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September 30, 2004

Building the Better Mousetrap?

By Peter Chapman

As for the pegging, Balabon posits, a liquidity provider, such as a market maker, would be encouraged to publicly display size at say 10 cents away from the inside as long as he remains 10 cents away from the inside at execution. The dealer could then theoretically offload his position somewhere near the inside, earning a 10-cent per share profit.

As an example, assume a trader places a large buy order on the ATS, pegging it at 10 cents below the National Best Bid. His order is transparent to the entire market because Deep Liquidity is an open book. In addition, the trader specifies a time range - say between five seconds and 15 seconds - during which the NBB must remain unchanged for an execution to occur.

An interested seller clicks on the order, studies the parameters, and agrees to the terms. (The process is not too dissimilar from the eBay experience.) The two contras now wait for a period of time randomly selected by the system somewhere between five seconds and 15 seconds. If, after say 10 seconds, the NBB has remained unchanged, the trade is completed. If instead the NBB moved, the clock is reset and the wait begins anew.

Not all traders will use the system the same way, Balabon maintains. Limit order traders pricing their orders at or better than the NBBO, are more likely to display only a small portion of their order. The rest can hide in reserve. These more aggressive traders are unlikely to show their full size as they are more susceptible to pennying.

Those traders placing orders away from the inside will most likely display their full size in order to attract a contra. Although Balabon expects most executions to occur at the inside, he believes most volume will be done away from the inside.

"A big trade occurring behind the inside quote will affect the market, but it won't necessarily move it significantly," Balabon says.

The inventor's first inclination was to tier the system's pricing at two levels. Those traders submitting orders at the inside would pay one rate. Those posting away from the inside would pay another. The latter group would likely include a select list of market makers.

Now Balabon has done away with the two-tier structure and is targeting the buyside exclusively. "The rules of the system will be geared to the buyside community," Balabon says. "They are the target audience." Pricing is likely to be uniform no matter where a trader is pricing in relation to the NBBO.

Balabon even foresees a day when large buyside shops will form their own block trading departments to price and trade large blocks in the Deep system. "When traders first seek liquidity, they will look for it at or inside the NBBO," the inventor says. "If they feel there is not sufficient liquidity [there], they will look outside the NBBO. The Deep order book is designed to provide liquidity at any price."