Specialists are out. Market makers are in. The Chicago Stock Exchange, as part of its plan to reinvent itself as an ECN-like utility, is casting aside its decades-old specialist model. Instead it will operate more like Nasdaq with market makers competing against each others in the same stocks. The core of the revitalized exchange-which soon is expected to announce investments from large broker dealers, possibly including Goldman Sachs-is a matching engine.
NASD market makers will be invited to post quotes and orders onto the system, but others, notably black box traders, are also being aggressively courted.
The CHX hopes to encourage the sharp-shooters by a combination of fast fills and its traditional pool of retail and institutional liquidity
Currently trading on the CHX floor are three specialists-E*Trade, LaSalle Securities and JMM Specialists-and about 20 or 30 floor brokers.
The CHX expects to launch Phase 1 of its new model this month. And despite the move to high-tech, it still plans to maintain its trading floor. It will charge for space and utilities, but is legally separating the floor from the exchange.
Traders Magazine executive editor Peter Chapman spoke with Dave Herron, the Chicago's chief executive officer, about the changes.
TM: How will the new CHX be different from an ECN?
Herron: We are trying to capitalize on our native liquidity. That is our large network of connectivity to retail and institutional broker-dealers. We are ECN-like in structure but have native volume. We are not like a brand new ECN coming out of the gate that is reaching out to the algo players in a bid to replace INET or BRUT. We at least have native volume.
TM: The original plan was to incorporate specialist-like "lead market makers" regulated by the CHX. Now you intend to be more of a utility for NASD market makers. What made you change?
Herron: We have changed in the past six months because of the approval of Nasdaq as an exchange and the blessing of the SEC of the NASD/Nasdaq trade reporting facility (TRF). The TRF lets NASD market makers effectively ignore the time priority that exists on exchanges when they want to interact with orders directed to them.
TM: This puts exchange specialists at a disadvantage?
Herron: That is a huge stumbling block for firms that want to play the role of traditional specialist. That's even if they could be a specialist on an exchange in multiple stocks. The SEC has made it quite clear that an exchange specialist would always have to yield to the time priority in an exchange book. So we will work with the NASD to create our own TRF, as a CHX subsidiary. I assume the other exchanges will do the same. We would create the same environment for our own specialists. They have said that because their competitors, the NASD market makers, will be able to ignore time priority by printing in TRFs, they need to as well. So, with the SEC's blessing of the NASD/Nasdaq TRF, it forces us to go down that path.
TM: And so they cannot be CHX market makers?
Herron: In order to access that TRF and, in effect, ignore the time priority of traditional exchanges, all of our specialists will have to become NASD market makers. Not Nasdaq market makers. NASD market makers will be regulated by the NASD. That is the only trade association, and only trade associations are allowed to operate without the time priority of an exchange book.
TM: So you are nudging your specialists into the arms of the NASD?
Herron: Our specialists will become NASD market makers with the ability to trade every stock. We intend to keep their access to all of their customers connected by our wide area network. That WAN will become a link between the order sending firms, ourselves, the NASD market makers and our own exchange book.
TM: The Chicago will look more like Nasdaq.
Herron: The back-end of the exchange starts to look more like Nasdaq and our specialists more like NASD market makers. But they are still able to leverage the relationships and connectivity and some of the technology of the exchange.
TM: The WAN will be separate from the exchange?
Herron: It will be within the holding company. We have been working with the SEC on that. It may not have to be completely separate. It will deliver orders not only to the CHX, but also to our current specialists who will become NASD market makers.
TM: As it stands today, CHX specialists solicit orders from retail brokers? And those retail brokers send the orders to the CHX?
Herron: Yes.
TM: The orders are not being routed to the specialist.
Herron: Exactly. But, in the current environment, the specialist has full responsibility for the order when it gets here. It is his book.
TM: Under your new rules, the market makers will still solicit the orders from the retail houses?
Herron: Yes.
TM: So now the orders can be sent either to the market makers or the exchange?
Herron: Yes. If a firm wanted to send its limit orders directly into our matching engine, they could do that. But, for market orders, they might find it preferable to send them to a market maker that can work the orders as agent.
TM: Okay.
Herron: An order sent to an ECN can only access the displayed bid or offer. So if they have 1,000 to buy and only 200 is offered, that is when the market maker becomes so valuable. Because you don't just walk the book. There is somebody there who is willing to say, "I will fill every order up to 1,000 shares" or "I will guarantee you the next print on the tape."
TM: We do see that sophisticated shops such as Ameritrade and a few others are sending limit orders to ECNs, but most order senders are still directing their orders to market makers and regionals. Is it likely that most orders will still be sent to market makers?
Herron: I would think so. We certainly have to provide access to our matching engine and that is where bids and offers will reside. We hope to incent the people who will be affiliated with us, the NASD market makers, to display. They still have order display requirements. We would incent them to display limit orders in our marketplace.
TM: Will you increase your marketing efforts?
