Thinking Out Loud: Michael Edleson
All the difficulties Nasdaq has faced recently—a weak market, competitors and regulators—have only made the exchange more vibrant, flexible and focused on the importance of technology as an antidote to uniquely 21st-century problems, argues Michael Edleson, Nasdaq's chief economist. CIO Insight recently chatted with Edleson about his view of the new stock market.
CIO Insight: Nasdaq's agent-based model predicted, mostly accurately, that true pricing of stocks could suffer after decimalization and that Nasdaq would likely lose business to over-the-counter competitors. What has Nasdaq done to weather these changes?
Edleson: We've let technology level the playing field. We've realized that you can't stand in the way of new market-moving forces. So we've opened our architecture by giving market makers easy access to our market with whatever equipment and software they're using. There are any number of weird computer-generated strategies that our customers are trying and this is bringing quality and liquidity into the Nasdaq market. I visited a "robot trader" not long ago, a market maker who was trading 82 different stocks via computer on Nasdaq. A human can trade only about 30. But he had an expert system that handled all of his routine trades and alerted him when a stock or transaction needed attention. The less technologically prepared won't survive this ice age. It's economic and technological Darwinism.
How has this emphasis on technology improved price discovery—the idea that a stock price should equal its true value—which BiosGroup's model predicted would be another victim of decimalization?
Despite the naysayers and people who want to put the genie back in the bottle, price discovery has improved substantially recently. If you have tiny one-cent increments in the spread, then everybody must have the same tools—or at least the opportunity to develop the same tools—to compete with each other fairly for buying and selling. Electronic and fast execution really matters when the spreads are thin. And we've speeded up trade execution—our SuperMontage system can do an auto-trade in one tenth of a second now. The faster the trades in an open transparent market, the less likelihood that noise enters into it, and hopefully prices reflect real value. So we're dealing with this fast-moving environment not by trying to slow it down, but by trying to make the tools to keep up.
The number of market makers has dropped significantly recently; it appears that decimalization and the recent bear market have cut into their earnings and made it more difficult to stay in business. What's Nasdaq response to that?
There's a technology spin to that as well. As in any industry, consolidation can be a good thing: It brings efficiencies, and the winners are low-cost producers that are helping push the market to become more technologically oriented. We now have 300 market makers, about half of what we used to have, but because of new technologies—like the robot traders I mentioned before and the smart algorithms that companies are building into their trading systems—these fewer firms are competing for more stocks and more positions than ever before. Some of them are even trying to cut the penny spread further by direct trades with other traders or other strategies. Those that are prepared with the best technology will be ready to earn a lot of money as the market recovers, and by opening up our architecture, Nasdaq hopefully will have a large piece of the pie.
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