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May 16, 2007

CHX Revamps Business Model with Routing

Three Market Makers in the Mix for Flow

By Sarah Rudolph and Peter Chapman

The Chicago Stock Exchange, taking a page from Nasdaq's playbook, is moving into the order-routing business. Under its revamped business model, the Chicago has begun operating an order-routing network that connects its 90 order-sending customers with market makers. The exchange now boasts three dealers that receive orders on its newly christened CHXConnect service: Citadel Execution Services and two former Chicago specialist firms, LaSalle Capital and E*Trade Capital Markets.

"The network was already in place for customers to access the exchange," said Chicago chief executive Dave Herron. "What changed was allowing the customers to access other firms as well." CHXConnect lets order senders access the CHX's order book as well as the connected NASD market-maker firms and CHX's institutional brokerage firms.

The Wrinkle

Most stock exchanges set up routing networks so that their customers can send orders to the exchange's limit order book, floor brokers or specialists. It is rare for an exchange to facilitate order routing between order senders and market makers.

Nasdaq is an exception. The company, which only recently became an exchange with its own limit order book, has long connected order senders with market makers via its ACES network.

The Chicago, like the four regional exchanges, abandoned its specialist-driven model last year. That means its order-sending customers must now send their orders to wholesalers, or NASD market makers, if they want specialist-like services.

Dealers pay the exchange $5,000 a month to receive orders over CHXConnect. They are under no obligation to trade on the exchange. They will likely print to the NASD/Nasdaq Trade Reporting Facility, according to the Chicago.

"Market makers can handle customer order flow and simply report a paired transaction and print that in an off-exchange venue," Herron said. It is the customer's choice, he added. One advantage to that is knowing what the spread will be, rather than being subject to price improvement. The Chicago calls CHXConnect a "neutral communications service" that would not "effect trade executions." Also, an order does not pass through the exchange on its way to a market maker.

Expanded Reach

For dealers such as Citadel, a rapidly growing wholesaler that has been in the business for about two years, the network extends their reach to more suppliers of order flow.

"Over the years, the CHX was able to connect to a large number of different brokerage firms," said Andy Kolinsky, Citadel's head of sales and client services. "Connectivity is a big hurdle for a new entrant like us. Not that people don't want to connect-it just takes time and technology resources on both sides. A number of firms that were not connected to us were connected to CHX. This gives us immediate connectivity to all those firms in one fell swoop, where it could have taken months."

Citadel is number three among wholesalers, after UBS and Knight Trading. It has 80 clients in the execution services division.

Citadel is under no obligation to represent incoming limit orders on the Chicago's electronic book, but the exchange clearly hopes it will.

"We hope Citadel will choose to display customer orders on the book. We're competing in that business with other markets," Herron said.

"We have the flexibility to adjust our pricing, so there are financial incentives for market-maker firms to turn around and put orders back into our trading engine," he added.