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December 6, 2006

TRF Applicants Queuing Up with SEC

By Gregory Bresiger

Several exchanges are moving ahead with game plans that one trading official says are a way "to make internalization respectable."

Trade reporting facilities (TRFs), as these plans are called, are limited liability corporations used by over-the-counter dealers to report their internalized trades. These are transactions in which a broker-dealer "internalizes," or trades against its customers' incoming orders. Trades are done at the broker-dealer. They are never sent to an exchange

Exchange officials hope TRFs will enable them to compete for more over-the-counter trade reporting business.

At presstime, the New York Stock Exchange had just filed for a TRF. Last year the NYSE had opposed Nasdaq's plan for a TRF.

But later Big Board officials reversed themselves, realizing the regulatory winds were blowing in favor of every major exchange having a TRF.

Indeed, the TRF application of the National Stock Exchange (NSX) is before regulators and in its comment period. Operations are expected to begin this fall, according to NSX officials.

"It will be a service for the purpose of reporting over-the-counter transactions in Nasdaq-listed equity securities to the NASD," according to NSX's filing.

At least two other exchanges, were expected to file TRF applications, according to industry sources. Boston Stock Exchange officials said their TRF application was also about to be submitted, while Chicago Stock Exchange officials said they were working on a TRF plan. Both exchanges said it was premature to give the details of their plans.

NSX officials said their plan is similar to Nasdaq's recently approved TRF plan. The TRF will be jointly operated as a limited liability corporation.

"We're the business partners and the NASD is the regulator," a spokesman for the NSX told Traders Magazine. The exchange, in this joint venture with the NASD, pays the costs of regulation but will also take any profits.

Exchanges already have various trade reporting operations. So what is new here? This new trading reporting pipeline will change one of the traditional functions of the exchange, which centralizes order flow in a single book. Until now, the exchange matched and executed orders based on time-price priority rules.

But now members will match and/or execute orders internally or through proprietary systems. They will submit these trades, in the case of the NSX, to the NASD/NSX TRF.

TRFs are critical for exchanges that want to capture a significant part of this OTC trade reporting business. One trading official estimates that about 30 percent of the Nasdaq market is "internalization or ECN business."

Exchanges that want this business will presumably use these TRFs, which have caused much debate.

The NYSE last year was trying to line up industry players to stop TRFs because internalization supposedly promotes conflicts of interest. But now NYSE will offer its own TRF to customers without a fee and will rebate market data revenues, says Robert McSweeney, NYSE senior vice president. McSweeney says "we're not looking to promote the internalization practice, but it would be imprudent to ignore this business." He adds that Big Board's TRF will be operating in early 2007.

One trading official, noting the recent regulatory approval of the Nasdaq TRF plan, said the regulators "are now forcing exchanges to get TRFs."