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May 31, 2003

More Auto-Ex on ITS

By David Herron

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  • More Auto-Ex on ITS

The National Market System for trading listed securities has worked well since the 1970s. That's because the NMS has effectively combined the price discovery benefits of an auction market with the competitive pricing structure of the dealer market.

There are two elements in this success. The first is the dissemination of national best bid and offer information. The second is the linkage of all market centers by the Intermarket Trading System, a system supported by clear rules and resolution procedures.

These principles of market structure have fostered the widespread availability of market information, as well as best price execution for all market participants.

There is general agreement about the importance of widely disseminated NBBO information. The debate is mostly about the efficiency of linkages between market centers. The ITS is criticized as slow. Critics charge it doesn't effectively link market centers with disparate models. Still, on average, 70 percent or more of commitments to trade are filled by the receiving market. And of the remaining 30 percent, cancellation of these commitments is typically the result of a quote change or stock trading prior to the arrival of the commitment.

There is merit in some of the ITS criticisms. However, any conclusion that eliminating ITS would improve the ability of the NMS to achieve its goals must be rejected.

What exactly are the strengths of ITS?

First, ITS is effective. It provides investors with the best price without regard to the market center to which their carrying broker routes that order. Although most orders are executed at, or within the NBBO at the receiving market, on average markets trade with each other via ITS over 35,000 times per day - to provide best price execution to a customer order.

Second, the availability of ITS reduces the incidence of locked and crossed markets. While it is possible to lock or cross a market in the NMS, ITS rules give the locked market an efficient vehicle to obtain a level of relief from the locking marketplace.

Finally, ITS not only protects customers, it also provides an incentive to enter limits at, or better than the NBBO. Although there is no cross-market time priority, ITS resolution procedures act as a measure to prevent one market executing trades at prices inferior to bids or offers displayed at other markets. ITS linkage and rules assure that, if a trade-through does occur, the customer will be satisfied. If these did not exist, there would be reduced incentive to submit limit orders that improve the existing NBBO.

The adoption of decimals have left traders increasingly frustrated with the slow turnaround time of the ITS. Users have responded by ignoring quotations for what they consider to be insignificant size, causing trade-throughs for relatively small share amounts.