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July 31, 2002

Lawmakers Look at Listed Prices: In the ITS Debate, a Sympathetic Ear for ECNs

By Desmond MacRae

The U.S. Congress may soon look more closely at access to a controversial trading mechanism.

It is a debate that was fuelled in recent times when Nasdaq sided with Island in the ECN's dispute with the Intermarket Trading System (ITS).

The ITS is the electronic pipeline, launched in 1975, that connects the NYSE, the regional exchanges and the dealer market in listed stock trading.

Island, which is clamoring for ITS reform, does not voluntarily participate in the ITS. One way it could do so is indirectly, via Nasdaq's Computer Assisted Execution System (CAES). That would also enable Island to post its quotes on the National Consolidated Quote System, which disseminates market data for the best bids and offers in listed securities.

If it all sounds complicated, perhaps that's because, as some contend, the ITS was designed to stem competition from non-NYSE members, such as a group of ECNs and other ATSs which offer fast execution services.

"Using ITS would slow executions for us because of the trade-through rule," said Andrew Goldman, specifically referring to a thorny aspect of a rule that does not allow participants to execute bids and offers at prices that might be inferior than the best available from the ITS.

The thorny aspect of the rule is that NYSE specialists have up to 30 seconds to accept or decline an order routed via the ITS. Island says that this length of time is unacceptable to many traders.

Other market participants argue, however, that Island's refusal to participate in the ITS gives Island an unfair advantage in trading of the popular QQQs, the exchange-traded funds pioneered by the American Stock Exchange. One industry insider complained that Island, which is a major player in trading QQQs, can "trade through" the best prices and use other opportunistic strategies. Others contend that ITS is a speedy enough pipeline, noting that the NYSE typically responds in under 30 seconds to ITS orders.

Change in the Air

As the debate rages, there is a whiff of change in the air. "The relevant Congressional committees appear to be trying to ensure that the Securities and Exchange Commission move along a path that will continue to allow electronic market places to compete with traditional markets," said Andrew Madoff, co-director of trading at Bernard L. Madoff Investment Securities in New York. Madoff supports the trade-through rule because, he stresses, it offers an extra layer of protection for his customers.

Still, Nicholas [Nick] Karos, manager of OTC trading at US Bancorp Piper Jaffray in Minneapolis, wonders if a trade-through rule will be necessary soon. "The Nasdaq and the NYSE operate very differently," he said. On Nasdaq, there is no need to post bids and offers on separate boards, he noted. It is, in effect, a consolidated system, the more so with the introduction of Nasdaq's SuperMontage.

"The NYSE is an order-delivery system in which bids and offers shown can be accepted or declined, but not everyone has the same or equal access," Karos said.

On the Nasdaq, investors from the largest institution to the smallest retail participant now have more equal electronic access to the price-quote competition, he contends. "Thanks to SuperSoes, an execution-based system that compels a broker to show customer orders lest he lose out on a good price, bids and offers at the same prices trigger trades," Karos said.

If uninterrupted access for trading in NYSE stocks was granted to ECNs and others, there would be no off-board markets, some observers suggest. A trade-through rule would not be necessary in this open market environment, an environment in which the barriers to competition in the listed market had disappeared. Karos, who stresses the importance of best execution and investor protection, thinks that the sooner this happens, the better.