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January 3, 2011

Consider Depth-of-Book: Nasdaq

By Peter Chapman

Circuit breakers are in. Price collars are coming. Is "depth-of-book" next? Eric Noll, a Nasdaq OMX executive vice president in charge of transaction services, believes depth-of-book price protection should be considered to make the market more stable. The exec is not pushing hard on the controversial notion, he told Traders Magazine, but contends depth-of-book is a potential solution to whipsawing markets.

Under Regulation NMS, the market's best, or top-of-book, quotations are protected. That means any trade done in the public markets cannot ignore them. They must take part in the trade.

All other prices, however, can be ignored. The idea of protecting these lower-rung, or depth-of-book, prices was mooted during the discussions surrounding Regulation NMS, but ultimately rejected. Those opposed said a depth-of-book rule would effectively create a government-mandated central limit order book, unnecessarily constrict competition between exchanges and be costly to implement.

Given the turmoil of May 6, however, Noll believes the idea of depth-of-book protection should be revisited. "We need to think of ways to change the web of the national market system in a way that will provide more stable liquidity, so events like a future sell-off don't cause a crack in the system so that it falls apart," Noll said at the ICI conference.

Part of the reason the market toppled on May 6 was because traders exhausted liquidity on exchanges that had little to exhaust. Because they were not required to route their orders to exchanges with more liquidity at more price points, they pushed prices down needlessly, Noll explained.

The Nasdaq official noted that on May 6, when trading on the New York Stock Exchange triggered its circuit breakers, traders went elsewhere. "The books elsewhere were thinner," Noll said, "and people ate right through them."


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