With the effects of the COVID-19 pandemic and other economic factors causing dynamic changes in worldwide financial markets, there’s a great deal of innovation taking place in the financial industry to manage the evolving challenges and seize opportunities. Nasdaq, a global leader in fintech that’s been driving transformative progress in the financial industry since 1971, is in the center of this innovation.
All institutional investors are intimately familiar the Nasdaq Composite Index, which tracks nearly 3,000 companies with a heavy focus in technology. Without pausing to think, most serious investors could quickly recite the names of at least 30 powerhouse companies in the Nasdaq-100 Index – which tracks 100 of the largest non-financial companies listed with Nasdaq. And perhaps almost as many investors know that Nasdaq Stock Exchange is the largest U.S. equities exchange by volume and value traded.
But many investors could benefit from having a more solid understanding of the arsenal of sophisticated tools, platforms, analytics, and software services that Nasdaq offers and the pivotal advantages these tools can deliver. We sat down with Chuck Mack, Head of U.S. Equities at Nasdaq, to learn about the latest innovations at Nasdaq – and some features coming soon – that have the potential to be game-changing advancements for institutional investors. He also shared his thoughts on some broader market issues.
First, what advantages does the Nasdaq ecosystem offer institutional investors?
We are part of a vast financial ecosystem. Exchanges play a critical role in the price discovery function, which provides reliable prices for thousands of assets and derivatives on those assets. The efficiency of the markets is really all about bringing issuers and investors together in a neutral, anonymous environment where everyone is treated equally under fair access rules. At the heart of it is the value the Nasdaq exchange brings via its significant book of liquidity, diversity of its ecosystem, and its neutrality.
At a high level, we bring together issuers seeking to raise capital for investments in their companies and the investors that want to provide that capital in return for capital appreciation. The trading and intermediation that take place between those two broad categories is what helps maintain efficient prices and markets, and Nasdaq plays a big role in that.
The prices that are displayed on exchanges drive everything in the market including market quality, the pricing that alternative trading systems (ATSs) use to trade at midpoint, and displayed prices support issuers’ capital investments and are the guardrails that hold intermediaries to better price improvement and execution quality. Many investors use bids and offers on Nasdaq as a reference point for their trades. For institutional investors, that transparency in the market helps them understand if they’re getting a good deal.
What are some misconceptions investors have about Nasdaq?
The biggest one is that exchanges don’t innovate. M-ELO, or our Midpoint Extended Life Order feature, was a key innovation we launched in 2018. We saw the market demand for a purpose-built solution that would bring together investors and traders with longer time horizons in mind, and we answered that need with M-ELO. But that’s just one example; Nasdaq spends a lot of time and money on market-quality programs because we believe the benefits accrue to all participants.
A second, related misconception is that you can’t trade on an exchange without creating market impact. This is simply incorrect. In fact, we designed M-ELO specifically to mitigate market impact, but it’s still only one of a few ways investors can minimize market impact when trading on Nasdaq. You can also use several of our features – such as reserve, discretion, auctions and others – to avoid market impact.
Let’s turn to some higher-level industry initiatives. What important trends and developments are you seeing in the competitive landscape that could be most impactful to institutional investors?
Over the last few years, we’ve been seeing more solutions for institutional investors based on use-case. These solutions can be based on schedule, trajectory, midpoint flavors, and other characteristics, and they seek to meet a specific need – such as achieving a percent of volume, adverse selection reduction, market impact mitigation, etc.. M-ELO is an example of this, of course. Another example is PureStream, a new ATS to which Nasdaq supplies the technology and the first trading venue that prioritizes and matches orders based on their liquidity relevance. I think we’ll keep seeing new purpose-built solutions for specific use-cases targeted to institutional investors. Barring significant regulatory change, I don’t see this trend changing.
Secondly, we’ve seen a significant increase in individual retail investor activity over the last two years. Institutional investors don’t always have access to that activity, and it’s important for them to recognize that – and understand the impacts of missing out on that market. We’ve created new ways to allow them to interact with that market and liquidity, one being recent updates to Nasdaq’s Opening Cross. We’ve increased the access of opening auction information to institutional investors and also extended the time they have to interact with that information. This gives institutional investors more flexibility to access the high retail liquidity that’s available at the opening.
Please say more about M-ELO and how institutional investors can benefit from it.
On M-ELO, as I mentioned, you’ll only find like-minded investors and traders interested in longer-term strategies – such as those who are building or reducing a big position. These investors want to be patient to find that strong liquidity – and above all, again, they want to avoid market impact. M-ELO achieves both goals.
M-ELO attracts these compatible parties on both sides of a trade with a simple strategy: we make them wait at least 10 milliseconds before they interact with each other. That delay may seem short, but it discourages more aggressive investors and traders using sophisticated strategies to capitalize on short-term opportunities. On top of that, M-ELO only allows trading at the midpoint and there are no spread-crossing orders. So, again, this means you’ll never engage with an aggressive trader that, say, wants to come in and buy out the offer. At the same time, when the market does move, M-ELO moves with it to the new midpoint, thus providing users with the better new price.
To sum it up, institutional investors know they won’t find urgent traders on M-ELO. You know your counterparty is also being patient with their trading. So it offers you a unique pool of liquidity while also protecting you and creating a quality experience.
Generally speaking, what makes the liquidity unique on Nasdaq?
