BBX has been cancelled, hence................
The Rise of the Pink
Traders Magazine June 2003
Nasdaq is making more room for one big fish in a small pond.
The OTC is turning pink. That's because the Pink Sheets may soon become the dominant trading venue in the over the counter market for stocks that do not trade on Nasdaq. And it's all because Nasdaq is planning to dramatically reduce its support for these OTC securities.
Under Nasdaq's plan, the OTCBB will disappear. That will leave the Pink Sheets in control of most of the 7,000 OTC securities bought and sold "over the counter."
Right now, the over-the-counter market is split between two trading venues -- Nasdaq's OTCBB and the Pink Sheets. But next January, Nasdaq will launch a new market called BBX, which stands for Bulletin Board Market. The BBX will list the strongest companies on the OTCBB. Six months later Nasdaq plans to terminate the OTCBB.
The proposal is still pending approval by the Securities and Exchange Commission. But if it gets the green light, no more than 700 of the 3,200 OTCBB securities are expected to qualify for a listing on the BBX. The rest will shift to the Pink Sheets, a venue, which like the OTCBB, has many risky securities.
Some 7,000 securities are traded in the over-the-counter market. OTCBB quotes 3,200 of them. Pink Sheets quotes 3,900 exclusively. Pink Sheets could pick up another 2,500 to 3,000 if Nasdaq's proposal is approved. The BBX listing fees and stringent corporate governance standards will likely prevent the vast majority of OTCBB companies from making the cut.
The upheaval reflects both the disdain Nasdaq has for its often scandal-plagued sister market and the dramatic transformation of Pink Sheets -- from a sleepy publishing company into a modern day electronic trading facility.
The Pink Sheets makes most of its money selling market data and charging market makers "position" fees for each security traded. It is eager to get its hands on 3,000 more securities.
"We would love to have them," said Cromwell Coulson, chief executive of Pink Sheets. "Our goal is to provide a competitive, transparent and efficient medium for market makers to make markets and brokers to transact in these securities." If Nasdaq's BBX proposal is approved and thousands of OTCBB securities fail to make the cut, the event will mark Pink Sheets' second major windfall in four years.
Between 1999 and 2000, OTCBB de-listed about 3,000 of its then 6,500-name roster. The companies were unable or unwilling to meet new requirements to file reports with the SEC.
At that time, the mass de-listing caused the number of securities quoted on the Pink Sheets' then-new Electronic Quotation Service (EQS) to surge from about 1,000 to 4,000.
Had the EQS not existed, it is questionable whether the SEC would have allowed Nasdaq to de-list 3,000 companies. Prior to 1999, the Pink Sheets was just a pink-colored printout of securities prices and market maker telephone numbers that was distributed to dealers. This relative lack of transparency in over-the-counter prices is what led the SEC to pressure Nasdaq to establish an electronic quotation service. The OTCBB was launched in 1990.
The EQS is popular with traders and Pink Sheets quote data is carried by Nasdaq's Level 1 feed and the major market data vendors. Pink Sheets prices have achieved widespread visibility.
So, transparency is no longer an issue, but the picture today is still more complex than it was four years ago. A listed market with higher corporate governance standards is a much bigger leap for companies than merely requiring them to file with the SEC, observers note. The SEC might be reluctant to approve another mass de-listing.
The BBX is far from a done deal. Nasdaq and the SEC have been going back and forth on the BBX issue for nearly two years. Nasdaq originally filed for its rule change in October 2001. The SEC has yet to publish the proposal in the Federal Register.
Publication in the Register would signal the SEC is reasonably satisfied with the proposal and ready to listen to public comments.
Although there appears to be little organized resistance to the creation of BBX, there is some grumbling. Market makers object to certain aspects of the BBX. Others say the Pink Sheets is an inadequate venue for the cast-offs.
Nick Ponzio, chief executive of Hill Thompson Magid, one of the largest OTC dealers, is strongly opposed to BBX as currently envisaged. "I am disappointed Nasdaq has not created something the market makers can participate in," he said. "I've been trading Nasdaq my entire career, so I am disappointed their product is something that may not work."
Specifically, Ponzio's complaint is about spreads. He says the BBX would eliminate the ability of a market maker to commit capital because of the rules that govern spreads. Because many OTCBB names trade only sporadically, spreads need to be wider than on Nasdaq stocks, for instance. Otherwise, dealers won't take on potentially money-losing positions.
"If I buy 20,000 shares of Apple, I can usually get rid of them fairly quickly at a price not much different than at what I bought them," he said. "That's not true with the majority of stocks in the OTCBB."
