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July 1, 2012

Nasdaq and NYSE Seek Retail Flow

By Peter Chapman

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Will action speak louder than words? Both Nasdaq OMX and NYSE Euronext have complained bitterly to the Securities and Exchange Commission about the dearth of retail orders on the public markets in recent years. Now with Nasdaq OMX's decision to establish a "Retail Investor Auction," both of the major exchange operators are actively pursuing retail flow. Their plans pit them squarely against the big wholesalers, which dominate the retail business, but at the same time include soliciting orders from them.

Both companies need SEC approval to move forward. At presstime, Nasdaq had yet to file its proposal with the SEC. The New York Stock Exchange and sister exchange NYSE MKT, both units of NYSE Euronext, filed for approval back in October, but have run into opposition from the regulator. The SEC has until July 6 to reach a decision.

Nasdaq announced its auction proposal in May during its annual Investor Day. Eric Noll, an executive vice president responsible for transaction services, told analysts the idea was to offer price improvement on retail orders by pitting market makers against each other in special auctions. The NYSE proposal is similar, but perhaps more convoluted.

"The New York Stock Exchange has made somewhat of a big deal about their 'Retail Liquidity Program,'" Noll said. "We think there are some problems with the structure, what they're trying to do and, ultimately, some problems with the way that process will work. So we have created what we believe is a much more innovative and effective competitive tool."

Both exchanges are looking to compete with the big wholesalers and other internalizers operating dark pools as well as solicit flow from them. The moves represent a significant step-up in a two-year campaign attacking the brokers' stranglehold on retail orders. Both NYSE and Nasdaq have complained bitterly to the SEC and in public forums that broker internalization is harming the public market's price discovery process. (It has also harmed their market shares.) Now the war of words is being accompanied by action.

"This is designed to take flow back from dark trading," Noll said. "It's going to pull business out of the dark side of the marketplace and back onto the lit venues." Part of the plan involves soliciting orders from the wholesalers by guaranteeing them a level of price improvement that they can then pass on to their customers.

Guaranteeing price improvement typically requires committing capital. Noll indicated that wholesalers may be reluctant to commit capital these days.

On the other side of the equation, the proposed model also benefits Nasdaq's registered market makers. In the past few years, many have complained that the quality of flow with which they interact has deteriorated.

The dealers say they want to trade against retail flow, but the high-quality material often does not make it to the public market. Rather, it gets caught in the web of dark pools and wholesalers, leaving the exchanges with the more "toxic" flow.

Under Nasdaq's auction plan, "market makers who wouldn't otherwise get a chance to interact with that retail order flow will compete to offer price improvement," Noll explained.