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December 1, 2004

Down in the ITS Dumps: Finding an Acceptable Industry Solution

By Nina Mehta

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The troubled Intermarket Trading System is a sorry mess.

Yet despite all the battles over the controversial electronic network that links the nine U.S. market centers trading listed securities, there is agreement among some pros: ITS doesn't work as intended; it should be upgraded or scrapped; and it will never be as efficient as private linkages between markets.

That's as far as these market professionals will go. Beyond that, there's no industry consensus about how the New York Stock Exchange and the eight other market centers should be linked.

"The basic principle behind ITS is good. It gives people price protection between markets," says Michael LaBranche, chairman and CEO of NYSE specialist firm LaBranche & Co. "But with today's technology, smart order routers can do what only ITS could do previously."

ITS has outlived its original purpose, according to Jeff Brown, director of product development at UNX, an institutional agency brokerage and direct market access technology provider.

"The ITS rule-set reflects the brokerage and trading industry of 30 years ago, certainly not the equity market of the 21st century," he says. "ITS is an impediment to progress, an impediment to technological innovation at the NYSE and the regional exchanges."

Earlier this year the Securities and Exchange Commission's Regulation NMS proposal took a 218-page crack at reforming the National Market System that Congress mandated in 1975. Some pieces of the proposed regulation on market structure affect ITS, which was created in 1979.

ITS started out, effectively, as a bulwark against NYSE dominance. The rules of the ITS involving orders and trading govern the interaction of its participant market centers. The 1981 trade-through rule, for example, specifies that a market must avoid trading through, or ignoring, a better price available in another ITS market.

ITS also encompasses the physical linkage that connects the market centers. The linkage allows investor orders in different liquidity pools to get price-improved. For instance, when the Boston Stock Exchange routes an order to the NYSE or the Philadelphia Stock Exchange routes to the National Stock Exchange, the order is sent via ITS. The ITS linkage is used only by ITS members.

The roots of the ITS troubles are clear. The technology is dated and its rules are abused, according to some upstairs trading pros. Others disagree, saying the technology and the fundamental model is still robust.

Response Time

However, many buyside traders complain that in today's fast-moving markets, the response time on ITS is too long and there is no execution certainty. The governance of the ITS Operating Committee is also compromised because the most significant decisions require unanimity. This means the competing interests of ITS members have hindered progress.

Over the last three decades, the trading industry has been revolutionized. New communications technology and trading venues, faster networking speed as well as decimalization, have all changed the landscape. In the Nasdaq marketplace, the changes include competition from aggressive ECNs and ATSs, coupled with advances in routing technology.