Gregg Dudzinski, who is in charge of trading at wholesaler Wm. V. Frankel, says his firm is not opposed to the BBX. But he's worried its introduction could lead to the same type of problems besetting the Nasdaq market in the SuperMontage era.
The BBX would likely usher in the ADF and ECNs, causing the market to fragment and lead to the scourge of locked and crossed markets, Dudzinski says.
Markets are said to lock when the best bid equals the best ask, and to cross when the bid exceeds the ask. "We're not saying BBX is a bad idea and shouldn't be done," Dudzinski said, "but we have a certain trepidation about the unintended consequences that could come of it."
Dealers also question Nasdaq's decision to implement SuperMontage as the BBX's central trading mechanism [see Traders Magazine, April 2003].
As for the Pink Sheets, dealers generally laud the venue as an efficient trading medium. They praise the real-time nature of EQS and the speed engendered by the recently launched Pink Link order delivery system.
But some worry that liquidity could dry up in some stocks. Brokers and investors may shun some of the stocks that fall to the Pinks if they perceive their quality as inferior to stocks on the OTCBB. "Without a doubt it's a concern," said one trader who did not wish to be identified. "I hope that doesn't happen, but I don't doubt it probably will. You will definitely see a little reduction in liquidity."
Andrew Berger, the publisher of Walker's Manual of Unlisted Stocks and a microcap investor himself, agrees. He says the perception of the quality of Pink Sheets securities causes investors to sell off even sound OTCBB stocks when they drop to the Pinks. "Frequently, when something goes Pink, voluntarily, as opposed to being de-listed, the stock price will take a big hit."
Dealers and others also fret over the impact on the future capital raising abilities of the thousands of companies that could drop to the Pinks. The cost to raise capital may increase, or the companies may not be able raise capital at all. Once again, some investors and bankers may shun the stocks because of a perception of lower quality. "This change will force the little guy even further down the chain," said Dudzinski. "This will have a tremendously negative impact on the capital formation process for small companies."
One trader who left the industry a few years ago, but trades for his own account, wrote in an e-mail: "I have seen the destruction that Nasdaq has caused these companies. Not only do shareholders lose out but so do employees when these companies are forced to go to the Pinks or back to being private due to lack of capital raising abilities."
Aura of Respect
Pink Sheets maintains the quality of its companies is little different as those on the OTCBB. Companies quoted in the OTCBB, Pink Sheets execs say, have always been cloaked in an aura of unwarranted respectability due to the association with Nasdaq.
"Investors get misled by OTCBB's relationship with Nasdaq and the NASD," said Coulson. "That's why the Pink Sheets are different. Our brand name represents opportunity and risk."
Investors know what they are getting into with the Pink Sheets, according to Coulson. They may not with OTCBB issues. That OTCBB-quoted companies must file reports with the SEC is "not a high hurdle," Coulson said. "The number of suspensions by the SEC is pretty evenly divided between Pink Sheets and OTCBB securities." The SEC will suspend a company's stock from trading for ten days for various reasons.
For Mark Borelli, a former enforcement official at the SEC, the issue is less about the reputation of the securities quoted in the Pink Sheets than the regulatory oversight of the quoters.
Borelli, now an attorney with Shevsky & Froelich in Chicago, maintains surveillance is more aggressive in the OTCBB because the venue is operated by Nasdaq, an SRO, or self-regulatory organization. Pink Sheets is not an SRO. It is a non-exclusive SIP, or securities information processor, under securities law. It possesses no regulatory functions.
Borelli is opposed to a mass dumping of securities onto the Pinks and contends that Nasdaq or the NASD, have an obligation to continue to provide a venue for securities not listable on BBX. "Is an exchange a for-profit enterprise run for the benefit of its owners or is it a public trust?" he asked. "That's the bigger issue."
Nasdaq is clearly acting as a for-profit entity, Borelli says. OTCBB is neither good for Nasdaq's reputation nor profitable. By retaining only those OTCBB companies that can afford to pay listing fees it can turn a subsidized venture into a profit-making one. "If Nasdaq is a public trust then maybe the fees from the other companies should be used to subsidize this market," the former regulator said, "instead of abandoning this market just because it is not profitable." The OTCBB is a better marketplace because it is regulated more closely, according to Borelli. "That is key," he said. "If a market develops to replace OTCBB where at least the trading is regulated, then investors will be better off."
