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January 31, 2008

Nasdaq Defends Dark Options

By Nina Mehta

Nasdaq failed to win Securities and Exchange Commission approval for its new options market, but is still standing by a controversial aspect of its proposal. Nasdaq had expected to launch the Nasdaq Options Market in December, but the SEC did not rule on Nasdaq's proposal.

The International Securities Exchange and Citadel, the exchange's most vociferous critics, charged that Nasdaq's various non-displayed order types violate the SEC's Rule 602, or firm quote rule, and encourage internalization. Rule 602 requires exchanges to publicly disseminate their best bids and offers and the sizes associated with them.

Nasdaq's proposed exchange "would create a hidden market for trading options that would impede transparency and liquidity, discourage market participants from placing displayable limit orders or quotes, and facilitate gaming and non-competitive trading," Citadel told the SEC last June.

In a December comment letter to the SEC, Nasdaq threw its critics a bone by saying it would remove the pure non-displayed order type from its proposal, but said it would retain its price-improving, discretionary and reserve orders, all of which involve non-displayed trading interest.

Nasdaq's most impugned dark order type is what the exchange calls a price-improving order. This order type enables participants to submit penny-priced orders in options quoted in nickel and dime increments, which would remain on Nasdaq's book, available for execution, but would be disseminated to the market at the allowable increment.

"Price Improving Orders will result in better execution prices for market participants and could add liquidity to the marketplace that would not otherwise be entered or displayed in any venue," Nasdaq wrote in its December response to five comment letters published on the SEC's Web site earlier in 2007.

Elsewhere in the letter, Nasdaq added: "Nasdaq's proposal to create Price Improving Orders would offer the same benefit of narrower spreads and the opportunity for price improvement [as the Boston Options Exchange's PIP and the ISE's PIM auctions], without the potential downside of freezing' the entered order for a period of time, as is done in existing price improvement facilities." Nasdaq dismissed critics' concerns about internalization and gaming related to its non-displayed order types.

Letters to the SEC from Citadel, the ISE, the American Stock Exchange, and the Securities Industry and Financial Markets Association critiqued or questioned key elements of the proposed Nasdaq Options Market. A letter from market maker GETCO was broadly supportive of Nasdaq's proposed exchange.

Nasdaq's letter took a swipe at Citadel. Referring to the latter's criticism of Nasdaq's dark order types, Nasdaq said, "Citadel raises the same arguments that many firms have raised throughout the years to avoid market developments that jeopardize artificially wide spreads and large profits."


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