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November 29, 2005

Chicago Courts Rapid Traders

By Nina Mehta

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The Chicago Stock Exchange, beset by declining volume, is revamping its trading platform in a bid to capture order flow from hedge funds and other fast-draw trading types. The initiative involves changes to its century-old specialist system and the construction of an internal ECN.

"Previously we had a model that discouraged the professional trader from coming in and getting in the way of the true agent investor," says Dave Herron, the Chicago's chief executive. "Hedge fund players are now so active that we can no longer discourage that business. We have to embrace it and integrate it with our existing customer activity."

The Chicago built itself a niche over the years by attracting online retail brokerage orders as well as institutional flow sent to floor brokers.

During the Internet boom the market drew a tremendous retail order flow from E-Trade, Ameritrade and other online brokerages. Since then, volume has fallen off. Average daily volume has decreased from an all-time high of more than 122 million shares per day in 2001, to 76 million per day in 2004.

To get more competitive, the exchange demutualized in February and became a for-profit corporation. In June the exchange's board of governors announced it would migrate toward an electronic environment while preserving the price discovery function of its trading floor. It said it would do this through a hybrid-trading model.

Change probably is necessary. The Securities and Exchange Commission's Regulation NMS is compelling the nation's stock exchanges to automate their executions. The announced NYSE-Archipelago and Nasdaq-INET mergers have also altered the game, giving regionals a potential boost as a counterweight to the biggies.

The Chicago plans to build on its existing customer base of traditional retail brokerages and institutions that use floor brokers, according to Herron. It hopes to entice new professional customers interested in interacting with orders from that base.

At the heart of the CHX's hybrid model will be an electronic book controlled by the exchange, not specialists. The book offering is "like an ECN," says Herron. The initiative is designed to attract volume by offering speed and immediacy to the primarily professional traders expected to use the facility. Currently, traders can immediately display and access orders on the exchange's book for stocks that do not have specialists assigned to them. The electronic book, already available for more than 1,000 low-volume OTC stocks, will be extended to listed stocks later this year.

New Order

The exchange has also created an order type called CHXpress for professional traders that want immediate execution or cancellation in both stocks that have specialists and stocks in the electronic book.

Hedge funds want low-cost, automated executions, speed and capacity. The CHXpress order type provides immediate automated display, execution and cancellation for electronic book issues and issues assigned to specialists. It eliminates order handling by specialists, however, and the potential for price improvement. CHXpress orders interact seamlessly with orders sent to market makers and floor brokers that have been placed in the exchange's limit order book. Orders that are matched are executed at the NBBO.