SuperDF, Alternative Montage, and the S-Word: A Hitchhiker's Guide to Complexity

Throughout 2002, Nasdaq market participants have been confronted with a new and ever-expanding lexicon that purports to describe the future of our business. For many, it's been like learning a foreign language--and at a mature age, to boot.

Assuming published schedules are met, over the next 12 months we will witness the launch of Nasdaq's SuperMontage; an upgrade of Nasdaq from an NASD-sponsored facility to a full national securities exchange; the creation of the NASD's Alternative Display Facility, or "ADF"; and, perhaps most significantly, cashiering Nasdaq as OTC Securities Information Processor--"SIP" in the vernacular--in favor of a fully-independent provider.

A spate of articles, SEC publications, FAQs, and other sundries describe these systems in painstaking detail. We do not attempt another taxonomy of minutiae here. Instead, we offer our analysis of the landscape, with the intention of sorting through the complexity to help separate signal from noise during this dynamic time.

A Brief Background
Throughout 2000, a war of words was waged regarding Nasdaq's proposed SuperMontage system. ECNs perceived SuperMontage as an unfair encroachment on their business, because it would allow Nasdaq to act at once as both regulator and competitor. Competing exchanges with designs on OTC trading likewise took umbrage with the scheme, in that Nasdaq does double duty as a collector of exchange information (a Securities Information Processor or SIP) and a provider of the same. Consider the listed marketplace: Would it be fair if NYSE ran the Consolidated Quotation System?

After many trees fell at the hands of the comment period process, and the trade press reported the latest pronouncements at industry conferences and cabals, the SEC arrived at a fair compromise: Nasdaq could have SuperMontage, but it would have to meet two conditions precedent. First, it would have to separate from the NASD, and the NASD would have to offer an alternative to Nasdaq so that participants in the OTC marketplace would have a true alternative to SuperMontage. (Hence the "A" in "ADF.") Second, the OTC-UTP Plan Operating Committee--the industry group that administers the Plan by which exchanges other than Nasdaq can trade OTC names--would have to undertake a review of Nasdaq's role as SIP, with a view towards the possibility of replacing Nasdaq with an independent entity.

The compromise marked an important milestone in the metamorphosis of Nasdaq from a collector of information from other marketplaces into a marketplace of its own. By shedding the two collection roles--the SIP function for exchanges and the ADF function for market makers and ECNs that "just say 'no'" to SuperMontage--Nasdaq aims to position itself as an execution venue.

What is the Alternative Display Facility?
The ADF is a system to collect and disseminate quotes and trades. Sponsored and regulated by the NASD and built by Sweden's OM Group, the ADF is essentially Nasdaq on a diet--or Nasdaq stripped of its ambitions to bury ECNs and build bridges to marketplaces around the globe. It's not likely that "ADF Deutscheland" will be launched anytime soon.

Importantly, ADF leaves linkages to the private market. ADF participants are required to allow reasonable access to their displayed liquidity, but there won't be a SelectNet-like utility order routing system providing access. That said, private market solutions abound; the number of firms offering "smart routing" has grown exponentially in recent years, each offering direct connections into the ECNs that may choose ADF over SuperMontage.

In terms of quote data, the ADF will disseminate a quote feed called OMDF, which will be available via the OTC SIP. (More on that below.) As with linkage to the ADF, private market solutions will likely consolidate ADF quote data with full depth of ECN books and SuperMontage data, much in the same way that data aggregators integrate ECN and Nasdaq data today.

The ADF has received a good deal of criticism over perceived conflicts of interest between NASD and Nasdaq. Specifically, if NASD has an $80 million a year regulatory contract with Nasdaq, how hard will they try to create a competing quotation venue? On the plus side, ADF offers a low-cost means to show a quote and print trades, and is unlikely to indulge in high-cost projects that may contradict member interests--like overseas adventures and new-fangled trading systems.

