Patacsil, Jerwin Dave V.

Financial Risk Management

Case: The Nasdaq Stock Market, Inc.

I. Background/Introduction

National Association of Securities Dealers Automatic Quotation service (Nasdaq) was

created in 1971 to restructure the over-the-counter (OTC) market through the use of
automation that would create a network to link market participants, providing broad
access to the quotes

Nasdaq is an electronic OTC market. The securities being traded in an OTC are those
by companies who did not meet the listing requirements of the New York Stock
Exchange (NYSE) or its listing fees. The Nasdaq system offered three level of services:
Level I for a representative only bid-and-ask quotation for a given stock, Level II
displayed the quotations of all the market makers (dealers) in a given stock, and Level III
enables dealers to enter updates to the prices and quantities they were quoting.

As a comparison with the traditional stock market (i.e. New York Stock Exchange
(NYSE)), Nasdaq is a dealer's market, wherein market participants are not buying from
and selling to one another directly but through a dealer while NYSE is an auction market,
wherein individuals are typically buying and selling between one another, and there is an
auction occurring; that is, the highest bidding price will be matched with the lowest
asking price. As to the market participants, Nasdaq generally attracted a larger share of
small, high-growth companies than the NYSE because of its different listing standards
and lower listing fees.

Everything was going well until the Securities and Exchange Commission (SEC)
adopted the new Order Handling Rules in January 1997 due to the dealer collusion
problem. This then required a dealer to display to the entire marketplace any unexecuted
limit order received from a customer that has priced at or better than that dealer’s current
quote. For Nasdaq, this means that the dealer could no longer avoid displaying his
customers’ orders to the market hence the blur of anonymity.

This legal predicament gave Electronic Communications Networks (ECN) a window to

steal the show since the sad SEC order doesn’t apply to ECNs since limit orders placed
on ECNs by nondealers could remain undisclosed to the public. The SEC order have the
ECN equal status with dealers in terms of being able to advertise their inventory on
Nasdaq. an ECN is generally an electronic system that widely disseminates orders
entered by market makers to third parties and permits the orders to be executed against
in whole or in part. The flexibility enjoyed by ECNs allowed them to offer features that
served unmet needs in the marketplace.
 The rise of ECNs threatened Nasdaq’s franchise and in 1998, the National Association
of Securities Dealers (NASD) supported the restructuring of the Nasdaq into a
shareholder-owned company from a membership owned entity and raised over $350
million in new capital. As a response to the threat of ECN, Nasdaq, in 2001, introduced
its own ECN: SuperMontage to replace SuperSoes and SelectNet, which was intended
to be nothing less than a reinvention of Nasdaq. It features an increased transparency
through an enhanced display, give market participants new order-entry tools that would
enhance their ability to carry out complex strategies, and it would improve Nasdaq’s
execution efficiency and capacity.

II. Statement of the problem

Would SuperMontage produce the benefits of centralization of liquidity, while preserving

the value of competition among multiple venues?

III. Areas for consideration

The case will be solved with the following assumptions:

 The ECN network competitors would be limited to Archipelago, Island, and
Instinet
 The timeframe of the problem would be prospective from the implementation of
SuperMontage

IV. Alternative Courses of Action (ACA)

1. ECNs would be registered as a national securities association to keep competition

afloat. It must be noted that NASD not only owns and supervises Nasdaq, in which
SuperMontage is a part of, but it also supervises the ECNs, which are registered and
regulated by it. As such, NASD will inevitably be confronted with a conflict of interest.
It would then own and regulate SuperMontage whilst supervising the ECNs, which
will compete amongst each other. Thus, the main benefits of the registration of
Nasdaq as a national securities exchange will be that the structure of the market will
be improved because Nasdaq will be an independent entity.
2. SEC’s intervention by creating a Consolidated Limit Order Book, which would
establish price/time priority for all displayed orders in all markets. This was actually
suggested by the Commissioner of the SEC at the time of the SuperMontage’s
inception.1 This proposal is to enhance market disclosure with regard to price
transparency.
3. Do nothing

1
Commission's Request for Comment on Market Fragmentation, A. Overview of Current Market Structure
 V. Summary, conclusion, and recommendation

The first ACA aims to keep the competition through the context of managing the
regulation side. It seems idealistic and burdensome to elect every ECN mandatory for
registration. But in the end, Nasdaq chose to restructure itself as a profit-making
corporation. As a profit-oriented company, Nasdaq will be more adequately able to
compete nationally and internationally with other exchanges and dispose of a modern
structure.

For the second ACA, it talks about the effect of transparency vis-à-vis anonymity in the
competition. It was studied by Chung (2009) that having a display system and efficient
trading platform prompted market participants to submit more aggressive quotes and
orders. Hence, relating that transparency actually promotes better trading.

The third ACA it must be noted that with regard to the competition among markets, it
was speculated that there is a risk that SuperMontage may have a negative impact.2 An
integration of the market will occur and SuperMontage will implement a rather
monopolistic, centralized execution system. In fact, this will increase competition among
the market systems and force the ECNs to innovate and offer new services. However, it
can also be anticompetitive, because SuperMontage will be able to cover all the
functions of a securities market and will neutralize many if not all of the advantages of
ECNs.

It was already proven in a study by Chung (2009) that both spreads and return volatility
declined significantly after the implementation of SuperMontage, meaning, it improved
the market quality on NASDAQ through greater pre-trade transparency and the
integrated, more efficient quotation and trading system

Overall, our results indicate that SuperMontage improved market and execution quality
on NASDAQ through greater pre-trade transparency and the integrated, more efficient
quotation and trading system.

Based on the foregoing, by doing nothing, the third ACA will solve the statement of the
problem since the implementation of SuperMontage would actually enhance the liquidity
of the market as well as developing competition in the market.

2
SEC Release No. 34-43863
References

Chung, K. H., & Chuwonganant, C. (2009). Transparency and market quality: Evidence
from SuperMontage. Journal of Financial Intermediation, 18(1), 93-111.
doi:10.1016/j.jfi.2008.01.002