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November 1, 2002

SuperMontage Is Not Enough

By Michael McCauley

It "boggles his mind" why the industry needs an alternative display facility, says STA Chairman Jack Hughes. Contrary to his opinion, competition is good, which is why so many want both the ADF and the SuperMontage. It was competition in the OTC marketplace that allowed the innovative and powerful technological advances of ECNs.

It was competition that allowed ECNs to currently capture 57 percent of the daily volume traded in Nasdaq. It was competition that allowed spreads to narrow dramatically, transactions costs to plummet and, most importantly, implicit trading costs to be reduced. That led to better executions. It was competition between ECNs and market makers that forced Nasdaq to scramble to create SuperMontage. And it was competition that forced market makers to change their spread-based business practices to an agency model in an effort to recapture market share and lost revenues.

However, if the rules of the trading game are controlled by a for-profit Nasdaq, then we may return to the bad old days of monopoly. That's even though we disguise it with a happy technology face. If the "only game in town" is the sole determinate of assessed fees, and if Nasdaq is to turn a profit, it is a matter of time before a constant increase of fees will follow. Competition keeps people honest.

Buyside institutions as a group have a "wait-and-see" approach to the SuperMontage. Most have no preference in where their orders are executed, provided they receive a good price with low transaction and implicit costs. Many prefer to execute trades for themselves, or to outsource to an agency desk. However, the impact of SuperMontage will be felt as it limits options. To access SuperMontage, institutions are forced to use a market maker or an ECN, not out of choice, but because of the fees paid. If liquidity is available - in an exchange, the ADF or SuperMontage - the firm will not accept a worse price because an executioner was unable to access that liquidity due to system limitations. Aggregators are providing traders with an option to compete effectively.

Many would agree the transformation of the Nasdaq market is long overdue. SuperMontage is a product that, like the ECNs before it, should improve the efficiency and speed in dealing with market makers. Still, many traders and ECNs, assessing SuperMontage's functionality, conclude that it is a crude ECN. Abilities such as using a reserve book and different price levels are positive steps, but the system fails in another way. Anonymity is compromised when the contra side is identified immediately after a trade and because of the inability to access liquidity outside its walls.

Why can ECNs access SuperMontage liquidity, but SuperMontage does not allow market makers the same ability when using an exchange or the ADF? To remain competitive, market makers need access to the same tools or they will continue to fall behind. The majority of the significant ECNs are only willing to display their top of book in SuperMontage. Institutions, like market makers, will still have to use ECNs to interact with those deeper pools of liquidity. A positive side effect of SuperMontage is the ability to now preference individual market makers. This allows the unbiased electronic trader to further pick apart Level II.

ECNs understood their buyside clients' wants: anonymity, price discovery, low costs and deep liquidity. They gave it to them and, in the process, created a very efficient OTC marketplace. The advantages of trading Nasdaq stocks have been transferred from market makers to the investing public because of this competition. SuperMontage will neither change underlying agency trends nor change the buyside desire for more direct access to the OTC market place. It will provide institutions with another tool to execute orders. However, it is the competition between participants within the marketplace - an exchange, the ADF or SuperMontage - which will continue to foster and promote technological progress and a more efficient market.

Michael McCauley is president of Pulse Trading, an institutional agency desk based in Boston. The desk specializes in alternative trading methods.