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March 1, 2004

The Windy City's Auto-Ex Democracy

By Editorial Staff

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Auto-ex ain't what it used to be at the Chicago Stock Exchange.

The Windy City marketplace, long famous for its automatic executions of small orders, has quietly dismantled its Midwest Automated Execution system, or MAX. Instead, it is allowing its specialists to decide whether or not to offer automatic executions using their own technology.

With the advent of decimalization and penny ticks, the Chicago has backed away from guaranteeing fast fills to all comers. Specialists were losing too much money. Now, in a novel twist, and with the approval of the Securities and Exchange Commission, specialists can control their own destiny.

Specialists can pick and choose which customers to give immediate executions. They must build their own systems though. That's because the Chicago, as an exchange, is prohibited from discriminating between customers in its order handling. It cannot use MAX to grant auto-ex to one broker and deny it to another.

The Chicago has not abandoned auto-ex completely. The exchange is building an ECN-like matching facility called CHXpress to bring customer orders together. Specialists may quote on the system, but are not required to.

Driving the project in part is a desire to get the Chicago's two distinct floor communities to trade with each other. Half of the exchange's 80 million (listed) shares per day is retail flow destined for eight specialist firms. The other half is institutional block orders. About 30 floor brokerages cross blocks for bulge bracket and other shops over the telephone.

Dave Herron, chief executive of the Chicago, believes auto-ex will solve another problem: what to do about the trade-through rule. The highly contentious rule prevents traders from executing outside the national best bid or offer. Many would like to. The rule is under review by the SEC.

Herron believes the trade-through rule should remain. And if all market centers offered automatic executions, then dealers could both trade through quotes and satisfy those quotes simultaneously.

Technology Editor Peter Chapman recently sat down with Herron to discuss the Chicago's auto-ex initiatives and the trade-through rule.

Traders: In Scottsdale, at the annual Security Traders Association convention, you told the crowd your specialists were trading more on an agency rather than a principal basis. What did you mean by that?

Herron: We've worked with the SEC to give our specialists the right to work customer orders as agent as opposed to taking the other side of every trade.

Traders: This has something to do with decimalization?

Herron: In a pre-penny environment, it was possible for a specialist to guarantee the NBBO on every trade. Instead of working the order-going down to the marketplace and trying get the best price-he'd just guarantee the best price. In a sixteenth or eighth environment that worked because liquidity tended to pool up. You knew there was size. So you could afford to trade 2,000 shares.

Traders: You could afford to take the risk.