Pink Sheets does not regulate. But market makers quoting in the Pinks must obey the same rules as those quoting in the OTCBB. For example, they both have 90 seconds within which to report trades; must maintain firm quotes; and must file Form 211s to sponsor a security.
In theory the NASD is watching. Yet the regulator didn't win SEC approval to monitor EQS quotes until March. For the past four years, it has had a fuzzy arrangement with the Pink Sheets to receive EQS data. "It shouldn't be fuzzy," said Borelli. "It should be clear. There is a vacuum that needs to be filled. Because of concerns over manipulation there needs to be a market for these orphan stocks where the trading is regulated."
Two names are mentioned as possible candidates to fill any perceived void between BBX and the Pink Sheets. One is ArcaBB, an alternative trading system formerly known as GlobeNet. ArcaBB is owned by Archipelago which runs the ArcaEx stock exchange in conjunction with the regulators of the Pacific Exchange. The other is the ADF, a quotation system run by the NASD in competition with SuperMontage for the quoting of Nasdaq stocks.
Under its previous ownership, ArcaBB did not make much headway in the trading of OTCBB names. It functions in similar fashion to an ECN on Nasdaq, but with considerably less success than such ECNs as Island or Instinet. In a recent month, it traded only a small fraction of OTCBB volume, according to the OTCBB website. But as part of Archipelago, one of the three largest ECNs, it could potentially tap into large sources of order flow.
The ATS has no immediate plans to build a marketplace based on dealer sponsorship of quoted companies, but is seeking to boost its liquidity in OTCBB names. "We want to capture market share before Nasdaq has a chance to de-list a significant portion of the OTCBB," said Tom Wilkerson, an ArcaBB exec. "We want to trade them all. We want to give the OTCBB stocks representation."
Still, Wilkerson says he gets calls from market makers interested in filing their Form 211s with ArcaBB rather than Nasdaq. In order to sponsor a company for trading in the over-the-counter market, a dealer files a Form 211 with either OTCBB or the Pink Sheets.
Wilkerson says that, given Archipelago's exchange status, ArcaBB has "a little more leverage on the Street" than its competitors. "We can do some things the other ECNs cannot," he said. ArcaBB's only competitor among the ECNs in the over-the-counter market is Track ECN.
"If the BBX forces us into our own corner and market makers don't want to participate in BBX," he added, "what is to stop Archipelago, because of its status, from creating its own marketplace?"
Carrying the torch for the ADF is Nick Niehoff, an ex-Nasdaq executive who launched the OTCBB in 1990 and is now under contract to Track. Niehoff is running a grassroots campaign to convince the powers-that-be in Washington that the ADF should broadcast quotes in OTCBB as well as Nasdaq names. The ADF was mandated by the SEC as an alternative to Nasdaq's SuperMontage. It has become the primary quote outlet for the giant ECN Instinet. Like the OTCBB and the EQS, the ADF is simply an inter-dealer quote service, albeit one associated with an SRO. For Niehoff, the ADF is a better venue than the Pink Sheets for the thousands of potential OTCBB orphans because of the quality of the existing Pink Sheets companies. "Most Pink Sheets companies aren't SEC-reporting," Niehoff said. "It's a quality of market issue."
Niehoff wants to see quoting and trading in any orphan stocks done in association with an SRO. His campaign involves writing letters to the NASD, promoting his plan to regional stockbrokers and working with the Security Traders Association.
Mark Madoff, co-head of the STA's primary Trading Committee, acknowledges the committee is in the process of setting up a sub-committee to evaluate the issues surrounding BBX.
Despite the opposition, Pink Sheets is pushing ahead with plans to make it easier for market makers to quote OTCBB securities in the Pinks. Right now most OTCBB securities, but not all, can be quoted in the Pinks as well as the OTCBB. Coulson says only about 860 of the 3,200 OTCBB are not eligible for dual quoting. He expects that number to drop to 600 soon.
Two of the largest over-the-counter dealers, Knight Trading Group and Schwab Capital Markets, are in the process of qualifying all their OTCBB names in the Pinks in advance of the BBX. Ponzio of Hill Thompson says his firm has always dually quoted a large number of its stocks.
Dealers which dually quote OTCBB names do so for any of three reasons: to advertise their interest more widely; to protect themselves in case a stock is de-listed from the OTCBB; and to use Pink Link. Generally, they do not quote prices and sizes in the EQS, but just their market maker IDs.
"Dual-listing is starting to take off," said Coulson. "Schwab, Hill Thompson, Knight, Monroe and Carr are dually quoting everything they can."