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May 10, 2006

Chicago Is Going Electronic

By Nina Mehta

The Chicago Stock Exchange, aiming to be both compliant and competitive under Reg NMS, will start rolling out a new electronic trading platform this month.

By summer, the 124-year-old exchange hopes to convert into a fully electronic exchange, jettisoning its specialist model and closing its trading floor.

"We are reworking every major system at the exchange," says John Kerin, senior vice president and chief technology officer at the exchange. "At the core of the exchange we'll have a lightweight, fast matching engine that's very ECN-like." These plans are subject to Securities and Exchange Commission approval.

A secondary version of the automated trading platform, with updates and new functionality, is planned for June. The new matching system will eventually replace the exchange's MAX and OTC engines for automated trading of listed and Nasdaq stocks.

"The electronic book should add liquidity here and put us on an equal footing with any ECN or SRO," says Luis Fontanez, a floor broker at Jefferies Execution Services.

The exchange plans to lease out space on its current floor to market-making firms, professional traders or anyone looking for connectivity to exchanges. The exchange says that divorcing the trading space from the SRO will not impact current customers' ability to operate from their current location.

Besides transforming the floor into a giant trading arcade, the new model spells big changes for specialist firms.

No longer will a single firm be given exclusive rights to make markets in a single security. Instead, the exchange will put in place a competing market maker structure. Any firm can make markets in any security it chooses. The transition is likely to occur in June and July, Kerin says.

Current specialists who trade for their own account against agency orders will be required to become NASD market makers if they plan to continue those operations. The exchange will have another category of market maker that can post bids and offers but will not handle agency orders directly.

The move to competing market makers is historic for the Chicago, but perhaps not so wrenching. Only a handful of firms still act as specialists at the Chicago; E*Trade is the largest.

As for the exchange's floor brokers, they will be known as "institutional brokers" under the proposal and will gain more flexibility in how they handle orders.

Their Brokerplex workstations will get new functionality that will let them send orders to a smart router or straight to an ECN or DOT vendor. Currently only specialists have access to DOT vendors.

"Once orders are in Brokerplex, we'll be able to piece them out to other market centers or keep them here," says Tom Kretzmann, manager of TK Securities, a floor broker who's been on the CHX since the mid-1970s. "They've patched together what we need so far," he adds, "but the version they're now building will have everything integrated."

Institutional brokers will have to clear the exchange's matching engine before routing out to other markets. "That should force higher match rates here," says CHX's Kerin. The CHX is also counting on new order types such as reserve size and hidden liquidity orders to bring in more business and drive up matches on the system.

Floor brokers and market makers will continue to receive order flow via the exchange's wide-area-network. The WAN will be separated from the SRO, enabling specialists who become NASD market makers to receive order flow from customers connected to the system. Approximately 100 retail order-sending firms hook into that network, Kerin says.