Nasdaq Prepares to Replace ITS with Private Linkage Strategy

After revealing plans on Monday to withdraw from the Intermarket Trading System, the Nasdaq Stock Market already is taking steps to fill the gaps in its private linkage system in preparation for when Regulation NMS takes effect next summer.

Next week Nasdaq will announce that it's partnered with Order Execution Services (OES) to reach the smaller regional stock exchanges. OES is an agency broker-dealer that provides electronic connectivity to regional stock exchanges, according to a Nasdaq spokesperson..

While Nasdaq already has a high-speed link to the New York Stock Exchange through its Brut smart order router, OES will supplement the private linkage facility Nasdaq currently has through Brut's smart order router, the Nasdaq spokesperson adds. Brut LLC is an electronic trading network that Nasdaq acquired last.

"Nasdaq is leaving ITS -- and thus that linkage, and we’re filling in the blanks," says Dave Scheckel, chief executive officer of OES, an independent, agency broker-dealer based in Princeton, N.J.

According to Scheckel, Nasdaq signed a contract with OES in July, which predates its announcement on Monday to pull out of ITS -- a 25-year-old electronic communications network that governs linkages among the nation’s stock markets. Nasdaq expects to withdraw from the ITS Plan in 2006, upon implementation of Reg NMS, with full withdrawal coming by Aug. 31, 2006. Its board of directors has approved Nasdaq’s plan, and it will also be filed with the Securities and Exchange Commission for approval.

The move is a direct response to Reg NMS, the new package of stock trading rules approved by the SEC on April 6, which demands connectivity because the trade-through rule requires market centers to route customer orders to the market displaying the best price.

"Regulation NMS enables Nasdaq to select a more effective, high-speed private linkage over the older, less-flexible ITS Plan," stated Chris Concannon, executive vice president, Nasdaq Transaction Services, in Monday's release.

In planning to leave ITS, Nasdaq will free itself of two components that are problematic: the outdated ITS technology and linkage, and the governance of the ITS. "It's problematic in that your competitors are being put in position to approve or vote down issues affecting your business model," says the Nasdaq spokesperson.

By relying on a private linkage instead of ITS, "Nasdaq is positioning itself to capture additional liquidity in NYSE-listed securities," added Concannon in the release. He goes on to predict that the trend toward trading NYSE-listed stocks on electronic venues will continue to accelerate in 2005 and 2006.

But, as a result of Nasdaq pulling out of ITS, other exchanges will need to connect to Nasdaq. "This should force a rush out (of ITS)," says Scheckel, who says his firm is also in talks with the American Stock Exchange and all of the regional stock exchanges who have RFPs (request for proposals) out.

"I think there is no future for ITS," says Scheckel, who agrees the ITS governance plan is more problematic than its technology. "It's easier just to scrap the whole thing and let people like Nasdaq and the other exchanges come out with their own plan for connectivity through private linkages. All of the exchanges will never agree on an ITS plan. Everyone wants to benefit themselves," he says.

Scheckel contends OES is uniquely qualified to provide the electronic connectivity because it's already providing anonymous electronic execution services to exchanges and broker-dealers. In addition, it's a member of all the regional exchanges "You have to be a member to have orders executed on the exchange," says Scheckel.

OES was formed in 2002 by the management buyout of the Herzog Heine Geduld-listed trading division from Merrill Lynch. Under Merrill, the core business of Herzog’s listed-trading group was executing orders for specialists on the regional exchanges who would execute via OES to reach other pools of liquidity, says Scheckel. "Because of that, we built up very beefy pipes and infrastructure," says Scheckel, noting that the firm can interact with all the listed exchanges and ECNs, and it provides anonymity, smart order routing and direct market access.

Currently, the firm's clients include: the Amex, Archipelago, Bernard L. Madoff Securities, Citigroup, Fidelity Investments, Knight Capital Markets and Track ECN. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio