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

2. October 15, 20152/29 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. October 15, 20153/29 Competing Business Models NASDAQ (+ Island/Instinet) Spear, Leeds & Kellogg (ECN) Terra Nova Trading, LLC B-Trade Services LLC The Brass Utility, LLC* Strike Technologies LLC* Attain-ECN PIM Global Equities - ECN Liquidity Providers NoneOneMany NYSE (+ Archipelago ECN 2006) AMEX

4. October 15, 20154/29 Auction Market Model  Floor-based  Single Specialist  Order-driven  Capital commitment limited to one firm  Trade halts for volume imbalances

5. October 15, 20155/29 Dealer Market Model  Screen-based  Competing Market Makers  Quote-driven  Capital commitment from multiple firms

6. October 15, 20156/29 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. October 15, 20157/29 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. October 15, 20158/29 NASDAQ Level II Screen

9. October 15, 20159/29 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. October 15, 201510/29 Retail “Buy” Order – Scenario 1 ASK 25.25 25.28 25.29 25.31 25.50 Retail “Buy” MM BID 25.00 24.87 24.86 24.85 24.84 200 Market Maker has 200 shares in inventory. Retail investor wants to “Buy” 200 shares @ 25.25 MM AA CC DD BB DD

11. October 15, 201511/29 Execution – Scenario 1 Retail “Buy” MM BID 25.00 24.87 24.86 24.85 24.84 200 Trade Report: 200 @ 25.25 ASK 25.25 25.28 25.29 25.31 25.50 Market Maker fills “Buy” order at best offer price of 25.25. Retail investor wants to “Buy” 200 shares @ 25.25. “Sell”

12. October 15, 201512/29 Retail “Buy” Order – Scenario 2 Retail “Buy” MM BID 25.00 24.87 24.86 24.85 24.84 “Sell” Trade Report: 200 @ 25.25 Market Maker does not have shares in inventory. Market Maker sells short 200 shares at 25.25. ASK 25.25 25.28 25.29 25.31 25.50 Retail investor wants to “Buy” 200 shares @ 25.25.

13. October 15, 201513/29 Cover Short Position – Scenario 2 ASK 25.25 25.26 25.27 25.28 25.50 Retail “Buy” MM BID 25.12 25.00 24.87 24.85 24.84 Market Maker raises its “Bid” price to build inventory which affects other prices. Retail “Sell” 300 Retail investor wants to “Sell” 300 shares.

14. October 15, 201514/29 Execution – Scenario 2 ASK 25.25 25.26 25.27 25.28 25.50 MM BID 25.12 25.00 24.87 24.85 24.84 Market Maker “Buys” 300 shares at its best bid price of 25.12 Trade Report: 300 @ 25.12 Retail “Sell” 300 Retail investor “Sells” 300 shares to Market Maker. “Buy” 300 shares

15. October 15, 201515/29 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. October 15, 201516/29 BID 75.25 75.24 75.20 75.19 75.18 Preferencing Explained ASK 75.30 75.31 75.32 75.35 75.39 Retail “Buy” MM Best bid in the market at this point is $75.25 so broker must sell at this price and no worse. Retail “Sell” 1000 Broker receives order to sell 1000 CSCO at best market price. He asks MM to buy them. Broker CSCO Preferred arrangement 75.20 – 75.35 LEHM LEGG MM LEHM LEGG SCHB MM buys at $75.25 and kicks back to broker $0.005 per share or $5. (1M shares daily = $1.2M yr)

17. October 15, 201517/29 BID 75.25 75.24 75.20 75.19 75.18 Preferencing Explained.. cont’d ASK 75.30 75.31 75.32 75.35 75.39 Retail “Buy” MM Best offer in the market at this point is $75.30 so market maker must sell at this price and no worse. Brokers Buy 2 x 500 Broker CSCO Bought 1000 at $75.25 even though bid $75.20 LEHM LEGG MM LEHM LEGG SCHB MM sells at $75.30 and kicks back to brokers $0.005 per share or $5. (1M shares daily = $1.2M) Sales $75300 Purchases $75250 Kickback $5 + 2x$2.50 Profit $40 per trade Per day 1m $40,000 Annually $96m

18. October 15, 201518/29 NASDAQ Technology - SOES  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. (small order execution system)

19. October 15, 201519/29 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. October 15, 201520/29 Comparisons Comparisons (NASDAQ vs. SuperMontage) Quotes on one screen; Orders on another Everything on one screen

21. October 15, 201521/29 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. October 15, 201522/29 SuperMontage PowerView Screen QuoteView DepthView See http://www.tradingacademy.net/nasdaq/ for more informationhttp://www.tradingacademy.net/nasdaq/ (size is in 100’s)

23. October 15, 201523/29 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. October 15, 201524/29 Faster Execution Rates  Execution speed improve by almost 90%

25. October 15, 201525/29 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. October 15, 201526/29 Other Technology: Heat Maps

27. October 15, 201527/29 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. October 15, 201528/29 Current Issues  NASDAQ merged with Island/Instinet (ECN)  Countered merger between NYSE and Arca|Ex  Evolution of hybrid markets

29. October 15, 201529/29 For Next Class…  Read – ECNs – check out http://en.wikipedia.org/wiki/Electronic_Communication_Network http://en.wikipedia.org/wiki/Electronic_Communication_Network – Articles on class website