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Nasdaq disconnects ECNs
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October 6, 1999: 2:48 p.m. ET
Software update causes problems, shuts down links to 3 electronic systems
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NEW YORK (CNNfn) - The Nasdaq stock market encountered a problem Wednesday morning while updating software that resulted in three electronic communications networks, or ECNs, being temporarily kicked off its system.
"We have experienced a system problem this morning related to a software change to accommodate the extension of our trade reporting and quotation system," Nasdaq spokesman Scott Peterson confirmed around 1 p.m. ET. He attributed the software failure to the extension of functions such as SelectNet that Nasdaq announced in August.
"Three market participants are down at the moment," Peterson said around 1 p.m., though all three reported they were reconnected around that time. "As a result they are not able to generate quotations over our network. The market is open and operating otherwise."
ECNs, computerized quasi-exchanges that let buyers and sellers of stock meet without going through middlemen such as Nasdaq market makers, account for around 30 percent of the volume on Nasdaq. During the day they normally operate through Nasdaq. They operate independently after-hours, though almost all have committed to linking their extended-hours trading, which they all now offer.
Nasdaq's software failure affected the two largest ECNs, Instinet and Island, which were effectively disconnected from Nasdaq and operated as independent exchanges for the morning, as they now do during after-hours operations.
Brut -- an ECN that is partly owned by Merrill Lynch, Goldman Sachs, Morgan Stanley Dean Witter and the Knight/Trimark Group -- voluntarily disconnected from Nasdaq when it noticed problems with Nasdaq's SelectNet system.
"It was a catastrophic failure," Island President Matt Andresen said. The problem began when Nasdaq started updating software Tuesday night, he said. When trading opened Wednesday, price quotes from his ECN were not displayed to other market participants for all of the morning and up until Nasdaq linked back to Island at 12:45 p.m. ET.
Though Nasdaq attributed the software problem to extending its quotation and trade reporting systems, Andresen said he understood the problem stemmed from the stock market's attempt to integrate Optimark into Nasdaq. OptiMark is a computerized trading system that, unlike ECNs, is to operate as part of the Nasdaq market rather than through it.
The ECNs kept operating and each said they had been reconnected to Nasdaq just before or after 1 p.m. While they were operating independently, only customers with direct links to them could participate in trading on the ECNs.
Nasdaq market makers and the other ECNs would not have been able to see quotes on those three ECNs, meaning customers were not guaranteed the best prices on their stock trades. Market participants also were not able to execute trades through them using Nasdaq's SelectNet system, which links trading among the different computerized trading platforms.
Andresen fumed that the choice to disconnect the two largest ECNs was arbitrary. "They didn't shut down any smaller ECNs," he said, and conventional Nasdaq participants such as the biggest market maker companies, like the Knight/Trimark Group and Mayer & Schweitzer, owned by Charles Schwab, were equally unaffected.
"Nasdaq made an arbitrary decision to penalize some of the market participants based on size, but not just based on size," he said. "It's like you have a traffic jam, and you went out with a big magnet and started picking up cars and dumping them in the East River."
By not sharing price information, the ECNs violated Securities and Exchange Commission rules on price disclosure during regular trading, Andresen said. That meant there were fragmented stock markets with different pools of trading, a situation that SEC Chairman Arthur Levitt frequently has said he wants to avoid.
"This was fragmented volume," Andresen said. "You're talking about a situation this morning that was an absolute catastrophic failure, and just about as bad a situation as you can have." Andresen said he would likely take the issue up with the SEC's division of market regulation.
"What is Nasdaq? Nasdaq is a list of different prices from different places. Our prices were no longer reflected," he said.
Still, trading on Island was fairly typical of its average 120 million share volume, Andresen said, and he expected volume close to that. He added that around 79 percent of Island's trades are executed internally, while only 21 percent use SelectNet to link an Island bid or ask with another market maker or ECN.
An Instinet spokesman confirmed it traded separate from Nasdaq for the morning and was reconnected sometime before 1:15 p.m. "Nasdaq had a systems glitch," Terry Mulry said. "Nasdaq had a problem." He said the problem did not really involve Instinet and referred all other questions to Nasdaq.
Mulry said he didn't know what Instinet's volume was today or whether it had been affected. Instinet averages trading volume of around 170 million shares a day.
Brut noticed problems for trades using SelectNet as soon as it opened this morning. Trades were crossing with six minute delays and the problem magnified until some trades took as long as 10 minutes to execute through SelectNet, which lets a participant on Brut execute a trade on another ECN or with a market maker that has a better price, and vice versa.
"We limped along a little while to see if it would correct itself. It didn't," said Brut's head executive, Brian Hyndman. At 9:57 a.m. ET, Brut voluntarily pulled its trading from Nasdaq. It reconnected at 1:05 p.m. On a normal day, Brut currently sees trading volume of 28 to 30 million shares.
The problem with Nasdaq's software update compounds already-frequent complaints that SelectNet is slower and more inefficient in processing trades than it should be. Hyndman said he had written several letters to that effect both to the SEC and Nasdaq without a response.
"We're going to have to get our lawyers involved and see if we can push this and get this resolved," he said, explaining that the lawyers would first make inquiries and look for discussion with Nasdaq rather than immediately filing suit.
An SEC spokesman was unaware of the situation early Wednesday afternoon and not able to comment on whether the events would require SEC action or how the commission might act.
John Schaible is president of NexTrade, one of the smallest ECNs, which recently and belatedly signed the agreement for ECNs to link their after-hours trading. Schaible pointed out that his ECN stayed open for business via Nasdaq throughout. He expected normal volume of a little over 1 million shares. Instinet and Island probably overloaded the new system, he said.
"I'm not surprised they're having certain difficulty," he said. "The volume of Instinet and Island is very profound. The burden of their trading is probably too great for them to link into Nasdaq" while the software update went ahead.
Nasdaq should do a better job making sure this and future updates supports all market participants, he said. "They really need to be careful when they roll it out."
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