as SuperMontage effectively eliminates market fragmentation -the problem that smart order routing was designed to fix.

SuperMontage's implementation will probably only reaffirm the importance of the Law of Unintended Consequences in market operation; it will trigger problems or help certain market participants in a way no one can predict right now. While a substantial impact should not be expected, traders should be paying careful attention to shifts that occur in the trading of initial SuperMontage stocks.

Jim Marks, a former brokerage industry analyst, is president of Toronto-based trading technology firm Belzberg Technologies.