The New York Stock Exchange has one. The American Stock Exchange has one. Will a call auction work for Nasdaq's opening?
Buyside traders hope so. They don't like how trading starts at the 9:30 a.m. open with unequal bids and offers on some stocks. As they see it, a call – operated electronically – would eliminate that confusion. A call, in short, would provide a single price open on these stocks, letting traders execute big orders faster.
The Securities and Exchange Commission doesn't like the current Nasdaq opening either and is pushing the market for a single price open.
The clamor has made Nasdaq's unruly opening the latest battlefront in the war to reshape the dealer market into a order-driven auction. Regulators, academics, and the buyside, are leading the charge.
The SEC-decreed limit order handling rules and Nasdaq's various limit order book proposals have had the most impact. Nasdaq wholesalers which execute other dealers' trades, have the most to lose and are offering the most resistance to the change. They fear a call would disintermediate their role. Dealers that serve institutions appear resigned to change.
At the heart of an electronic call auction is a computer software program that matches buy and sell orders at a price determined by their interaction. It is a price-discovery mechanism. As such, it differs from the popular electronic crossing offered by Instinet and others. That system uses a reference price from the continuous market to match orders. An electronic call is little used in the U.S. A manual call opens trading every day at the New York and American stock exchanges. The specialist does the work normally done by the computer in the electronic systems.
AZX Deal
The buyside generally likes the service it gets on the NYSE in the morning and is demanding similar treatment on Nasdaq. Its efforts seem to be bearing fruit.
Since late May, a group of investment banks led by Goldman Sachs has provided support for a 9:29 a.m. electronic call auction run on the Arizona Stock Exchange for Nasdaq stocks. AZX, the parent company, was near death earlier this year when Goldman reportedly bought a 25 percent stake. Liquidity on the new auction, which is run independent of Nasdaq, is respectable. Buysiders, such as the mammoth TIAA/CREF, have waded in.
"We are going to show the world how Nasdaq could open with a multi-party auction," said Steve Wunsch, president of AZX. "The Nasdaq process needs to be fixed."
AZX has been around for 10 years, but has been used chiefly as an after-hours crossing network in Nasdaq stocks. Volume has averaged about 10,000 shares per day and its financial position is precarious. The deal with Goldman could prove fortuitous.
A second line of attack is also making progress. Nasdaq's Quality of Markets Committee, in which nine of its 20 members are on the buyside, is submitting a proposal to the Nasdaq board to incorporate an electronic call auction at the opening. Nasdaq is under pressure from the SEC to change its pre-opening and opening procedures. It must do something, but faces dealer resistance.
Robert Schwartz, a finance professor at Baruch College's Zicklin School of Business in New York and an advisor to Nasdaq's Quality of Markets Committee, likes what he sees.
"The call is moving toward center stage and I couldn't be happier," said the long-time proponent of call auctions. "I recognize that it's not simple to get these things started. But once it gets to critical mass I have every confidence that people will benefit from the quality of price discovery a call would offer." (Schwartz is an investor in AZX.)
It's the present "quality of price discovery" that irks the buyside. The decentralized nature of the dealer system means that several market makers post different prices for the same security at the opening. Since the average trade on Nasdaq is now down to 600 shares, the subsequent executions involve relatively few shares at a variety of different prices. That kind of liquidity is inadequate for an institutional trader trying to move a large block.
"There isn't one price you can look to and say yes, that's a good open,'" said Holly Stark, chief trader for Kern Capital Management in New York. "To actually open on 100 or 500 shares…is that a good opening for a stock that trades millions of shares?"
Big Board Size
On a recent day in early June, top Nasdaq stock Dell Computer traded nearly 20 million shares. Only a small fraction of that-1,700 shares-traded in eight separate transactions at 9:30 a.m., according to time and sales data from Bridge Information Systems. Over at the Big Board, IBM traded 123,500 shares at 9:30 a.m. That was 3 percent of the total 3.7 million shares traded that day.
"You can do size on New York at the open," said Stark, a member of the Quality of Markets Committee. "You can't on Nasdaq because there is no facility to assess buy and sell demand. That's a frustration."
