While most of the readers of this thread probably know much of the content that is below, I thought I might post it for those who are slightly less knowledgeable in this area. We had hosted a chat session the other day where I had prepared much of the material below from a document in our Library, so I figured I would cut and paste it in here for those who might find it useful. All you grammar and spelling perfectionists, this is no legal brief. Fair Disclosure - This is 4 pages long.For those uninterested, just use your <NEXT> button.
The NASDAQ Marketplace
The NASDAQ market is an electronic marketplace comprised of market makers who act as principal in the securities in which they trade. The various market makers and their various bid/asks comprise the inside market for the security, the consolidated quote. The best bidders and the best offers generate the inside market for an OTC stock. This is unlike listed exchanges, such as the NYSE, or AMEX where stocks are maintained by a singular individual, called a specialists, who is responsible for maintaining and orderly market in the stock, holding a book of customer orders to buy and sell at different prices, the best bid and best offer comprising the inside market.
The NASDAQ "book" on the other hand is not maintained by any one person, but is rather an electronic bulletin board that is generated as a consolidation of the various market maker's quotes on the stock.
An example on ABCD stock:
Best bids Best offers
GSCO 10 x 10 ¬ PWJC 9 _ x 10 1/8
LEHM 10 x 10 3/8 GSCO 10 x 10 ¬
PWJC 9 _ x 10 1/8 LEHM 10 x 10 3/8
As a result, in the above example, the stock is bid 10, 2 times, offered at 10 1/8 once. Its GSCO (Goldman Sachs), LEHM (lehman brothers) versus PWJC (painwebber) or what is referred to as "two by one". If there were only one bidder and one offer, the stock would be considered "one-up"
As a result of the graphical display of the various market makers and their dynamically changing quotes and positions, many traders feel the NASDAQ provides an advantage as they can visualize strength as a result of market makers joining or increasing the current bid, as well as conversely, lowering or adding to the current offering as well as decreasing the bid.
Traders on the NASDAQ have several execution system available, including the primary four, SOES, SNET, ECN, and Phone based trading.
SOES -Small Order Execution System -
Following the stock market crash in 1987, where clients and their executing firms could not reach market makers, as firms left their phones off the hook so as to avoid having to buy stock in a buying market or sell stock in such volatile swings, the NASDAQ developed an electronic system which firms had to commit to certain quantities ("tier levels") of stock to which they would obligate themselves in establishing a quote. Thus in the example above, for GSCO to meet the firm quote standard, they must obligate themselves to 1000/500/200 shares, depending on the Tier Level, to buy on the SOES system.
SOES orders are entered onto the NASDAQ circuit electronically and instantaneously routed to the NASDAQ servers where the orders are automatically executed against the market maker as long as the quote is still valid. Often, in active stocks, many investors or traders enter SOES orders in the same stock where the market makers only has a limited quantity of stock to sell. In the case of multiple SOES orders on the same stock, the orders are kept in a cue and executed against the market marker on a first come, first serve basis.
Therefore, SOES can only be used to buy stock at the offer and sell at the bid, the worst prices at the inside market.
In fairness to the market makers, who are taking risk in buying and selling out of inventory, the NASD permits the market maker, once they are executed against, to take a period of time to evaluate their position and to reenter and re-expose their firm to the SOES system. During this time, those investors/traders in the SOES cue must wait while the marketmaker first in line, evaluates and possibly reestablishes their position.
Because of the relatively speed at which orders on SOES can be executed when there is no cue present and when a market makerhas exposed themselves at the traders price, "SOES" traders and "SOES" trading houses developed where traders would wait until a stock strengthened to the point that few market makers remained at the low offer, and then the SOES trader would execute the trade against the few remaining MMs.
A SOES order might look like : S1000ABCD10; or S1000ABCDmkt
Advantages of SOES:
1. Speed of execution; almost instantaneous when mm exposed andno cue
2. Speed of report; trade confirmation can often be viewed instantaneously as well
Disadvantages:
1. Not available for more than 1000 shares; in some cases, 500 or 200
2. Can not break up a large ticket into smaller tickets. If you call your broker with an order to sell 2000 you can not use SOES
3. Often much delayed in the more popular stocks with cues and other delays, games played by mms.
SNET - Selectnet
Another trading/execution system available on the NASDAQ is SNET, SelectNet. Selectnet is a system whereby a firm can display an order to market makers at any price, in any quantity. The firm could offer stock above the offer or try to buy stock on the bid. Soes can only be used to sell at the bid and buy at the offer. As well, SNET can be used to offer stock in between the bid/ask spread.
Unlike SOES which is limited to 1000 shares, SNET can be used for any number of shares, for price improvements as well as to move large pieces at prices inferior to the market, justified by the size.
Our traders often use SNET to test the market with small pieces of a large order, to reveal other interested market makers. Once we have established contra firms and their willingness buy or sell and prices at which they will do the business, we might call them on the phone or go back to them with a SNET preference order.
A SNET order might be as follows: S3000ABCD10 1/16. By default, a SNET order is broadcast to all market makers. The order is not displayed on consolidated quotes and market makers ( who do a great % of the business) are the only players that see it. If I entered an order to buy the 3000 at 10 1/16, per our example, the inside market DOES NOT change to 10 1/16 x 10 1/8. There are disadvantages and advantages of this as we will discuss following ECN discussion.
A SNET might be directed to specific market firms. This is called a preferenced SNET order. Lets say I had 30,000 ABCD to sell.I put in to sell 1000 at 10 1/16. GSCO steps up and buys the stock via. Snet. I now know who a buy is. I can now direct (prefence) GSCO with more stock. ONLY GSCO sees the order and only we (GSCO and I) know if they take or deny the trade. Actually, if they do the trade, you see a print to the tape of the piece but no one knows who did the trade.
Advantages of SNET:
1. Unlimited in size, price
2. Fast although not automatic like SOES; New backing away standards and resolutions prevent abuse
3. Can be used to trade around the SOES cue.
Disadvantage
1. Not as fast as SOES
2. Not automatic if there is no cue and stock is available
3. Requires more effort on trader's behalf and thus is not utilized by most firms on clients' behalf.
ECN
While not an execution system, perse, ECNs have developed into an important element in successful trading on the NASDAQ. ECN, Electronic Communication Network, are proprietary trading "books". Traditionally, the largest ECN was Instinet. Instinet was developed by Reuters as a system upon which large institutions could place bids and offers. They sold the book as being cheaper, faster and a book which would not be seen by the rest of the world on a consolidated quote. Thus, if Fidelity had « million shares of ABCD to sell at 10 1/16, they could display this offer on Instinet (INCA). Only those who subscribed to INCA could see that offer. The rest of the world would continue to see 10 1/8 offered.
Ie.Instinet's book could look like this
Fidelity 9000 bid @ 9 Robertson Stephens 10,000 @ 10 1/16
Vanguard 10k @ 9 « Smith Barnet 12,000 @ 11
As you can see, in the example above, the ECN book represents the larger orders, and is often inferior to the inside market as the consolidate qouote has a higher bid, YET this book has a lower offer, albeit only visible to those on the INCA system.
This was an incredible windfall for market makers as they could continue to fill market orders to buy at 10 1/8, the inside market, yet cover their short position (they just sold) at 10 1/16 since someone was offering stock, just on this invisible system.
Because of the unfairness of this relationship and the impact on the individual investor, and its increasing volume, the NASDAQ demanded that while ECN's would not be considered a marketplace, they would have to display their quotes on the NASDAQ system and be exposed to SNET, although not SOES orders.
Additionally, various manning rules now require firms to reflect clients bids and offers in their firms' market or route the order toand ECN. Thus if you put in an order to sell 1000 abcd at 10 1/16, the order, within 30 seconds, must be displayed by the Mm or routed to an ECN. To not disturb their inside market, many MM's route customer orders to ECNS.
