The Azx: A Desert Trading Post

Out in Arizona, a computer may make stock pricing fairer

For seven years, Steve Wunsch has struggled to launch his innovative electronic auction system, the Arizona Stock Exchange, into the big time. And for seven years, Wunsch has watched his enterprise flounder as trading volume failed to materialize. But while the AZX's long-range goal of handling as much as 30% of all U.S. trading volume seems wildly optimistic, his venture may finally be gaining steam.

In recent years, the AZX, which is run from a Sun Microsystems Inc. server in Phoenix, has traded a paltry 200,000 or so shares a day for its institutional clientele--well below the 750,000 that Wunsch says he needs to break even. The problem, he says, has been Securities & Exchange Commission rules limiting the AZX to a single auction at 5 p.m. Eastern time, when most traders have packed up for the day. But the SEC has changed its stance, and at the end of April, Wunsch will launch a 9:15 a.m. auction in the 15 most actively traded NASDAQ stocks. Within a few months, he plans to trade in all the 4,147 stocks on the NASDAQ National Market. NASDAQ has become an unlikely ally, planning to build computer links to the AZX and then using Wunsch's system to officially open trading for all NASDAQ national stocks later in 1997. With a daytime auction, Wunsch figures that he could easily quadruple volume in a year.

BIG MEET. What does the AZX offer traders that other systems don't? Its auction is designed to bring together as many buyers and sellers as possible at a predetermined point in time. Then, based on the orders in the system, it sets a stock's price at the level that will execute the maximum amount of shares. There is no middleman to take a spread between a bid and ask price.

This "single-price" system contrasts with continuous auctions such as the New York Stock Exchange or Instinet, where traders can place orders throughout the day but may not find any takers immediately and so may reveal their hand to the market. And unlike popular crossing systems such as ITG's Posit System or Instinet's Crossing Network, which also bring traders together at fixed times, Wunsch's system sets its own pricing, rather than executing trades at NYSE or NASDAQ closing prices. "Nobody else offers a true auction that can set pricing that is independent of a major exchange," says Wunsch.

Here's how it works: Any time in the hour before AZX's computers run an auction, traders can log into the AZX auction books, click on an equity, and put their order up on the screen. Buyers post the size of their order and the maximum price they're willing to pay, and sellers post their minimum sale price and trade size. For total anonymity, traders can post orders to a special "book" of undisplayed orders, but they pay a commission cost of 1 cents per share, instead of as little as 1/2 cents for displayed orders. After an hour, the computer aggregates the orders and selects the one price for each equity that will maximize the number of shares traded (table). In practice, however, this hasn't worked. Instead of trying to discover new prices, traders have used the AZX like a crossing system, putting in trades at NYSE or NASDAQ closing prices.

Wunsch hopes his morning auction will attract greater volume from more active traders. Since the AZX is designed to bring a large number of buyers and sellers together at one time, traders should be able to place large orders without causing a swing in an equity's price. Therefore the exchange has the potential to set prices that are more reflective of supply and demand in the market. The key, however, is attracting volume. "It's a great concept that has never worked in practice," says Christopher Keith, a founder of the Chicago Stock Exchange's failed electronic trading system, Chicago Match, and now the president of Global Trade Inc., a financial software and product-development firm.

"CLEAN OPENING." That doesn't faze Wunsch, whose single-mindedness is legendary. After college, Wunsch spent 10 years as a full-time rock-climber before heading to Manhattan to trade interest-rate futures. Before long, Wunsch was helping develop the market in stock index futures at Kidder, Peabody & Co. After failing to interest Kidder in his idea for a new stock-trading system, Wunsch looked farther afield, and in 1991, linked up with the state of Arizona, which was eager to promote itself as a budding financial market. In return for naming his venture the Arizona Stock Exchange and shipping his computer to Phoenix, Arizona gave Wunsch a $2 million loan.

Attracting the backing of NASDAQ is a major coup for Wunsch. NASDAQ's motivation for adopting the AZX system is, in part, an attempt to mute investor criticism of its own system. NASDAQ has no official opening--that is, no set opening price for each stock. Dealers simply begin the day by posting different quotes, and the first trade to hit the ticker becomes the opening price, often creating a frenzy of volatility. NASDAQ dealers, who make a spread on each trade, can take advantage of temporary inefficiencies in pricing by trading for their own accounts. That frustrates traders.

NASDAQ's opening "is chaos," says Harold S. Bradley, director of equity trading at American Century Funds. "The volatility undermines any confidence that pricing is fair and objective. It is very risky to place any orders."

Wunsch's morning auction would get rid of that excess volatility at the start of the day by computer selection of the opening price that matches supply and demand. With that benchmark set, traders could then begin the day with less fear of being hurt by swings in stock prices. "We think Wunsch's single-price auction could be a dramatic tool to make a very clean opening for our market," says NASDAQ chief economist Dean Furbush. AZX's software is being integrated into the network of workstations that make up the NASDAQ National Market, which would give all NASDAQ investors access to the system. That could cut into some profitable trades for NASDAQ market-makers. But the more stable opening prices and lower trading costs should bring increased volume. Wunsch's hope is to eventually have three daily call auctions.

To beef up volume, Wunsch plans to display his auction in real time on the AZX Web site this spring. He hopes that will spur retail investors to place orders on AZX through online brokers. He is also building links with other alternative trading systems, such as Posit. The AZX will also be accessible over Bloomberg's new Tradebook system in the spring.

Wunsch's success is far from assured. The AZX wouldn't be the first alternative trading system to fail: In the last decade, only three of the approximately 20 electronic trading systems launched have been successful. But Wunsch remains optimistic: "The stars are coming into alignment," he says. "It is the right place in time to make this work."

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