It's a frustration because news that affects a stock's price is often released after the close. Buy-side traders would like the ability to participate in the next day's opening in size. Some see a call auction as the best way to do that.
"There's a lot of information that aggregates overnight and must be impounded and priced in an orderly way," explained Paul Davis, co-head of quantitative portfolio management and trading at TIAA/CREF, the world's largest pension fund. "The best way to do that is to bring traders together at a single point in time and have an auction."
Davis adds that an auction, where many people come together at one time, will find a much better price than will a disparate group of people searching for prices on their own. He concedes there is no practical way to prove that, but points to the volatility on Nasdaq. "That's pretty strong evidence that price discovery around the opening is not effective," he said.
Locked and Crossed
Critics also point to locked and crossed markets as evidence the opening procedure on Nasdaq is flawed. The opening best bid will sometimes equal or exceed the opening best offer, respectively locking or crossing the quote. In a normal quote, the bid, or the price at which a trader is willing to buy, is always lower than the offer, the price at which he is willing to sell.
"Investors want to see the market open in a consensus and stable fashion," AZX's Wunsch said. "They don't want to see prices swinging widely. In the first half hour on Nasdaq no one has a clue where the real supply and demand is."
Wunsch praises the New York open, but says his system is superior. "In the Internet age it is possible to involve a lot more people than just those insiders on the NYSE floor," he said. "The entire world can participate."
AZX is one of two electronic call auction mechanisms in use in the Nasdaq secondary market. OptiMark, a facility of Nasdaq, is the other. The systems differ in three important ways, according to Wunsch.
First, OptiMark runs every 15 minutes while AZX operates only three times per day. Most calls, such as those in Europe and Japan, run infrequently in order to compress as much trading activity into a single point in time. Second, OptiMark uses a multi-price algorithm which could produce two or three or even four different prices. AZX produces one consensus price. Finally, OptiMark is a blind' auction where participants can't see others' bids and offers. AZX displays orders, but does offer participants a hidden reserve facility.
What they both have in common, however, is a shortage of order flow. OptiMark has offered trading in listed and Nasdaq stocks since 1998, but is struggling. It recently indicated in a report to the SEC it would run out of cash this summer.
Call in Action
"We thought that by running a pilot we would see first hand whether an opening call can work or if we are just talking about things that don't really matter too much," Duncan Niederauer, a Goldman managing director, told the audience at a recent conference on electronic call auctions at Baruch. "This will give the Quality of Markets Committee an opportunity to see one in action."
Niederauer singled out the AZX's reserve facility for praise. "The key to a call auction is that people must be able to hide before confronting each other to fix the price," he said. "We have to figure out a way to get reserve orders working with the displayed limit orders."
The AZX auction appears to be meeting with some success. Eight stocks are traded including top draws Dell, Cisco, and Intel. One morning saw 30,000 shares of Dell exchange hands while another saw 60,800 shares of Cisco traded. Other broker dealers participating in the pilot are Salomon Smith Barney, J.P. Morgan Securities, and Lehman Brothers.
Bill Harts, a managing director at Salomon, says his firm's interest in the AZX experiment did not result from client prompting. "We've always offered the AZX to our customers," Harts said. "The difference here is our Nasdaq market makers are specifically looking at the AZX pre-open just to see what liquidity is there. If, in fact, liquidity is there, we need to determine how hard it is to access it."
Harts adds that SEC pressure for a single-price open on Nasdaq is also a factor. "It's pretty clear to us that there will be some order imposed on the opening pretty soon," he said. "We'd like to take the initiative to see if this alternative is something that could work for everybody."
Levitt Speaks Out
SEC Chairman Arthur Levitt publicly aired his views on the Nasdaq open at the Securities Industry Association's annual conference in Boca Raton last November. "Widely disparate prices sometimes prevail during [the opening]," he told the crowd. "This is unacceptable. A unified opening on Nasdaq is both possible and long overdue." In May, he sent a similar-sounding letter to NASD chief executive Frank Zarb, according to sources.
Salomon isn't placing all its eggs in one basket, however. It is working with the NASD to evaluate several different proposals for the opening on Nasdaq. "We're not sure that an automated facility alone is an adequate solution," Harts said. "This may call for some combination of new rules or procedures as well as a system like AZX, Primex or POSIT."
