Securities Market Operations:

The Effects of SOES on the Nasdaq Market

GGD-98-194: Published: Aug 31, 1998. Publicly Released: Aug 31, 1998.

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Thomas J. McCool
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Pursuant to a congressional request, GAO provided information on the Small Order Execution System (SOES) and its effects on the Nasdaq Stock Market, focusing on the: (1) extent to which SOES is being used for its intended purpose; (2) effects of SOES on the marketplace; (3) results of attempts to limit trading on SOES or replace SOES; and (4) effects of recent market developments and proposals affecting SOES.

GAO noted that: (1) the National Association of Securities Dealers (NASD) developed SOES to provide automatic access to the Nasdaq Market and market makers for the securities orders of small, retail investors; (2) however, 1995 NASD data show that the primary users of SOES are SOES day trading firms; (3) these firms generally have provided access to SOES and proprietary computer software to assist the trading of day traders; (4) market makers told GAO that many retail investors' orders are being filled by market makers using their own internal automated systems, at prices that are to match the best Nasdaq prices; (5) the day traders have used a trading advantage provided by the automatic execution feature of SOES, proprietary software the SOES day trading firms designed to benefit from this feature, and Nasdaq rules that limited market maker access to SOES, to profit at the expense of market makers and their customers; (6) this advantage has diminished over time because of market maker software improvements and changes in trading rules; (7) market makers and SOES day trading firm officials disagree about the effects of SOES day trading on the market; (8) NASD has proposed various rule changes to reduce or eliminate the advantage of SOES day traders; (9) however, a court decision in favor of a SOES day trader strengthened the position of the SOES day trading firms and their day traders; (10) Securities and Exchange Commission (SEC) officials told GAO that they had become more skeptical of NASD rule proposals to change SOES, and that NASD had failed in two attempts to eliminate SOES' automatic execution feature in favor of systems that attempted to limit the availability of automatic executions exclusively to smaller investors and that routed orders to market makers for execution; (11) despite NASD's lack of success in controlling SOES traders through rule changes, the volume of SOES trading as a percentage of total Nasdaq share volume has been declining; (12) to make automatic trade executions more widely available, Nasdaq has proposed an Integrated Order Delivery and Execution System that would replace two existing systems, including SOES, and provide an integrated order routing and execution system and a voluntary limit order file, in which customer orders at specified prices could be matched and executed; and (13) Nasdaq officials told GAO that this system is intended to eliminate the unintended double liability incurred by market makers as a result of SOES day trading, without unduly benefiting market makers.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: In January 2001, SEC approved a new trading system, SuperMontage, which will eventually replace Nasdaq's current SuperSOES and SelectNet services with two new processes: a directed order process and a non-directed order process. In the interim, NASD phased-in SuperSOES, which accepts orders up to 999,999 shares at a time.

    Recommendation: The Chairman, SEC, should ensure that any trading system approved to replace the current Nasdaq trading systems be designed to correct the trading advantage available to SOES day traders and provide for the immediate, automatic execution of investors' small orders at the best possible prices.

    Agency Affected: United States Securities and Exchange Commission

  2. Status: Closed - Implemented

    Comments: SuperSOES, which replaces SOES, was implemented in July 2001.

    Recommendation: The Chairman, SEC, should require Nasdaq to provide adequate data analysis to support aspects of the system that may affect market efficiency and discipline.

    Agency Affected: United States Securities and Exchange Commission


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