Herron: We actually had a large marketing staff at one point five years ago. But the specialists decided to hire their own marketing staffs, so we downsized. We may need to expand if we want to expand our wide area network.
TM: How can you compete against Nasdaq for the market makers' quotes and orders?
Herron: Our pricing will be competitive. But we also hope our combination of liquidity and accessibility of the large network will give us a leg up. Reg NMS plays into that with the automation of outbound orders from the New York. The display of an order in our marketplace and the possibility of interacting with a large network will be enough to put us over the top. So to the extent that we can be cost competitive and offer our routing network to an ATD or a Knight or others, we might be able to reach out to them.
TM: To be a market maker, a firm must either quote or trade a certain minimum. Why set floors?
Herron: In order to get the benefits of being a market maker-short sale relief and Reg T exemption for margins-there have to be some obligations. They have to be doing something good for the public. That, in effect, is laying quotes that in turn translates into volume for us. It's not just so we can make money on it. It's a quid pro quo. You get a benefit; you have an obligation.
TM: If they are NASD market makers, they aren't regulated by the Chicago.
Herron: That is another plus. The cost of regulation is very high. If they are going to become NASD market makers, and are handling customer orders…That will be something the NASD does.
TM: You will still do some regulation?
Herron: We will still regulate activity that occurs in our matching engine. And we will still regulate our floor brokerage community. They will be able to operate without being NASD members.
TM: Is the participation of market makers necessary for your success?
Herron: Keep in mind, Arca and INET built up tremendous volume without any market makers. To the extent that our ECN-like matching engine is the core of the exchange, we don't need specialists and market makers. We are able to operate in an electronic format as have those ECNs.
TM: I imagine it is good news for the CHX that shops such as Ameritrade are starting to send limit orders to ECNs. Is that so?
Herron: As firms like Ameritrade have evolved, I would think others would follow suit. A lot of intelligent order routing capability is being built into brokers' networks. So, I think you will probably see that happen more and more as firms take advantage of liquidity rebates with their limit orders.
TM: You will also have a second class of market maker. These firms will not be permitted to handle customer orders?
Herron: We will have a program for CHX participant market makers. They won't be market makers handling retail volume. They are principal traders who want to play the role of laying bids and offers in the system. They will get some of the advantages of margin treatment and short sale relief in return for some minor obligations.
TM: That would be smaller firms prop trading?
Herron: That would be prop trading.
TM: You've had a matching system for a couple of years now. It has been used for stock not handled by specialists?
Herron: We had an electronic book, but it couldn't handle high-capacity volume. It was primarily in place for our floor brokers to put up manual trades. So we added to the capacity and the automated functionality.
TM: Is it as robust as an ECN?
Herron: We intend it to be. It is easily scalable. We had older technology that was difficult to update and adapt, expensive to add to. We will be retiring the old mainframe legacy systems and migrate to more modern structure.
TM: How about the floor brokers? Is there much change for them? Your filing says they must "clear the matching system before sending an order to another market for execution." Is that new?
Herron: Not much. Right now an order has to clear the book to go up on the New York Stock Exchange. A floor broker cannot trade stock at $30 if there is a bid for $31 here. We are just making that clear in the new rules.
TM: So that rule exists today?
Herron: Yes. There will be more automated functionality to make it easier for them. There will also be an audit trail.
TM: How will that automation work? Say they are crossing stock.
Herron: To the extent there is a bid in the book and they want to do a "cross with satisfy," they might send in an order to sell 1,000 shares, which is the satisfy piece, and then cross the balance.
TM: And in an automated world?
Herron: They will be able to send in an order with the instructions, "cross 30,000 shares with satisfy." That means they will sell 30,000 and buy 29,000. We will automate what is now done manually. And really only 5 percent of that is still done manually. We are making sure there is an electronic audit trail and making sure they can't accidentally break a rule.
TM: Today, a floor broker will execute a lot of trades in other venues, specifically the New York. Will that change? Will more trades get done at the Chicago?
Herron: If one of our brokers is working an order to buy 300,000 shares and 80 percent of the volume is at the NYSE, he will have to represent that order at the NYSE. Without the protection of Reg NMS that is especially likely.
TM: And in the future?
Herron: With the protection of Reg NMS and with the advent of the intelligent order routing networks, smart routers, he will be able to display much more aggressively in our marketplace, instead of routing those orders to the NYSE. That is the real advantage of Reg NMS. Those orders that now go outbound through the ITS… We hope with new tools and Reg NMS they will be able to display their business here. Smart order routing technology is migrating to the listed environment. The combination of those two things.
TM: Listed volume is expected to grow under Reg NMS. Will you be able to capture more?
Herron: There is some speculation that with Reg NMS… It's not so much that the NYSE will lose their existing volume, but that the volume will grow and they won't get 80 percent share of the new volume. We hope to get a healthy percentage of that new volume with our trading partners and our liquidity.
TM: Thanks, Dave.
Herron: You are welcome.
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