By our lights, although conflicts are certainly possible, it's more likely that the ADF is simply struggling to effectively communicate its role and create a business. Once its rules are approved and it begins operation, market participants will begin to understand how to display a quote and access ADF-displayed liquidity. If ADF can carve out a role by turning back the clock to a simpler facility for OTC trading, it will satisfy a niche that Nasdaq vacates with SuperMontage. But ADF needs time and more effective communication to see its way through the complexities and confusion surrounding its role.

The New OTC SIP: Process and Possibility
Another mystery to many is the OTC SIP. As described above, a SIP is simply an aggregator of quote and trade information, but for exchanges as opposed to broker-dealers. Because Nasdaq played this role historically for broker-dealers, it agreed to assume the SIP role in the early 1990s when the Chicago Stock Exchange began trading OTC names on an Unlisted Trading Privileges (UTP) basis. As part of the SuperMontage compromise, Nasdaq will be removed from this role in favor of a new, independent SIP.

To better understand the notion of UTP and where it's headed in the OTC marketplace, it helps to draw analogies to the listed side. In 1975, Congress amended the Securities Exchange Act of 1934, adding sections that required a "national market system." In conjunction with the Securities and Exchange Commission (SEC), exchanges constructed this system by way of a number of intermarket plans, such as CTA/CQ for quote collection and dissemination and ITS for intermarket linkage. Each of these plans is governed by an operating committee with one representative of each exchange. On the OTC side, the OTC-UTP Plan governs how quotes are collected from all exchanges (and Nasdaq) that trade OTC securities. The OTC-UTP Operating Committee meets on a regular basis to administer and make rules via amendments to the Plan, subject to SEC approval.

Back to the OTC SIP. As part of the SuperMontage compromise, the SEC directed the OTC-UTP Plan operating committee to review Nasdaq's role as OTC SIP, with an eye towards removal. Throughout the fall of 2001, the committee worked to solicit and review proposals for replacement SIPs, and recently winnowed the list to a handful of finalists. The committee will soon choose a replacement and begin work to create the new SIP; the goal is an April 2003 launch.

How will the new OTC SIP affect the marketplace? For one, it will likely provide the SIP service at a lower cost than Nasdaq, which seems expensive relative to market rates. (SIAC provides the service on the listed side.) Second, the OTC SIP will provide a central consolidator of data for all venues that trade OTC securities. So, while the OTC SIP will not include the proprietary feeds of individual markets, it will offer a Level 2-like display for component markets. As liquidity centers leave the Nasdaq nest to become exchanges (Archipelago) or join the ADF (ECNs?), the OTC SIP feed will provide the complete data picture.

There's also an opportunity for expanding data provision via the OTC SIP. While many market participants provide proprietary means--including direct ECN links, SuperMontage equipment, and OpenBook feeds--there may be a role for a utility consolidator to aggregate richer data. For instance, are ECNs and next-generation exchanges who display limit order books on the Internet interested in a SIP that can make full depth of book available to vendors on a low-cost basis, and via lines that are already in place using formats that are easy to understand? You bet they are.

SuperMontage (or Legion of Doom?)
What is SuperMontage, really? When Microsoft launched Windows95 to much fanfare, some quipped that the "new" product could have just as easily been called Macintosh87. After careful consideration of the functions that SuperMontage intends to perform--providing a book and collecting away-market quotes for order routing--Nasdaq02 looks a bit like ECN97.

Like a routing ECN, SuperMontage has a book, consisting of market makers and ECNs that accept autoexecution, and integrates away-markets, such as ECNs, via an order delivery mechanism. Also like a routing ECN, SuperMontage offers its brand of "smart routing", allowing users to choose price-time, price-size, or price-fee-time. (The latter allows a user to go to ECNs that charge a fee last, not unlike typical ECN routing algorithms that go to the home book first, then on to competing books.)

How will Nasdaq compare to ECNs? On the plus side, it possesses the dual advantage of scale and inertia. Every OTC desk has Nasdaq equipment and, what's more, they perceive it as an operational necessity. While competing exchanges may erode this enviable installed base at some point, it's a sizable asset today.

