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September 10, 2007

Some Cheer Nasdaq's New ETF Market

By James Ramage

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Nasdaq has garnered a healthy proportion of ETF trading (see chart), but it still falls well short of NYSE and the Amex for listings. And specialists may have something to do with this fact, as they have played an important role in ETF creation and trading.

ETFs are similar to index-based mutual funds, but trade on exchanges like stocks. And launching one requires initial capital funding that specialists have provided. While Nasdaq currently employs a competing market maker system that doesn't designate a specialist to make markets for ETFs, both NYSE Arca and the Amex use specialists to be the dealers of last resort and to provide that start-up funding to ETF issuers. In return for making narrow quote spreads, specialists are given a monopoly on the trading.

Fewer Specialists

Using a specialist to trade ETFs in an electronic market isn't an original concept. The NYSE embraced electronic markets with its hybrid market and the purchase in 2006 of Archipelago Holdings. Its market retains a specialist component within an auction-electronic market fusion. By adding market makers to its electronic model, Nasdaq appears to be arriving at the same point from the opposite direction. It is launching this because its trading platform wasn't helping ETFs sufficiently in their developing stages. "The historical relationships that have been used to bring ETFs to market didn't port too well to Nasdaq's model," O'Brien says.

That model has worked well with trading ETFs, though, because the most liquid of them are well suited to an electronic market's advantages in efficiency over floor trading, says Matt Andresen, co-head of Citadel Derivatives Group, one of the biggest dealers of the popular PowerShares QQQ on Nasdaq. But trading ETFs electronically has been both a blessing and a curse for Nasdaq. Because electronic trading has shrunk ETF market makers' profits considerably, fewer of them have seen enough of an economic incentive to remain in the industry, let alone join sponsors and develop new product to list in this new market.

Nasdaq sees price incentives for designated liquidity providers as a way to capture more ETF listings market share and catch up to the Amex and NYSE (see chart). Nasdaq will not say how many new or existing ETF issuers have signed on to list on the new market. However, Nasdaq's Bloom says it is aiming to have more than 100 ETFs listed on its market within a short period of time after the launch.

Market makers and ETF sponsors agree that Nasdaq is smart to identify the need for a preferred market maker in its electronic model, as well as to pay that person to provide liquidity. But any incentive to launch an ETF on an electronic market such as Nasdaq's needs to be substantial to generate any serious commitment from a market maker, McCabe counters, and Nasdaq's doesn't appear to be. Still, he adds, "It's a step in the right direction."