Nasdaq trading under the scenes: market makers, ECNs, brokers. Who buys from and sells to whom?

Question

U. S. Securities and Exchange Commission (SEC) defines market maker as:

"A market maker is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. You'll most often hear about market makers in the context of the NASDAQ or other "over the counter" (OTC) markets [...] Market-makers generally must be ready to buy and sell at least 100 shares of a stock they make a market in. As a result, a large order from an investor may have to be filled by a number of market-makers at potentially different prices."

It looks like when a broker receives order from their clients, they might route an order to a market maker in the NASDAQ market (or to several of them if the have agreements with them?)

1. What makes me confused is the price quoted by market makers. To who exactly they quote ask/bid prices. Are those prices at which a market maker is willing to buy to / sell from other market makers (if market markets trade with each other) or the prices at which they would accept orders from their clients -- brokers?

2. What orders (for example, when deciding the price of the last order) are seen publically? The order between two market makers? If one market maker just matches two opposite orders (one broker buys x stocks at y price, the other sells x stocks at y price), will it be seen for NASDAQ? What if the broker does not route the order to market maker, but do the same matching/cancelling out procedure for its clients - individual traders?

3. ECNs seem to be another type on participants in NASDAQ. