MIS 3090: IT for Financial Services

1. MIS 3090:IT for Financial Services The Market for the Next 100 Years!

2. Outline • How is NASDAQ different from NYSE? • Technology • SelectNet • SOES (small order execution system) • SuperSOES • Understanding order flow: some tricks of the trade • SuperMontage • Existing market shortcomings

3. None One Many Competing Business Models Liquidity Providers Spear, Leeds & Kellogg (ECN) Terra Nova Trading, LLC NYSE (+ Archipelago ECN 2006) NASDAQ (+ Island/Instinet) B-Trade Services LLC The Brass Utility, LLC* Strike Technologies LLC* AMEX Attain-ECN PIM Global Equities - ECN

4. Auction Market Model • Floor-based • Single Specialist • Order-driven • Capital commitment limited to one firm • Trade halts for volume imbalances

5. Dealer Market Model • Screen-based • Competing Market Makers • Quote-driven • Capital commitment from multiple firms

6. Role of Market Maker • Compete for investor orders • Commit capital • Maintain inventories • Seek the other side of a trade • Trade on both sides of the market • Generate investor interest

7. Screen-based Markets • Allow equal access to trading and market information (in theory) • World’s most common market structure • Unlimited number of market participants, so it facilitates expansion • No central trading floor • The network is the market – attack the network and the market will suffer

8. NASDAQ Level II Screen

9. NASDAQ Level II data • Shows “book” of market makers • Used by day traders • Many just follow the “ax” • Potential tricks • Breaking large orders up • Posting false orders and pulling them • Hide orders by trading through ECNs

10. Retail “Buy” Order – Scenario 1 ASK 25.25 25.28 25.29 25.31 25.50 BID 25.00 24.87 24.86 24.85 24.84 AA CC Retail “Buy” MM MM BB DD CC 200 AA BB DD MM Retail investor wants to “Buy” 200 shares @ 25.25 Market Maker has 200 shares in inventory.

11. “Sell” Trade Report: 200 @ 25.25 Execution – Scenario 1 ASK 25.25 25.28 25.29 25.31 25.50 BID 25.00 24.87 24.86 24.85 24.84 Retail “Buy” MM 200 Retail investor wants to “Buy” 200 shares @ 25.25. Market Maker fills “Buy” order at best offer price of 25.25.

12. Trade Report: 200 @ 25.25 Retail “Buy” Order – Scenario 2 ASK 25.25 25.28 25.29 25.31 25.50 BID 25.00 24.87 24.86 24.85 24.84 Retail “Buy” MM “Sell” Retail investor wants to “Buy” 200 shares @ 25.25. Market Maker does not have shares in inventory. Market Maker sells short 200 shares at 25.25.

13. Retail “Sell” 300 Retail investor wants to “Sell” 300 shares. Cover Short Position – Scenario 2 BID 25.12 25.00 24.87 24.85 24.84 ASK 25.25 25.26 25.27 25.28 25.50 Retail “Buy” MM Market Maker raises its “Bid” price to build inventory which affects other prices.

14. “Buy” 300 shares Execution – Scenario 2 BID 25.12 25.00 24.87 24.85 24.84 ASK 25.25 25.26 25.27 25.28 25.50 Retail “Sell” MM 300 Market Maker “Buys” 300 shares at its best bid price of 25.12 Retail investor “Sells” 300 shares to Market Maker. Trade Report: 300 @ 25.12

15. NASDAQ Technology - SelectNet • Order delivery and negotiation system (large orders usually; not for individual investors) • A communications tools between market makers and brokers • System does not cross or execute orders • SelectNet orders received at posted bids or offers must be executed at that price • Can be used to preference an order to a specific market maker or to broadcast the order to the entire market • preference: a way to gain order flow without having to post the best bid-offer (possible payment for order flow) • Some large traders (e.g., mutual funds) can directly send an order to the market through their broker – “pass-through”

