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July 31, 2002

Time for an ITS Facelift

By Joseph Kennebeck

Guess who'll soon be 25-years old? It's everyone's buddy, the Intermarket Trading System, an electronic pipeline connecting the NYSE, the regional exchanges and Nasdaq in the trading of listed stocks.

The ITS came into the financial world on April 17, 1978, the same year Laverne and Shirley was the top TV show in America while Saturday Night Fever was a number one album.

But, like those prized celebrity properties, the ITS in some eyes is starting to look worn, broken and old-fashioned. It is also generating controversy at the Big Board. The NYSE, earlier this year, announced its intention to divorce ITS. The Big Board said it was tired of giving access to its quotes - free of charge. "Our data is more valuable than the [other] exchanges," announced Ed Kwalwasser, an NYSE executive vice president.

While I do applaud the intention - and hopefully the final result - of this announcement, I must dispute Mr. Kwalwasser's statement. Even so, the Big Board has at least helped fuel a good debate about a malfunctioning system. On the NYSE, specialists must take orders routed over the ITS and manually execute them. If the order is not executed, a sender must wait 30 seconds before the order can be cancelled.

As for Mr. Kwalwasser's claim that the NYSE (or an ECN, exchange or market maker) is the owner of its quotes and pricing data, I disagree. Those quotes and prices surely would not exist if it were not for the orders of public customers as well as institutions.

What if the investing public awoke one morning with a massive hangover, called in sick and stopped sending orders to venues for execution? Do you think that the specialists, floor brokers, market makers and ECNs would simply trade happily amongst themselves all day? But let's return to the ITS.

Some say if the ITS were eliminated private intermarket linkages would spring from the ground like daisies. In scrapping the ITS, however, we would, at least initially, take a step backwards in our market structure. In doing so, a listed stock traded in more than one location would sometimes become expensive to trade. Proponents of abandoning ITS argue that market centers would fork over their thinning profits to build private individual linkages.

But what is to ensure these private networks would perform better than ITS does? How will they prevent trade-throughs? Will the executions be manual or automated? Will there be a delay when canceling orders? And in the end, who will foot the bill for the construction and upkeep of these networks? Even if these lines were built, what mandate would there be for a market center to use them for the benefit of public orders? The trade-throughs that happen on ITS today may simply turn into arbitrage opportunities in the land of a thousand liquidity pools.

Back in 1978, ECNs didn't exist. Today's bandwidth and infrastructure didn't either. And if we take the computer industry's standard line that computing power doubles approximately every three years, the systems of today are about 250 times better than the miniframes of 1978.

Manual System

The solution is not to abandon ITS, but to automate and improve it. Build a new version. Take the manual processing out of the hands of the specialists. Keep all seven of the exemptions to the trade-through rules (trading through 100-share size, putting up a block, etc.).

They all still have merit in today's markets. Auto-execute against quoted size and price. Even allow access to reserve size at that price if the order over-hits the quoted size. And, above all, allow cancellations to happen instantly. That's with the understanding that the system could return a fill as too late to cancel.

The way to ensure access to liquidity and to protect the integrity of limit order trading is not to abandon it, but to create a new intermarket system.

Joseph Kennebeck is head of North America trading at Electronic Global Securities in San Francisco.