Nasdaq's New Trading System Won't Show and Tell All

WASHINGTON -- You might have thought that the overhaul of the Nasdaq's computer-based trading system would provide an opportunity to make the system more transparent -- long a stated goal of regulators, who say they want the public to get as much information on pricing and volume as possible.

That was certainly one thing Nasdaq tried to accomplish with the design of the new SuperMontage.

No X-Ray Vision for SuperMontage

But, thanks to some features that the Nasdaq's biggest customers want, the system may in fact give those trading firms and big institutions new ways to conceal their intentions from the rest of the market.

See Also
Is Nasdaq's New System Anticompetitive?

Big shareholders and the firms handling their orders have always sought to prevent their big block trades from producing price swings. And they have also tried to trade anonymously. Both practices prevent small investors from getting a full picture of market demand and SuperMontage, now under consideration by the Securities and Exchange Commission, would perpetuate them.

"As soon as you start hiding information from the market, you're essentially manipulating it," says Barbara Roper, director of investor protection for the Consumer Federation of America. "It allows a relatively few powerful players to play the market in their best interests, in a way not available to smaller players. It's just not how the markets are supposed to work."

Nasdaq executives say they're sympathetic to the argument, but claim they have no choice. In an ideal world the Nasdaq would bare all, but in this case it must respond to the institutions, they say.

"We react to market forces," says Dan B. Franks, Nasdaq's senior vice president for market operations. Otherwise, "we'd create a system that's so pure, no one would play in it."

Indeed, it is precisely because big players want things done differently that the Nasdaq has felt competitive pressure in recent years from alternative trading venues such as "electronic communication networks," which match up buyers and sellers away from the main Nasdaq system. ECN operators, in fact, say that the Nasdaq is using its new system to keep big customers from straying to the new markets.

To a significant degree, the Nasdaq's proposed new system is aimed at fighting this trend. In fact, SuperMontage has turned into a major battle between Nasdaq and the ECNs, which are urging the SEC to reject it.

There's currently no firm timetable for SuperMontage, although the earliest it's planned to be introduced is after the first quarter of next year, once the Nasdaq has moved to decimal pricing.

As envisioned by Nasdaq, SuperMontage is an expanded way for the broker-dealers known as market makers, as well as others, to display orders to the marketplace and for buyers and sellers to find each other and execute orders more quickly and easily.

One of its biggest improvements will be a more complete display of trading interest for stocks. Currently, the Nasdaq system generally displays the best available price for a stock and the volume available at that price. Typically, however, the posted volume represents only a small slice of overall trading interest for a stock.

Protecting the . . . Big Guy

SuperMontage, by contrast, is designed to display the three best levels of pricing and volumes associated with each, thus providing a richer view of the overall supply of, and demand for, a given stock. Regulators and others favor this process of "opening up the order book," which can provide valuable help to buyers or sellers trying to judge where a stock might move.

But that benefit could be undermined by another SuperMontage feature, called "reserve," which would let market makers advertise a stated amount of shares they're willing to trade, when, in fact, they're sitting on a much greater volume that they'd like to move.

For example, suppose a market maker has an institutional client wanting to trade 50,000 shares. Dumped on the market all at once, such a block could depress the price. (Likewise, a big buy order could bump prices up.)

To avoid that in Nasdaq's new system, the market maker might post a quote offering to sell, say, only 2,000 shares at a certain price. The remaining 48,000 shares would go into a hidden reserve, which essentially carries an electronic note that says, "By the way, buyers, if you want more than the 2,000 shares I've posted at that price, I'd be happy to give you more."

Thus, even though those 48,000 shares make up the bulk of the order, SuperMontage won't show their availability to the overall market. All the market will see is the 2,000-share quote, which becomes, in essence, a work of fiction. A buyer might snatch up the first 2,000 shares, and then all or part of the reserve, without the broad market ever knowing the reserve shares were there.

The result? Whether one were a would-be buyer or seller, anyone thinking they've scoped out the trading picture for the stock would have a fuzzy view at best, and that could cost them money.

The reserve feature is available for blocks of at least 1,000 shares, meaning institutions will be the primary beneficiary.

Another SuperMontage feature will allow market makers to post price and volume quotes anonymously, which also can deprive market participants of useful information.

For example, it's common on Wall Street that certain market makers become the dominant traders of certain stocks, and that other players watch their moves carefully as a result. In Wall Street parlance, they become the "ax" for a stock.

So if quotes go up on the Nasdaq system showing that an "ax" wants to move shares in a stock it "owns," that can be a valuable clue that something's up.

The Price Discovery Is Right . . . Right?

Two kinds of information that institutions or trading firms don't like to give up -- true trading intent and market maker identification -- are part of what's known as "price discovery", the vital, albeit inexact, process that establishes market prices by exposing buyers' and sellers' intentions.

The more that those intentions and other information get broadcast to the world, the more "transparent" the market is said to be, and, in theory, the fairer prices become.

Among Wall Street's big players, everyone loves transparency -- for the other guy. It's a big-bucks version of a favorite Wall Street game: You-show-me-yours-but-I-won't-show-you-mine.

Nasdaq's Franks readily concedes that SuperMontage's reserve and market-maker anonymity features mean someone can come out a loser. "For every buyer that's helped, a seller is hurt, and vice-versa," he says. "You cannot have price improvement on both sides of the market."

But, he adds, if SuperMontage is to succeed, it must attract volume. And if it wants volume, it must accede to the big traders' desires -- especially since participation in SuperMontage, beyond the basic level of information now in the Nasdaq system, will be voluntary.

As a whole, SuperMontage's reserve and anonymity features represent a compromise between the need to attract institutions with the volume they bring and the worthy ideal of a fully transparent marketplace, Franks says.

"This is as much transparency as we think the market participants will allow their orders to have," he says.

Some others agree, and say that all in all, Nasdaq appears to have hit a good balance. "They (must) consider the fact they have to provide a level enough playing field so people will want to trade, but not to the point where people give up private information in order to trade," says Jennifer Conrad, a University of North Carolina finance professor and associate editor of the Journal of Finance. "If I don't have the information someone else has, I'm at a disadvantage, but I don't know if that's an unfair advantage."

Even the Consumer Federation's Roper appreciates Nasdaq's logic. "They're probably right, from a practical point of view, in that they have to offer what people want, to make their market attractive to people who use it," she says.

The real problem, Roper says, is the self-regulatory nature of Nasdaq, coupled with the tendency it and other organizations have, when challenged, to "compete by lowering [their] standards," she says.

A better solution, she says, would be to level the playing field with higher, not lower, standards -- in this case, for the SEC to step in and bar the practice in all trading venues.

An SEC official involved in the project could not be reached. Roper concedes that "politically, the chances that anything will be done about this sort of thing anytime soon [are] pretty slim."