It worked once. Will it work again?
The National Stock Exchange, newly re-energized by Regulation NMS, is looking to its recent past for its strategy going forward. As it did five years ago, the National (then known as the Cincinnati Stock Exchange) is embracing ECNs and the market data revenues they generate as a way to profit in an overcrowded exchange space.
While most of the country’s 10 stock exchanges view ECNs as threats, the National figures servicing them is a golden opportunity. The exchange has already made great strides in executing its plan, and has earned the envy of some of its competitors. But its success is not assured. Customers and prospects are playing hard to get, while the competition is catching up.
“We want to be the aggregator of the ECNs,” says Joseph Rizzello, chief executive of the National Stock Exchange Inc. and chairman of NSX Holdings. “We have decided to be the place where they can both quote and print.”
Rizzello, a 37-year industry veteran, replaced David Colker as chief executive of the National last October. Formerly an adviser to the exchange, as well as a top executive at the Philadelphia Stock Exchange, Pershing Trading and Vanguard, Rizzello runs the 50-person National operation out of Jersey City. The headquarters and half the staff remain in Chicago.
Fast Market
Catering to ECNs was not the exchange’s original game plan for a Reg NMS world. After the Securities and Exchange Commission recast the marketplace as an electronic bazaar with Reg NMS, the National sought only to become a fast electronic market.
It jettisoned its traditional specialist model and adopted strict price/time priority supported by a new matching engine called Blade.
The problem is that there are now 10 stock exchanges all pursuing the same strategy. All are scrambling to find ways to differentiate themselves in what has become a commodity business. Most observers don’t believe the market can support 10 exchanges; they expect consolidation.
The chance for the National to set itself apart came last April, when Nasdaq announced changes to the way it worked with ECNs.
Nasdaq informed the ECNs publishing their quotes on its system that when it consolidated trading on its new “Singlebook,” it would require them to accept automatic executions. It would end order delivery. Also, in the interim, Nasdaq would charge them for every order it delivered.
Nasdaq’s moves were unfair, the ECNs charged, and would put them out of business. Nasdaq had traditionally “delivered” orders to the ECNs, giving them a millisecond or so to decide whether or not they wanted to execute.
That gave ECNs protection against the primary risk of an automatic execution: the double fill-one fill on Nasdaq and one on their own books from customers that accessed them directly. Nasdaq also traditionally charged the senders, not the recipients, of those orders for delivery.
New Opportunity
The ECNs complained loudly to the SEC, but to no avail. Nasdaq went ahead with its plans, and most ECNs moved their quoting business elsewhere.
“Once Nasdaq eliminated order delivery,” Rizzello says, “the competitors of Nasdaq and the New York Stock Exchange needed a place to do their business. We saw that as an opportunity.”
The exchange huddled with the five ECNs, promising them order delivery on its new trading platform and a place to print, or report, their trades. The proposal was not unlike the arrangement the National had had with the Island and Brut ECNs in the first half of the decade.
From 2002 until 2006, when Nasdaq bought Island, the ECN printed the trades it matched on its book on the National. The two split 50/50 the market data revenues those trades generated. In 2002, the National incorporated order delivery into its NSTS platform and Island quoted there as well.
Brut also printed to the National for several months in 2004 before being acquired by Nasdaq.
Trade Reporting Facilities
The practice of reporting off-board trades is a little different now. Under new SEC rules, broker-dealers must report these internalized trades to a so-called trade reporting facility, an entity owned jointly by an exchange and the NASD. Previously they could report directly to the exchange (see box for more on TRFs).
These facilities are fast becoming standard issue at the country’s stock exchanges. The National won approval for its TRF last fall and is currently sharing half of the market data revenues it receives with its reporting broker-dealer partners.
So far, two of the five ECNs have moved their operations to the National: BATS and Track. BATS went first, coming over directly from Nasdaq last spring. It now quotes on the National under the “CINN” identifier and prints to the TRFs of both the National and Nasdaq.
Track joined the National in November, having spent much of the year quoting on the NASD’s Alternative Display Facility. It now both quotes and prints to the National.
The three other ECNs-Bloomberg Tradebook, Direct Edge and LavaFlow-are all seriously considering quoting and possibly printing at the National. Their parent corporations-Bloomberg, Knight Capital Group and Citi, respectively-even invested in the National.
Last September, they formed a consortium with Credit Suisse, Bear Stearns and Merrill Lynch to take a 50 percent stake in the exchange. Some sources peg the total investment at about $30 million.
