Eric Noll, a Nasdaq OMX executive vice president responsible for transaction services in the U.S. and U.K, spoke about the exchange operator’s new initiatives during Nasdaq’s Investor Day last month on May 10. What follows is an edited transcript by Peter Chapman. This is the first part of a two-part series, covering Nasdaq’s moves in cash equities. The second part will cover Nasdaq’s options business.
>>On Nasdaq’s Retail Investor Auction proposal
The New York Stock Exchange has made somewhat of a big deal about their “Retail Liquidity Program.” We think that 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.
>>On the mechanics of the program
We will re-segment the market, attract flow from dark pools from retail investors. We will give them a live auction process for them to get price improvement on a lit exchange with competitive market makers competing to provide that price improvement. We expect that to add about 1 percent to 2 percent market share when we grow it out. We think it’s an opportunity for us to segment the market in a realistic, competitive and transparent way that adds value.
>>On the problems of wholesalers
If I am a liquidity provider to retail equity order flow [providers] today, I have to guarantee them price improvement on a certain percentage of their orders. And I have to use my own capital to do that. So what this model allows them to do is to say, ‘You know what, I don’t want to use my own capital to price improve those orders because either I don’t know where the market’s going or I’m capital constrained. I want to go to more of an agency model, but I do want that order flow. I want to continue to service that retail broker-dealer and that retail customer.’
>>On the benefits of R.I.A. to wholesalers
This model opens up the price improvement process for that order consolidator to every liquidity provider on the street. So they can route the order to Nasdaq and we will run a retail auction price improvement option. Market makers who wouldn’t otherwise get a chance to interact with that retail order flow will compete to offer price improvement. The consolidator gets to pass that price improvement number back to the retail broker, meeting their obligations to the retail broker. And this allows them access to a much larger pool of liquidity and a much larger pool of price improvers that they wouldn’t otherwise have access to.
>>On offering VWAP algorithms to brokers
The most interesting thing I think we’re doing this year is the introduction of what we call benchmark orders. VWAP, TWAP and percent-of-volume strategies have become relatively commoditized in the algo space. So what we intend to do is offer those as order types on our exchange. This is not to go directly to the buyside customer. This is intended to provide order functionality to our broker-dealer base. [We will] provide a cheaper, better, faster product than having them all develop their own algo offerings and go out into the marketplace and compete for that low-end commodity business.
>>On the target market
This is not intended to compete with the high-end, high touch, highly sophisticated algo providers. It is instead addressed to the largest part of the market, which is the VWAP and TWAP market and say, we can do this for you better, faster, cheaper than you can do it for yourself. We expect to roll that out in the second quarter.
>>On the problems with the PSX exchange
PSX started out as a price-size exchange and still is a price-size exchange. One of the issues with that is that the rest of the market is a price-time market and this exchange is locked into that National Market System. The advantages of quoting on size haven’t really been apparent to the liquidity providing community. So while you had some modicum of success in the last month-we’ve increased market share to 1 percent, 1.5 percent, up-it hasn’t grown the way we wanted it to. It’s really intended to provide services to core institutional users who are looking more for liquidity than for speed.
>>On the proposed changes to PSX
So what we’re proposing to the SEC is that we create a speed bump in that system that allows our liquidity providers to really provide size quotes without being exposed in a way that has been at risk for capital for fast-moving orders. This is not to violate price, the best price in the marketplace. It’s intended to address what’s the real concern, which is how can I quote in large size in the marketplace and not be taken advantage of? And so, we hope that we’ll have some success with this. There is some interest in the end-user community. And there’s quite a bit of interest in the broker-dealer community to provide markets in that. So we think that should, over the long term, grow to be a 3 percent to 5 percent market share. Again, all of this is pending SEC approval.
>>On segmenting the market
What we’ve been able to do-which some of our competitors have either chosen strategically not to do or have not executed as well as we think we have-is to figure out how to segment the market to meet the needs of some of the other market participants. Some of our competitors don’t segment at all. It’s a “one size fits all” strategy and we’re going to barrel down that path. They’ve had some measure of success with that. But I ultimately don’t think that that’s a long-term growth strategy. Other competitors have tried segmentation strategies that have not really been successful yet. I think we’ve demonstrated our ability to attract different kinds of order flow to our platforms.
>>On winning business from broker dark pools
These are products that are designed to take flow back from dark trading, by providing a better solution to what other people have gone to the dark to do. This isn’t so much directed at moving share from one of our lit competitors, though we certainly hope to do that. It’s really designed to answer some of the dark trading crush. We’re going to provide you with some additional functionality and services and price discovery that will pull business out of the dark side of the marketplace and back onto the lit venues.
>>On the growth in off-board trading
If you look carefully at the numbers, there are some securities, actually a large number of securities-over 1,000-that have 50 percent to 60 percent off-exchange trading. So it has a significant impact. I think we can compete very effectively by segmenting the market, particularly with things like PSX or algos, or Retail Investor Auction. Also, some of the pricing we’ve done allows us to remain competitive with dark trading. But [speaking to the] larger macro issue, we’re concerned about the primacy of price discovery. So we want to make sure that as we’re managing our business and the regulatory postures that we’re taking in Washington, that we make sure that price discovery remains the highest priority of our lit markets. That it remains front and center in everyone’s mind as they’re thinking about how these markets evolve.