There are three important aspects of liquidity. The biggest one, obviously, is the sheer dollar volume traded. And if you look at the entire trading market, we’re the largest by far in that measure. Our total notional value is nearly $108 billion right now, with nearly 20% of the total, while the next biggest exchange is just over $61 billion with 11%.
Secondly, you need diversity in that liquidity. In the Nasdaq platform you’re not just trading against a market maker. Maybe you’re trading against an executing broker posting on behalf of a retail investor. Or against child orders of algorithms issued on behalf of large investors. Or against derivatives firms that need to hedge. With a diverse ecosystem, all parties can have a different viewpoint of the value that any trade holds – and there can be multiple winners.
The third aspect, as I touched on with M-ELO, is what I call the uniqueness of the liquidity. This ties into the diversity factor but it’s a little different. While traders utilize off-exchange venues to avoid interacting with certain types of liquidity, often times they can over-filter. M-ELO inherently segments based on behavior versus participant type, and thus only avoids trading with types of liquidity rather than participant types. The result is that you are able to mitigate market impact without missing out on liquidity.
The Regulation National Market System (Reg NMS) brought in sweeping changes to equity trading more than a decade ago. What new developments are impacting, or could shortly impact, institutional investors and how is Nasdaq helping them navigate these changes?
One of the things occurring is just the way volume and liquidity are shifting. As I mentioned earlier, there are more bespoke solutions targeted at the institutional investors, such as M-ELO and PureStream, and I expect to see more of these types of solutions. I wouldn’t be surprised to see the SEC approve more on-exchange mechanisms similar to what you see off-exchange, but these do take significant time to get through the regulatory process.
In addition, with the new Chair of the SEC laying out the agency’s priorities and focusing on competition for retail orders, we might see some regulatory movement around that. We are already finding new ways to bring institutions and individual investors together, such as our recent changes to the Opening Cross, and we want to provide more opportunity for institutional investors such as with our Retail Price Improvement program on BX where they can provide more attractive prices to retail than the National Best Bid and Offer (NBBO).
Are there any specific moves you’d like regulators to make that might even the playing field a bit?
Certainly, there are several and some are fairly small. For example, it’s important to markets for tick size increments to be aligned among execution venues; if the tick size is too big, which can be the case for lower priced stocks, that costs investors money and reduces price competition. Regulators should consider reducing the tick size for certain stocks where the price and liquidity dynamics are ripe for a smaller tick size. We’ve talked about this in the past and laid out a plan in our Intelligent Ticks paper to start the discussion.
Let’s turn to benchmarks. M-ELO’s quote stability measure has received a lot of attention...
Since we created the quote stability benchmark in 2018, everyone has copied it. It’s brilliant for its simplicity: it only measures market impact.
Before our benchmark, markouts was the primary metric that everyone focused on to gauge trade execution quality.. Where does the market go versus my trade price a millisecond after the trade? A second later? What does that curve look like? Is it negative or positive? Quote stability simplifies this by just giving the percentage of trades in which the NBBO midpoint did not change after the trade.
So rather than using markouts as the main estimator of the quality of trades for of M-ELO, we think the quote stability measure answers the core issue more directly: What was the trade’s impact on the market? Did the market move? Our theory is, if the quote has not moved in a full second after a trade, then we avoided creating market impact. It confirms that you’ve found liquidity with a like-minded counterparty And again, that’s valuable to institutional investors – all investors – especially in volatile times.
Of course, it never makes sense to look at one benchmark alone. We still look at markouts. But to me, quote stability is the benchmark that really defines M-ELO and its value. Most data we see shows M-ELO is the leader in achieving quote stability.
What innovations are coming next from Nasdaq?
We spoke earlier about the changes we made to our Opening Cross to give institutional investors greater access to morning retail liquidity. We’re also making changes at the end of the trading day; one new tool we’re especially excited about is the Extended Trading Close (ETC). We’re waiting for SEC approval for it. It will allow investors to trade at the closing price for five minutes after close, or until 4:05 pm. This will be valuable for institutional investors who say, “Okay, I’m comfortable trading at 10% of the closing price, but not 20%,” but after the auction they may be willing to trade more at the closing price. The ETC will give them another opportunity to find liquidity at the closing price.
This feature is building on changes we’ve already made to give investors more flexibility. For example, we recently changed our Closing Cross rules so that investors can get in an order between 3:50 and 3:55pm and get a guaranteed execution. There’s been great adoption of this and we’ve actually seen less volatility in the last five minutes.
The ETC will work as a compliment to the close for those participants who have more to do after the close. Just like M-ELO, this can occur on both sides of the trade. ETC can also serve as a stable execution mechanism for trading during the generally more volatile after hours continuous trading session.
In the coming months, we’ll also be debuting many improvements we’re making to streamline other existing tools and features. Honestly, there are many functionalities on Nasdaq – such as reserve, pegging, discretion, router, new auction functionality, and others – that investors should utilize more, and we’re making these upgrades to encourage that. And by the way, this includes M-ELO; we think the platform is still underutilized for the exceptional value and benefit it offers.
Did the pandemic influence any of the coming innovations?
Yes. The market stress we experienced in 2020 highlighted just how important it is to manage risk and ensure the market is resilient. So we are implementing a significant risk management system on top of the Nasdaq exchange. We’ll have more to say about that soon. We think it will protect the markets and streamline the workflow for brokers – and anything that accomplishes those two goals will benefit institutional investors.