For the National, partnering with the ECNs gives it two benefits-in theory, anyway. First, the ECNs’ quotes will help it build liquidity on its new Blade trading platform. Second, the ECNs’ trade reports generate market data revenues. (Their quotes will too, under new SEC rules slated to go into effect next month.)
Building liquidity with ECN quotes may not mean much in the final analysis. That’s because most trades are likely to be done on the ECNs, not Blade. That has to do with the relationship between the National’s pricing structure and that of its ECN tenants.
Pricing Model
The National, like most “new” exchanges, has adopted the transactions pricing model developed by the ECNs. It charges traders for removing liquidity from its books. It pays rebates to those who add liquidity.
Unlike most ECNs or exchanges, however, the National has decided not to make a spread between what it charges and what it pays out. It both charges 30 cents per 100 shares and pays rebates of 30 cents per 100 shares.
The take charge is comparable with that of other exchanges and ECNs, but the rebate is considerably higher. The resulting lack of a spread is practically unheard of.
In any event, it is the relationship between the National’s take charge and that of its largest tenant, BATS, that defines the exchange at the moment. At 30 cents, the National’s take charge is 4 cents higher than BATS’s. That drives order flow to BATS and away from the National.
Quotes that display on both BATS and Blade can be accessed by routing either to the ECN directly or to Blade. So since BATS’s take charge is lower than the National’s, a trader would be inclined to route directly to the ECN.
That suits BATS. It makes a spread and can report the trade to the TRF, where it shares in the market data revenues.
For its part, the National says it maintains a 30-cent take charge to offset a relatively high 30-cent rebate, otherwise it would lose money. The focus is on generating liquidity, National execs say.
For now, the National is alone among the exchanges in offering order delivery. Since most stock exchanges today are little more than ECNs themselves, they are not inclined to make life easier for the real things.
That could change. At least one exchange, the Philadelphia, is seeking approval from the SEC to offer order delivery. It also plans to operate a TRF.
“We are actively engaged with the NASD in establishing a TRF and order delivery,” says Bob Miller, a senior adviser to the Philly. “We believe order delivery will be part of that.”
Additional players may also take the plunge. “Other exchanges are clearly looking at what the National has done,” BATS chief executive Dave Cummings says. “In the future, we may quote or print in other SROs.”
Competition for BATS’s trade reports rather than its quotes is the more likely scenario. All of the exchanges are expected to promote their print facilities to ECNs.
More Flirting
The Boston Stock Exchange is one. “We will market our TRF to ECNs, internalizers, market makers, alternative trading systems, everyone,” says Tom Richardson, president of the BSE’s stock market, the Boston Equities Exchange.
BeX has no immediate plans to offer order delivery, though, according to Richardson.
The Boston has flirted with ECNs at least once before, when it tried to win Brut’s printing business in 2003. A regulatory snafu scuttled that deal, and Brut went to the National.
ECNs that agree to quote on the National are under no obligation to print any or all of their trades to the exchange’s TRF. BATS’s Cummings says he reports his trades to the TRFs of both Nasdaq and the National to “encourage competition.”
That competition doesn’t make the National’s job any easier. And with no maker/taker spread in the mix, the exchange is looking to make all of its money from market data revenues. All told, though, that may not amount to much.
Annual TRF monies are expected to add up to only about $25 million. And most of that will be derived from the internalized trades of market makers, not ECNs. In total, TRF funds represent only about 5 percent of the market data revenue pool of about $450 million per year.
Transactions Flow
Despite the small take from TRFs, most exchanges want to be able to offer them to their broker-dealer customers as part of a full-service package. For most exchanges, the TRF is just one part of their core transactions services offerings. For the NSX, though, it is the core offering.
To make it work, sources say, the National will have to run a lot of trades through its TRF. That may be difficult. One source says that just to break even on the TRF, an exchange has to pump 225 million to 250 million shares of executions through it every day.
At presstime, BATS was matching about 200 million shares per day on its system. Some of those trades were reported to the National’s TRF; some to Nasdaq’s. Track, which also prints to the National, is a much smaller player, typically processing about 20 million shares per day.
In any case, the National has two ECNs down and three to go. BATS, which has seen its volume explode in recent months, was a coup for the National, but the exchange still needs to bring Direct Edge, LavaFlow and Bloomberg on board.
That’s especially true since BATS may not hang around for too long. Cummings told Traders Magazine that the ECN had begun the process of putting together an application to become a stock exchange (see story in Industry Watch).
