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November 1, 2002

National Market Under Fire

By Peter Chapman

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Top Execs Want ITS Electronic Link Eliminated

In the wake of the Island ECN's big snub of the National Market System, market center officials are calling for the dismantling of a key NMS component - the Intermarket Trading System.

Speaking at the Security Traders Association's annual conference in Boca Raton, last month, top execs from the New York Stock Exchange, Nasdaq, and Archipelago, as well as the former president of Island, called for an end to the government-mandated order routing network that ties together the country's various market centers.

The anti-ITS rhetoric came on the heels of an astonishing act of defiance by Island. In September, the big ECN refused to comply with a Securities and Exchange Commission order to post price data related to the heavily traded ETFs, or exchange-traded funds, in the Consolidated Quote System.

Island is bound by rule to participate in the CQS, one of three systems that make up the National Market System. That's because its market share in three of the ETFs exceeds five percent.

Island snubbed the SEC because it did not want to be subject to the rules of the ITS, an obligation which accompanies CQS quoting. Participating in the ITS would have meant routing away certain orders to slower-moving trading venues such as the American and New York stock exchanges.

Instead, Island chose to remove the data from public view and is now trading five brands of ETFs completely in the dark.

Island's stonewalling marks the first real challenge to the controversial ITS. It illustrates both the stature achieved by electronic venues such as Island and the difficulty of linking them to the traditional floor-based open outcry markets.

The ITS, which links the nation's seven stock exchanges and Nasdaq, is one of three electronic networks that make up the National Market System. The other two are the CQS, over which specialists and dealers broadcast their prices, and the Consolidated Tape System, over which executions are reported.

Criticism of the ITS is universal, but the reasons differ. The New York Stock Exchange doesn't like the ITS because it says it gives dealers in other markets free back door access to its liquidity. Competitors don't have to become members or pay brokerage fees to trade.

The Big Board has stated in the past it would like to see the ITS reformed. Robert McSweeney, senior vice president, market structure and new market initiatives at the NYSE, told the Boca crowd: "If you want to get an execution within a couple of seconds you can come directly through the front door through a member firm."

The New York's electronic competitors, such as ArcaEx and Island, dislike the system because of its rules regarding trade throughs and locked and crossed markets. Their customers would often prefer to quote at prices inferior to the national best bid and offer. Doing so would either lock (bid equals ask) or cross (bid is greater than ask) the broader market price and is forbidden under ITS rules.

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