Long shot or not the electronic call is getting the attention of Nasdaq. Earlier this year, six electronic systems – AZX, OptiMark, POSIT, Primex, and Bond Connect and one from software developer Evan Schulman – were demoed for the Quality of Markets Committee.
"The SEC has urged us to look very closely at a single price open," said Richard Ketchum, president of the NASD. "And we're going to do so. But we haven't reached a conclusion yet."
Ketchum said any solution must accommodate both institutional investors and those broker dealers handling retail orders. "There are a lot of complications when you start swinging those orders out into a single-price open and back again," he said. "The [Quality of Markets] committee has also explored other alternatives that would make the opening more transparent and work differently than a call auction."
Indeed the committee is making two recommendations to the Nasdaq board on how to impose order on the opening. The first is an electronic call mechanism such as the AZX. The second has been dubbed a distributed call.'
Designed by Jim Angel, a Georgetown University professor and visiting fellow at Nasdaq, the procedure makes no changes to the opening price discovery process. Once the NBBO has been discovered,' however, the midpoint is designated the official opening price. If a trader does not want to execute an order at this price, he throws it up on a screen representing the distributed call facility. Other market participants can then fill it.
"I used to think that AZX was the way to go," Angel said. "But when I started to look at the data of real order flow I concluded it would only work for the 50 most liquid stocks. You need to have market makers for the rest."
Compromise System
Angel's proposal would essentially institutionalize what market makers like Knight Trading Group and Bernard L. Madoff Investment Securities have offered their customers every morning since June 1999. Knight guarantees to execute the first 250,000 orders in any given stock at the midpoint of the first unlocked/uncrossed NBBO. Madoff offers a similar service.
"The existing system works well most of the time," Angel said. "And most market makers will go to a midpoint cross anyway. Any retail broker who's not sending his order to a broker who offers the midpoint is not living up to best execution."
Angel, who has been studying the markets since he entered Berkeley University's doctoral program in 1985, calls his proposal a compromise. "It fixes some of the problems that Nasdaq is getting heat for," he said. "But it also reflects the fact that there are a lot of people who like the existing system."
That would include wholesaler Herzog Heine Geduld's president E.E. "Buzzy" Geduld. "The Nasdaq opening works fine," he said. "[An electronic call auction] is not necessary. I think the multi-market maker system is still the finest system anyplace, anywhere, anytime."
Nasdaq's chief operating officer Patrick Campbell told the crowd at the Baruch conference that winning the approval of the wholesalers for an electronic call would be tough. "If it was dictated to them and it didn't foster competition they would be against it," he said.
Wholesalers are opposed to any form of centralized order execution that might disintermediate them. Charles Schwab & Co., for example, has been a vocal opponent of the SEC's idea of a mandatory limit order book (CLOB).
Restructuring Nasdaq
The electronic call is simply the latest in a steady stream of regulatory and technology initiatives introduced in the last few years that have restructured Nasdaq along the lines of an auction.
Dealers have weathered the limit order handling rules, the reduction in ticks from eighths to sixteenths, and various attempts by Nasdaq to impose a mandatory CLOB. Next year they will likely have to contend with Nasdaq's supermontage and decimalization.
As the reformers see it, a centralized, order-driven marketplace is superior to a decentralized, quote-driven system.
The debate is not completely black and white. Knight, the largest Nasdaq wholesaler, says it is open to a voluntary
electronic call auction in the morning. "We'd like to explore it," said Michael Dorsey, Knight's general counsel. "We'd be in favor if it aids in an organized and orderly opening to the market." Dorsey suggests fear of disintermediation is not great because Knight already gives up some profits when it fills orders at the opening bid-ask midpoint.
Dorsey is more circumspect when contemplating a mandatory call auction. "We would have to see the proposal," he said. "It's almost impossible to say what our response would be."
Dealers whose bread and butter is institutional order flow have fewer doubts. "We're talking about a major structural change, but I'm in favor of moving Nasdaq in stages to an auction market," said Tony Cecin, director of equity trading at U.S. Bancorp Piper Jaffray. "We're heading down the road of one quote pricing anyway."