Direct Edge is the second-largest ECN after BATS, matching at least 50 million shares per day, but so far it has not shifted its allegiance to the National. The ECN currently quotes and prints on the ADF.
Rizzello is confident the big ECN will up and move, though. “Our economic model is superior to that of the ADF,” Rizzello says. “That is why we think Direct Edge will come our way.”
Indeed, sources say, the ADF has at least two financial drawbacks: It doesn’t share market data revenues, and it charges broker-dealers to update quotes.
Listed Trades
Still, Direct Edge is taking its time about moving over to the National. The wait-and-see approach can be attributed to concerns over capacity constraints at the NASD/ National TRF, sources believe.
Rizzello says there are no capacity problems with the TRF vis-a-vis Nasdaq-listed securities. In late January, he acknowledged that the National was still testing with the NASD for processing listed trades.
For listed names, the NASD/National TRF was rated at 90 messages per second, Rizzello says. That’s the equivalent of a 2-billion-shares day. That may not be good enough. Volume at the open and close has been known to exceed 90 messages per second.
To ensure it can keep up with those volume spikes, the exchange was testing at a rate of 300 messages per second, according to Rizzello.
TRF Primer
A trade reporting facility is a joint venture between a stock exchange and the
NASD established for the purpose of reporting broker-dealers’ internalized trades. The entity makes it possible for the exchange to profit from sales of reports of trades that did not take place within its facilities.
The first TRF was set up by Nasdaq and the NASD and approved by the Securities and Exchange Commission last June. The idea of a TRF was developed by Nasdaq in its pursuit of exchange status. It wanted to continue to profit from the market data revenues generated by market makers’ internalized trades.
The SEC, however, believed that an exchange print should reflect the principles of price and time priority inherent in exchange trading. Off-board trades typically follow the rule of price priority, but may not obey any rule of time priority.
The SEC, Nasdaq and the NASD settled on the idea of an NASD-sponsored TRF. Nasdaq receives the bulk of any revenues generated. TRF prints are considered NASD, and not exchange, prints.
Four TRFs have been established so far between the NASD and, separately, the Nasdaq, National, New York and Boston stock exchanges. Others are planned.
A trade reporting facility is a joint venture between a stock exchange and the
NASD established for the purpose of reporting broker-dealers’ internalized trades. The entity makes it possible for the exchange to profit from sales of reports of trades that did not take place within its facilities.
The first TRF was set up by Nasdaq and the NASD and approved by the Securities and Exchange Commission last June. The idea of a TRF was developed by Nasdaq in its pursuit of exchange status. It wanted to continue to profit from the market data revenues generated by market makers’ internalized trades.
The SEC, however, believed that an exchange print should reflect the principles of price and time priority inherent in exchange trading. Off-board trades typically follow the rule of price priority, but may not obey any rule of time priority.
The SEC, Nasdaq and the NASD settled on the idea of an NASD-sponsored TRF. Nasdaq receives the bulk of any revenues generated. TRF prints are considered NASD, and not exchange, prints.
Four TRFs have been established so far between the NASD and, separately, the Nasdaq, National, New York and Boston stock exchanges. Others are planned.
New Guy at the National
Joseph Rizzello has come out of the shadows. The National Stock Exchange’s chief executive officer has only been on the job for six months, but his influence on the exchange has been felt since the early part of the decade.
From 2000 to 2003, Rizzello ran the Pershing Trading Company, a Nasdaq market maker and regional exchange specialist. One of those exchanges was the Cincinnati Stock Exchange, now known as the National.
Rizzello represented Pershing on the board of the National and remained on the board after he left Pershing. His involvement with the National grew, as did his influence over its strategy. He eventually left the board, but stuck around as an adviser to the exchange.
The 37-year veteran of the securities industry acted as chief lobbyist in Washington for the National when the industry was debating the Securities and Exchange Commission’s Regulation NMS proposal.
Rizzello also led the negotiations with the Chicago Board Options Exchange-at one time the majority owner of the National-that resulted in a gradual phase-out of the CBOE’s stake. The exchange demutualized last year and is now owned by about 50 firms, mostly former members. A group of six large broker-dealers own about half the exchange. Bernard L. Madoff Investment Securities, a former specialist at the National, owns about 10 percent.
Rizzello was named chairman of the National’s board last September and chief executive a month later. As CEO, he replaced longtime leader David Colker.
The National is not Rizzello’s first exchange; the exec spent 12 years with the Philadelphia Stock Exchange on the marketing side. There, he was credited with developing several groundbreaking products, including foreign currency options.
