What Regulation NMS didn’t kill, Nasdaq just might. The Securities and Exchange Commission’s new trade-through rule has largely neutered the specialists at the New York and American stock exchanges. However, it left their role in managing stock openings untouched. While most trading at these exchanges is now done automatically, openings are still handled by specialists the old-fashioned way.
Nasdaq hopes to change that. Taking advantage of complaints leveled against the New York and Amex over the slowness of their opening processes, Nasdaq has begun soliciting NYSE and Amex order flow from broker-dealers for its opening cross.
“At both NYSE and Amex, orders at 9:30 a.m. are still sitting there at the so-called primary market,” says Chris Concannon, executive vice president for transaction services at Nasdaq. “That’s frustrating for the retail investor. We have order flow that wants to open at 9:30 on the nose.”
Nasdaq last month expanded its automated opening and closing auctions to 5,000 NYSE and Amex names. Nasdaq began testing the waters in July when it added seven active Amex-listed exchange-traded funds to its crosses.
Specialists open their stocks by gathering buy and sell interest from floor brokers, institutions and orders in their book to “discover” the best price that will meet the supply and demand. They may commit capital and negotiate with brokers to facilitate this process. When a stock is going to open away from the previous night’s close, or has amassed a large imbalance in orders, they publish repeated indications of the likely opening price to solicit contra-side flow. That helps them try to dampen volatility at the open.
Nasdaq’s opening and closing auctions, which launched for the market’s own securities in 2004, are single-price electronic auctions that also discover price, but without the involvement of specialists. The auction process uses electronic indications to attract contra-side flow when necessary.
Competition has now reached across from the trading day, during which multiple markets compete for orders, to the opening and closelong the bastion of the primary listing venue. “Expanding Nasdaq’s automated opening and closing crosses is a logical extension for Nasdaq,” says Michael Rosen, senior vice president for product development at institutional broker UNX Inc. “Nasdaq is responding to a market need by offering an alternative.”
Nasdaq’s foray into exchanges’ sacred habitat wasn’t taken lightly by the NYSE. On Oct. 31, the NYSE preemptively eliminated its fee for all trades at the opening. Orders that participate in specialists’ opening auctions now execute at no charge.
The NYSE and Amex both concede that market participants want stocks to open earlier and want more transparency around the pricing process at the open and close. But both markets stress the importance of hands-on, human-negotiated price discovery at these critical times, which Nasdaq’s automated auctions cannot provide. They question the ability of Nasdaq’s crosses to produce good, or efficient, prices since the bulk of liquidity is in their markets.
“Clearly the market is moving toward wanting an opening that’s faster,” says Larry Leibowitz, chief operating officer for U.S. markets at NYSE Euronext. The NYSE, he says, will reduce delays by giving specialists tools to open stocks faster and to disseminate pre-open indicative prices to brokers more efficiently. Since October, specialists have also been able to open stocks automatically on quotes when there is no opening trade.
Nasdaq’s ambitions are big. “Our intention is to take the volume away from Amex,” Concannon says. Nasdaq set its sights on the NYSE’s and Amex’s openings because delays at 9:30 a.m. occur after a night or weekend when the markets are closed and therefore lack reliable price discoveryand because many retail customers trade in the opening. More trading also occurs at the open than at the close. Snatching volume at that time could thus add precious percentage points to Nasdaq’s market share. On most days, a little less than 5 percent of daily volume appears to trade at the open.
In comparison to the open, the close is dominated by institutions. Some institutions, such as index players, insist on trading at the primary market, particularly if they’re following indexes and want to eliminate tracking error. That makes closing volume more difficult for Nasdaq to siphon away from other markets.
Steve Swanson, chief executive of Automated Trading Desk, an electronic market-making firm owned by Citi, predicts Amex will lose the opening and close to Nasdaq in the coming months. At a Security Traders Association conference in October in Boca Raton, he said “problems” with Amex’s auction process “have begun to wear” on customers.
Oscar Onyema, chief administrative officer at Amex, doesn’t think his exchange’s grip on the open and close will loosen. “We have to open as promptly as possible,” he says. “But our opens are robust in terms of size and the market quality of the prices.” He adds that Amex is the “leader” in Amex-listed stocks at the open and close, although during the day that market share falls off.
Onyema stresses that Amex’s specialist system provides additional benefits to customers. “We guarantee the opening,” he says. When imbalances occur, specialists typically take the other side as part of their affirmative obligations. “If there’s an imbalance of 3,000 shares on Nasdaq, that 3,000 shares is out of luck in Nasdaq’s opening cross,” Onyema says.
NYSE’s Leibowitz agrees. “If there’s a specialist, they will make the market and a trade can happen,” he says. At Nasdaq, if the other side isn’t there, that trade can’t occur.
Amex is considering additional modifications to its opening process such as allowing automated openings for illiquid stocks, along the lines of what the New York now does. “When there’s no on-open order, we may allow the specialist to do a shotgun open,” Onyema says. Amex also intends to reduce the waiting time once imbalances are published before stocks can be opened.
Still, many market participants believe Nasdaq could grab some of Amex’s business. Amex is “particularly vulnerable” because its market share in its own listed securities has declined dramatically in recent years, says Joe Gawronski, president and chief operating officer at institutional broker Rosenblatt Securities. However, he adds, while firms servicing retail customers may like the certainty of Nasdaq’s prompt openings, they wouldn’t want to execute “away from where most of the trading and price discovery occurs.”