16. Preferencing Explained CSCO BID 75.25 75.24 75.20 75.19 75.18 ASK 75.30 75.31 75.32 75.35 75.39 MM LEHM LEGG Retail “Sell” Retail “Buy” LEGG SCHB Preferred arrangement 75.20 – 75.35 MM LEHM 1000 MM SCHB Broker Best bid in the market at this point is $75.25 so broker must sell at this price and no worse. Broker receives order to sell 1000 CSCO at best market price. He asks MM to buy them. MM buys at $75.25 and kicks back to broker $0.005 per share or $5. (1M shares daily = $1.2M yr)

17. Preferencing Explained.. cont’d CSCO BID 75.25 75.24 75.20 75.19 75.18 ASK 75.30 75.31 75.32 75.35 75.39 LEHM LEGG MM Retail “Buy” LEGG SCHB MM LEHM Brokers Buy 2 x 500 MM SCHB Broker Bought 1000 at $75.25 even though bid $75.20 Best offer in the market at this point is $75.30 so market maker must sell at this price and no worse. Sales $75300 Purchases $75250 Kickback $5 + 2x$2.50 Profit $40 per trade Per day 1m $40,000 Annually $96m MM sells at $75.30 and kicks back to brokers $0.005 per share or $5. (1M shares daily = $1.2M)

18. NASDAQ Technology - SOES (small order execution system) • Electronic system for routing small orders from brokers to market makers • Automated system – if a market maker’s quote is hit, they cannot back out of the trade • Originally capped at 1,000 shares maximum • Problems from day traders • SelectNet trade followed rapidly by SOES order • Creates dual liability: “SOES bandits” • NASDAQ dropped limit – at market maker’s discretion • Day traders moved to SelectNet instead – developed very fast order execution interface: installed an automatic “back-away” complaint procedure, forcing market makers to comply.

19. NASDAQ Technology - SuperSOES • Automated execution up to 9,900 shares • 5 second delay between orders received from same broker • Difficult for market maker to back away from a trade • ECNs were included in the montage (or display of available market makers) for each share but were liable to be cut off if their response to a trade request was deemed “slow” • Went live late 2001 • Set the stage for SuperMontage

20. Comparisons(NASDAQ vs. SuperMontage) Quotes on one screen; Orders on another Everything on one screen

21. SuperMontage - features • Shows depth of market on buy and sell side • Replaced SOES and SuperSOES • Enter multiple quotes/orders at the same time for a stock • Ability to hold stock in reserve – don’t show the entire order to the market at any one time. To avail of this, you must show a minimum order size of 1,000 • Anonymity is possible – market maker’s name is masked • Broker could previously cancel an order within 10 seconds of submission (even if it was accepted by a market maker) – that is now removed so execution is automatic (ECNs can still refuse an order) • Scrapped in favor of Instinet in 2005 after $107M • Moving to opensource

22. See http://www.tradingacademy.net/nasdaq/ for more information SuperMontagePowerView Screen DepthView QuoteView (size is in 100’s)

23. Higher Fill Rates • 93% of marketable orders are fully or partially executed, up from 67% pre-SuperMontage • A marketable order is a limit or market order that is executable at the time the order enters the system

24. Faster Execution Rates • Execution speed improve by almost 90%

25. Greater Depth and Use of Reserve • During the pre-launch period, approx. $125,000 was available 5 cents from the inside price on both the bid (buy) and ask (sell) side in Starbucks. About $95,000 of that was displayed. • This increased to $190,000 in the post-launch period. About $95,000 of that was displayed also.

26. Other Technology: Heat Maps

27. Opening Prices – still some concerns • No consolidated order book for all market makers • Opening prices are set between 8:15am and 9:30am • Problem came to a head with dot.com IPOs • Possibility of wide range of quotes at market open, trades executed at inappropriate prices – not at the inside bid or ask

28. Current Issues • NASDAQ merged with Island/Instinet (ECN) • Countered merger between NYSE and Arca|Ex • Evolution of hybrid markets

29. For Next Class… • Read • ECNs – check out http://en.wikipedia.org/wiki/Electronic_Communication_Network • Articles on class website