NASDAQ Plans Enhancements To Meet The Competition

The National Association of Securities Dealers plans to upgrade NASDAQ to make it more competitive with vendors that serve the OTC market. NASD is building a system to allow OTC traders to automatically execute orders of any size, says NASD president Joseph Hardiman.

Known as the Advanced Computerized Execution System, the service will be operated on behalf of participating market makers and tailored to their requirements, Hardiman recently told the Securities Industry Association's operations group.

"That is to say, ACES would permit a participant to specify that he would accept orders of up to 2,000 shares from firm A, up to 5,000 shares from firm B, and so on," Hardiman says.

NASDAQ currently offers electronic execution for retail orders of 1,000 shares or less for NASDAQ/National Market System securities and 500 shares or less for the remaining NASDAQ issues.

NASDAQ's limitations in electronic trading allowed vendors such as Instinet Corp., a Reuters Holdings PLC unit, to successfully penetrate the OTC market with automatic execution services.

Several broker/dealers also developed their own electronic execution systems. For instance, Troster Singer Corp. offers the "Inside system while Herzog Heine Geduld has "Auto-Ex," which is being marketed by Citicorp's Streetsense.

In addition to building ACES, NASD plans to add a file to the Small Order Execution System to allow subscribers to enter orders that can't be filled immediately. Unlike exchanges, NASDAQ doesn't guarantee investors the ability to place away-from-the-market orders.

While some NASD members accept limit orders from institutional investors, they generally charge extra for this service. In addition, there has been confusion about a broker/dealer's responsibility in handling limit orders.

Because the OTC market is fragmented, it's difficult for a broker/dealer to guarantee a customer placing an away-from- the-market order that another securities firm will not execute at a better price than the one specified in the limit order.

In the absence of a system-wide limit order file in NASDAQ, Instinet has acted as the limit order book for the OTC market. (Since the Intermarket Trading System connecting all U.S. exchanges doesn't prevent a specialist on one exchange from executing at a price better than one specified by an order in the book at another exchange, Instinet has also become the de facto central limit order file for listed securities.)

When the Midwest Stock Exchange began trading 25 OTC stocks earlier this year, another vehicle for placing away- from-the-market orders for NASDAQ issues was created. But, like any other OTC market maker, the MSE can't promise investors that another broker/dealer won't trade through the price of the limit order.

However, the MSE is accepting away-from-the-market orders at no extra cost to investors, and the threat of other exchanges trading OTC stocks has been powerful enough to convince NASD to build a file for small limit orders.

All transactions that take place through SOES are reported as locked-in trades for clearing purposes. The NASD is now working on a system that will combine telephone negotiation with the trade detail reporting feature of SOES.

Under the Automated Confirmation Transaction system, a market maker will include contra-side information in the trade report he enters through his terminal after completing a transaction by telephone. The information will be displayed to the contra-party and if confirmed within 30 minutes, the trade will be automatically submitted for clearing at the end of the day.

Both the trading and uniform practice committees of NASD have recommended that use of ACT be mandatory. NASD has talked with the London Stock Exchange about eventually interfacing with a similar service there.