Knight, a large market-making firm, launched a pilot in November to test Nasdaq’s opening cross. The pilot ETFs, all listed on the Amex, are DIA, SPY, MDY, OIH, SMH and XLE. Orders in those six names are sent to Nasdaq’s opening cross instead of to Amex.
The concern with Amex’s openings is speed and efficiency, says Frank Grampone, managing director of operations and client services at Knight. On the Nasdaq side, the concern is capacity and system performance, as well as the quality of its pricing. “If there’s not enough critical mass [at Nasdaq’s opening], there could be potential pricing gaps,” Grampone says.
So far, Grampone hasn’t seen gaps in pricing in the pilot ETFs relative to the primary market’s opening print. “In our experience, Nasdaq is faster than the specialist opening on Amex,” he says. The time saved ranges from seconds to a minute or two. However, Grampone points out that there’s less volume on Nasdaq than there is on Amex.
Leonard Amoruso, Knight’s general counsel and regulatory affairs officer, says his firm is “agnostic” about whether a manual or electronic opening is better. “We have no stake in the race and will monitor the openings carefully,” he says.
Chris Nagy, managing director in charge of order routing, sales and strategy at TD Ameritrade, one of the largest retail brokers in the U.S., isn’t agnostic when it comes to openings. “Nasdaq is fast, fair and transparent, and has the consistency of a 9:30:00 opening,” he says. “That’s unparalleled in the industry today.”
Ameritrade began using Nasdaq’s opening and closing auctions for all stocks on the Nov. 5 launch date. “Why should we have clients wait until 9:40 in the morning when valuable information has been disseminated and trading time is ticking away?” Nagy asks. He says he’s comfortable with the prices he’s been seeing on Nasdaq, although, like Knight, he says Nasdaq’s volume is currently thinner than it is on the primary market.
Nasdaq knows its pricing at the open must be deemed reliable for customers to use its cross. Nasdaq initially launched the product with popular ETFs because their liquidity gave Nasdaq’s electronic auction a good chance of attracting enough flow to produce efficient opening prices. Since expanding its opening to all listed securities, Nasdaq has broken, or cancelled, many trades at the open that reflect dislocations in the price of the security. Knight’s Amoruso says they are the result of Nasdaq’s cross in those names not having sufficient liquidity.
Concannon says Nasdaq broke 20 opening trades on Nov. 5 and a “smaller number” on Nov. 6, and has had fewer “clearly erroneous trades” since then. He also points out that Nasdaq’s initial opening cross, for Nasdaq-listed securities, had many broken trades after it launched in 2004. As liquidity builds, he says, the pricing improves.
In the current competitive market structure, Nasdaq’s assault on the traditional specialist-run auction process has struck a nerve. “New York seems to be viewing it as a serious threat,” says Rosenblatt’s Gawronski. “New York’s value in the opens, closes and IPOs is particularly high, but the emphasis on automatic executions means it has less of the information flow and color needed to maintain that edge.”
Gawronski points out that running the opening is also part of NYSE’s brand. “The open is very important to listed companies” that want to understand how their stocks trade, he says. “Nasdaq’s cross, if successful, could threaten the core franchise.”
The NYSE’s reaction has been swift. “They’ve broken a lot of trades,” Leibowitz says of Nasdaq’s opening cross. “They’ve traded a lot of stocks outside our range for the entire day. They’ve had a lot of price dislocation, and they haven’t gotten a lot of volume. They can’t claim it’s a success.”
Leibowitz says New York’s opening prices stay closer to where the stocks trade shortly after the open. He notes that there’s no objective measuring stick for what’s a fair price, “but if a stock opens at a price and rapidly trades at another price and stays there, it’s fair to infer that the price that opened wasn’t good.”
For its part, Nasdaq has little to lose by taking aim at NYSE and Amex. “Nasdaq sees the opening as a contestable market,” says James Angel, a finance professor at Georgetown University who focuses on securities market structure. “Nasdaq has the technology and connections to broker-dealers. It costs them nothing to do this.” Angel was part of a group that helped develop Nasdaq’s automated crosses half a dozen years ago.
A former specialist takes a different view. “Speed does not price assets,” says Anthony Corso, a managing director at Rosenblatt Securities. “In a bull market with low volatility, you may get away without high-touch service, but not in a volatile market like August.” Corso, who previously ran LaBranche’s NYSE floor operation, stresses that openings and closes can be risky times to trade and that specialists still have a level of accountability that gives their auctions more relevance than a computerized system.
A pure auction, Angel concedes, could have “air pockets in demand” and a lot of volatility associated with the prices it produces. But he thinks Nasdaq’s auction is battle-tested on Nasdaq-listed stocks and addresses imbalances at the open by attracting imbalance-only orders.
Still, Angel acknowledges the powerful role humans can play at difficult trading times. The problem, he says, is that specialists can no longer earn a profit doing what they’ve been doing. And if they can’t earn a profit, they can’t fulfill their obligations. In addition, Angel points out, fewer bodies on the floor of the NYSE means that specialists have fewer people to negotiate with face to face as they seek out the right price for a stock.
UNX’s Rosen doesn’t expect Nasdaq to capture the open from New York or Amex in the near futureif at all. But he says Nasdaq has begun changing the game by questioning what the opening print means when an exchange’s market share dips below 50 percent in its own listed securities, or when its competitors trade more than it does. In his view, an opening print remains a “static concept,” but could ultimately be defined by the client. And if that happens, and the volume in particular securities on the primary market “isn’t the determinant of price, at some point that exchange could be vulnerable to a reasonable alternative in those names,” Rosen says.