Somewhere around this time (and I don't specifically recall which came first), but other ECN's began popping up. Several of the largest include Instinet (inca) , Island Trading (ISLD), Bloomberg (BTRD) , TNTO
Currently, ECNS account for a very large percentage of Nasdaq volume. They are very active an often constitute the inside market on more active stocks.
Advantages:
1. For larger orders, you can use them to display any quantity, any size at virtually any price
2. For smaller orders, the ECNs provide interfaces which give almost instantaneous executions
3. They are quite active and often improve the inside market
4. They are effective for displaying a customer order and ensuring the stock does not trade through theclient.
Disadvantages
1. They are not SOES eligible, and as well, screw up cued SOES orders which have been entered. Ie. You put into sell 1000 abcd at the MARKET (market order). There is a cue, lets sayyou are fourth in line. MLCO is bidding and taking stock. Lets say an ECN goes to 10 1/16. Hey! That's great! You should get 10 1/16!. No, you SOES order is rejected and kicked out of the system because ECNS are not SOES eligible.
2. You can use SNET to execute against an ECN but it is slower than a proprietary interface and SOES
3. Some act strangely on partial fills, often kicking out and cancelling the order
4. Due to anonymity and bizarre behaviour relative to partial fills and SOES, etc., ECN's could be left open to abuse by a manipulative market player.
Phone Based Trading:
Traditionally, before SOES and SNET, trading most securities involved use of the telephone, dialing a market maker and verbally taking them up on their bid or offer, or representing your particular order. In fact, before Nasdaq had the L2 display, going back a number of years, firms actually had to call three market makers, get three quotes on the security (to ensure they were paying a fair price) and then execute against the best. With the advent of the L2 workstation, firms no longer have to call to get three quotes (although the 3quote rule still is in effect) because the trader can visually see the quotes.
Nonetheless, telephone based trading still has its place. Often, on larger orders or on orders where the ECN and SOES cues are incredibly long on days such as the morning after the crash of 550 in October of last year, we will often use the telephone to execute trades against market makers
For example, in ABCD example, GSCO and LEHM are both bidding at 10. GSCO is the SOES eligible firm. They are currently taking SOES orders, waiting , refreshing their quote, etc. During this period of time, LEHM is still bidding 10 waiting for GSCO to move aside and let LEHM take on stock. Or if the stock weakens, while GSCO is pausing, LEHM could drop their bid. In the end, all the SOES orders remain in cue for theone market maker. A firm could call LEHM and smack their bid, avoiding the SOES cue.
As well, in an extremely volatile market, where market makers are scurrying and not leaving them selves exposed to SOESor SNET or ECN trades, phone based executions are useful. If you call GSCO and get them on the phone, they cannot back away. Afterall, you have someone's name at the firm (this is one of the first things you ask). They might say "we're not there, SOES ahead" but then you can demand they refresh their quote and if you want to hit their new bid, again you have beaten the SOES cue.
A typical Script might go something like:
GSCO "Goldman"
Yamn "Steve at Yamner, who's this?"
GSCO "Billie here, steve"
YAMN "Billie, ABCD..Alpha, Bravo, Charlie, Delta, I have 2000 to go at 10, your bidding, two by one"
GSCO "Yamner, you sold 1000 at 10 , wait a moment..you're complete.you sold, we bot 2000 abcd at 10"
YAMN "Thank you billie, pick you up on ACT"
Total time: about 5 seconds.
Advantages:
1. good for large orders where you would otherwise move the market against yourself
2. Good for large order where a little savvy, finesse is need to get improvements.
3. Good for avoiding SOES cues
4. Good for obligating a firm to its firm quote
Disadvantages
1. Relatively slow compared to SOES, SNET or ECN
2. Always leaves open to possibility the contra firm later DK's the trade.
Hope someone finds this useful.
There are some other documents like this in the Yamner University, yamner.com
Regards,
Steve@yamner.com
yamner.com |
