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January 21, 2010

Cover Story: Weathering the Storm

Diversification Helps Nasdaq Endure Troubles in Cash Equities

By Peter Chapman

The year just passed was not a good one for Nasdaq OMX's flagship stock exchange. It came under attack by a tenacious competitor and saw its share of trading plummet and its margins collapse. That, in turn, set the exchange operator back two years on the revenue front. Adding insult to injury, the damage occurred during a strong year for trading volumes overall. Through November, industrywide volumes reached 2.3 trillion shares, up 12 percent from the 2 trillion shares traded in the same period in 2008.

Behind Nasdaq's bad news was DirectEdge ECN. The market center, which revitalized itself via a change in ownership in 2008, grabbed flow from all the major exchange operators last year, including Nasdaq. It initiated a bruising price war in December 2008 that continues today.

Nasdaq reacted clumsily. It changed its pricing from one that emphasized liquidity providers to one that favored liquidity takers and then back again. Then it flip-flopped a second time. The moves did little but irritate brokers. In 2009, Nasdaq Classic's market share across all three tapes stood at about 20 percent in mid-December, down from 28 percent in January. That's a considerable fall from grace for the large exchange operator. Nasdaq had managed to hold onto a nearly 30 percent share after Regulation NMS fragmented trading across several marketplaces in 2007.


See Cover Story Sidebars and Chart:

Nasdaq Experiments with Price/Size

Power Hungry

Betting on Swaps

Nasdaq's 2008 Shopping Spree


Nasdaq's fight to hang onto its share of the pie this year forced it to take its pricing model into the red. Until July, the exchange operator was able to maintain a positive "capture," or spread between what it received from its biggest takers and paid to its biggest providers, of 1 cent per 100 shares. But starting in June, Nasdaq increased its rebate across the three tapes significantly, agreeing to pay liquidity providers a generous 29.5 cents per 100 shares.

Bob Greifeld, Nasdaq

Then, in July, Nasdaq reduced its take charge in Tape A (NYSE-listed) and Tape C (Nasdaq) securities to 27 cents, or below its rebate. The result was a negative spread of 2.5 cents per 100 shares in those two markets. (It maintained a positive half-penny spread in Tape B--mainly exchange-traded fund--shares.)

The market share war with DirectEdge has been costly. On an annualized basis, Nasdaq was set to take in about $160 million from its domestic stock trading business last year. That would be about $90 million less than it grossed in 2008. It's just a little bit more than the exchange operator took in for 2006.