For Nasdaq, Stakes Are High as It Plans on Further Changes

NEW YORK —  The Nasdaq Stock Market is trying to grow without tearing loose its roots. Last month, in a bid to solidify its competitive position against its archrival, the New York Stock Exchange, Nasdaq’s parent body, the National Assn. of Securities Dealers, struck a deal to buy the 87-year-old American Stock Exchange.

Besides letting Nasdaq tap into Amex’s lucrative stock-options trading business, the deal would give Nasdaq access to an auction market--like the NYSE’s--in which stock prices are mainly set by customer orders instead of dealer quotes.

At least initially, the Nasdaq and Amex markets will remain separate. Still, it’s clear that “Nasdaq is in the midst of re-engineering its marketplace away from the historical role of dealers at both sides of the trade and nobody in the middle,” said Patrick Healy, a Chevy Chase, Md., consultant and former Nasdaq official.

An important part of the process is technological. Nasdaq has proposed a major revamp of its computerized order-execution mechanism, which now consists of the separate SelectNet system and the Small Order Execution System, or SOES. The former handles orders from brokerages and other institutions; the latter automatically executes orders of up to 1,000 shares from individuals at the best available dealer price.

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The proposed “Nodes” system would combine the two existing systems and would also contain a central facility to automatically display customer limit orders that arrive through Nasdaq dealers or through electronic communications networks, or ECNs, such as Instinet, used for trading by big institutions.

Nodes would provide immediate execution of non-directed orders--those not sent to a particular market maker or ECN--that match the price of orders in the central display.

In other words, when one investor’s buy order matches another investor’s sell order in the central file, the orders would be executed against each other without involving a dealer, provided the two investors’ prices are the best in the market at that time.

But the main advantage of the new central order file, according to Nasdaq, is that it would show greater depth of the market--that is, it would show the buying or selling interest a little below or above the current best prices.

If a big institution wanted to sell 50,000 shares of XYZ stock, for example, it would find it useful to know that beyond the best bid of $20 a share for 2,000 shares, there also were buyers willing to take 10,000 shares of XYZ at $19.88 and 25,000 shares at $19.75, and so on.

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At the moment, there is no central facility to show such market depth, although the individual ECNs show depth within their own systems to their subscribers.

Nasdaq’s proposed system would be voluntary; orders sent to private ECNs would not appear in the central limit-order display unless they were specifically directed there.

The Securities and Exchange Commission is pushing for still more disclosure. It has proposed requiring ECNs that handle 10% or more of the volume in a particular stock to display their best prices for that stock to the entire market.

Nasdaq contends that its proposed new system represents a big step toward better prices and greater simplicity.

But there’s also something in the changes for market makers, who insist they need protection from short-term traders who try to “game” Nasdaq’s electronic system, allegedly by manipulating prices so as to lure market makers into meeting a better market price, then hitting them with a deluge of orders at that price on the automatic systems, such as SOES.

The proposed rules would eliminate the current problem of “multiple liability,” whereby a dealer’s quote can be hit simultaneously by orders arriving over SelectNet, SOES or the telephone.

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If a market maker, for instance, is posting an offer to sell 1,000 shares of a stock at $20, he or she should be required to make good on the quote if an order arrives. But it is unfair for the dealer to be liable to provide twice as many shares at that price when two orders arrive at the same time through different channels, Nasdaq says.

Combining SOES and SelectNet ensures that only one electronic order can hit a market maker at a time. To eliminate double liability from phone orders, Nasdaq has proposed a controversial “phone ahead button” that a market maker could push to provide a 17-second timeout from electronic orders while he or she is on the phone.

Critics immediately branded the proposed invention the “back-away button,” calling it a means for dealers to refuse to honor their quotes when the market turns against them. Dealers are currently subject to sanctions for backing away, and that wouldn’t change, Nasdaq says. Nasdaq would investigate violation suspicions by examining records to make sure that the button was used only in conjunction with legitimate phone orders.

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The proposal also has drawn opposition from those who say that Nodes would be an unfair new competitor for ECNs--and for dealers themselves. “It wouldn’t necessarily drive out the other ECNs, but it would act as a very, very strong competitor,” said John Tognino, head of the Security Traders Assn., a trade organization for market professionals.

“Nasdaq runs the potential of a conflict of interest,” Tognino said. “When you put the regulator on it, it becomes the de facto standard. Anyone who makes a market would feel he has to be on it.”

Nasdaq takes pains to note that although the market’s self-regulatory organization, NASD Regulation, is also a unit of NASD, the regulator is an entirely separate organization.

The SOES system is favored by professional day traders--dubbed “SOES bandits” by market makers who regard them as parasites. These traders say that Nasdaq is leaning too far to try to protect its market makers at the day traders’ expense.

Nasdaq says it is trying to handle the system upgrade--and its evolution in general--as evenhandedly as possible.

“Our challenge as we begin to incorporate order-driven characteristics in our market is to retain the strengths of a dealer market in terms of capital provision,” meaning dealers’ willingness to stand ready to buy and sell, NASD Chief Economist Dean Furbush said.