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Jared Dillian
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In this piece from 10th Man, author Jared Dillian discusses how the ETF revolution is less about ETFs and more about indexing; about how people have come to view stocks less as stocks and more as blobs of stocks.

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September 10, 2007

Some Cheer Nasdaq's New ETF Market

Generous Pricing Model Looks to Attract Market Makers

By James Ramage

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Nasdaq's plan to create a special marketplace for exchange-traded funds is drawing mixed reviews. Some see the initiative, which involves grafting the specialist function of the New York and American stock exchanges onto Nasdaq's multiple dealer platform, as furthering the growth of the booming ETF market.

"This should increase the volume and the quality of the markets," says Vaidas Uzgiris, head of ETF trading at Timber Hill, the market making division of Interactive Brokers. "We are already a specialist on Arca, and we will be a specialist also at the Nasdaq. It's a good model."

To others, though, Nasdaq's plan to offer price incentives to liquidity providers likely won't be sufficient to encourage those very providers to participate. "I wouldn't take the time to commit the capital under [Nasdaq's proposed] rule base, because I don't think you can get the rate of return that's sufficient," says Daniel McCabe, a former specialist and president of Bear Hunter Structured Products, and currently chief executive officer at M7 Ventures, a company that will soon develop ETFs. "I mean, if you gave somebody a real rule base, where they can make some real money, absolutely."

Standard Pricing

Nasdaq is signing up designated liquidity providers, or specialists, to those ETFs it already lists, according to Steven Bloom, senior vice president for Nasdaq Financial Products. It expects to add more for its new listings when the market launches this month.

When it opens, Nasdaq hopes its new program will encourage issuers to list ETFs on its market by appearing as a more competitive option to NYSE Arca and the American Stock Exchange. Nasdaq listed 20 ETFs through July, while the NYSE and Amex listed 197 and 337, respectively.

At the program's heart, a prospective ETF sponsor will select one or more designated liquidity providers to supply seed capital and place two-sided quotes in the Nasdaq Market Center during the new ETF's initial listing. To give the providers incentive to do this, Nasdaq will make their baseline rate rebate for adding liquidity higher than their charge for removing it during this incubation period, according to William O'Brien, the Nasdaq executive in charge of new listings who moved to Direct Edge ECN after the interview. That is a reverse of standard practice in which take charges exceed liquidity rebates.

When accessing liquidity, the designated market maker would pay 30 cents for every 100 shares executed, according to Nasdaq's rule change filing. And he would receive a credit of 40 cents for every 100 shares executed when providing liquidity.

Quality Control

Nasdaq will ensure a "backstop of execution quality" within its new market by requiring its chosen market makers to provide liquidity and tight spreads, O'Brien says. "They have to earn the place they're going to have within our market structure," he says. The incentive structure only lasts until an ETF is able to trade without support, or once its average daily volume on Nasdaq exceeds 250,000 shares on any two calendar months in a three-month period.

As the thinking goes, Nasdaq can then revert back to standard pricing for the liquidity provider, O'Brien adds. "Once an ETF becomes mature in that type of high-volume environment, the [liquidity provider] won't need exchange incentives to earn a fair return for providing liquidity."