Three negatives come to mind, however. First, only market makers, ECNs, and competing exchanges can provide liquidity directly on the SuperMontage book--there's no role for the proprietary traders who provide much of the liquidity in today's marketplace. Here, SuperMontage's choice is somewhat ironic: ECNs are unlikely to give full depth of book information to a competitor trying to build an ECN, and market makers have historically resisted the advancing tide of SEC-spurred quote transparency. Indeed, many market makers would prefer to show zero prices instead of one, let alone five.

Second, SuperMontage "smart routing" doesn't pass the test, because it only involves SuperMontage participants. If liquidity centers depart for the ADF (Island/Instinet?) or competing exchanges (Archipelago), SuperMontage routing will ignore them. Private market routing solutions have successfully integrated disparate liquidity pools for years and will continue to do so.

Third, SuperMontage cost $100 million. This tidy sum will be recouped via higher fees. For example, the TotalView feed, that includes all price levels from each participant (i.e., the full depth of book), costs a $150 a month per user, with a minimum of $10,000 a month. Rather than take its cue from ECNs and next-generation exchanges, which give book data away or at line cost, Nasdaq followed the pricing lead of NYSE OpenBook. We'll see what the market will bear.

Thinking About What's Next: Guiding Principles
We hope the review of the many moving parts adds clarity to the lay of the land. The question remains: How might all this evolve? In lieu of a crystal ball, there are four basic principles to bear in mind:

1. SuperMontage is very expensive, not particularly innovative, and targeted towards a potentially uninterested audience. It could very well be a big yawn, with participants sticking to display of BBO just as they always have. If it turns out to be a book of market maker BBOs and a not-so-smart routing mechanism that ignores liquidity outside its bailiwick, SuperMontage will simply be a large ECN with sub par functionality.

2. The past few years have marked a clear trend towards private market linkage and liquidity aggregation solutions. Indeed, there is a great deal of competition and innovation in this new market segment. It is not likely that SuperMontage will "own this space." Instead, look for the private market solutions to step up and continue to solve the liquidity aggregation-access problem as the world gets more complicated. (See appendix for what things might look like post-ADF/new OTC-SIP.) And as the most technologically advanced trading desks continue to insource these functions, they'll build their own linkages to liquidity pools--effectively "rolling their own" montage.

3. As a business, Nasdaq is in flux. The recent NASD-Nasdaq unraveling changes its corporate culture from quasi-utility to competitive business. By spinning out the ADF and filing an application to become an exchange, Nasdaq has put its role as "print factory" for OTC desks at risk. (Exchanges execute orders; they don't "print" trades.) In terms of cost structure, Nasdaq pays NASDR $80 million a year for regulation and employs about 1300 people, almost 10 times as many as most rival ECNs. You can't cheat the economics: Nasdaq isn't positioned to be a low-cost provider.

4. The OTC and listed business are converging, as the former becomes commission-based and the latter becomes more electronic. Although institutional brokers have historically formed the backbone of the OTC marketplace, over the next few years they will ask themselves: "Why do I need a quote in CSCO, but not IBM?" A handful of all-agency, fully electronic institutional brokers has arisen recently, almost analogous to an OTC floor brokerage community. They aren't using quotes in CSCO, just representation in electronic systems.

Stay Tuned
The industry is at the precipice of Nasdaq's cosmic makeover from regulator/quote collector to competitive marketplace. Starting with the N*PROVE and NAqcess limit order book proposals in the mid-90s, moving on to the Optimark and Primex deals of the late 90s, and accelerating with the launch of SuperSOES last summer, SuperMontage (and the exchange filing) closes this chapter, and opens the next.

The effects of SuperMontage, the ADF, and new OTC SIP will play out over the coming twelve months, often in confusing ways as liquidity centers bounce from one to another to maximize their own economics. But at the end of the day, more choice and useful private market solutions for quote access-aggregation should turn complexity into opportunity for market participants.

Appendix: Market Structure Schematics