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June 6, 2006

Chicago's Brave New World

By Peter Chapman

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Specialists are out. Market makers are in. The Chicago Stock Exchange, as part of its plan to reinvent itself as an ECN-like utility, is casting aside its decades-old specialist model. Instead it will operate more like Nasdaq with market makers competing against each others in the same stocks. The core of the revitalized exchange-which soon is expected to announce investments from large broker dealers, possibly including Goldman Sachs-is a matching engine.

NASD market makers will be invited to post quotes and orders onto the system, but others, notably black box traders, are also being aggressively courted.

The CHX hopes to encourage the sharp-shooters by a combination of fast fills and its traditional pool of retail and institutional liquidity

Currently trading on the CHX floor are three specialists-E*Trade, LaSalle Securities and JMM Specialists-and about 20 or 30 floor brokers.

The CHX expects to launch Phase 1 of its new model this month. And despite the move to high-tech, it still plans to maintain its trading floor. It will charge for space and utilities, but is legally separating the floor from the exchange.

Traders Magazine executive editor Peter Chapman spoke with Dave Herron, the Chicago's chief executive officer, about the changes.

TM: How will the new CHX be different from an ECN?

Herron: We are trying to capitalize on our native liquidity. That is our large network of connectivity to retail and institutional broker-dealers. We are ECN-like in structure but have native volume. We are not like a brand new ECN coming out of the gate that is reaching out to the algo players in a bid to replace INET or BRUT. We at least have native volume.

TM: The original plan was to incorporate specialist-like "lead market makers" regulated by the CHX. Now you intend to be more of a utility for NASD market makers. What made you change?

Herron: We have changed in the past six months because of the approval of Nasdaq as an exchange and the blessing of the SEC of the NASD/Nasdaq trade reporting facility (TRF). The TRF lets NASD market makers effectively ignore the time priority that exists on exchanges when they want to interact with orders directed to them.

TM: This puts exchange specialists at a disadvantage?

Herron: That is a huge stumbling block for firms that want to play the role of traditional specialist. That's even if they could be a specialist on an exchange in multiple stocks. The SEC has made it quite clear that an exchange specialist would always have to yield to the time priority in an exchange book. So we will work with the NASD to create our own TRF, as a CHX subsidiary. I assume the other exchanges will do the same. We would create the same environment for our own specialists. They have said that because their competitors, the NASD market makers, will be able to ignore time priority by printing in TRFs, they need to as well. So, with the SEC's blessing of the NASD/Nasdaq TRF, it forces us to go down that path.

TM: And so they cannot be CHX market makers?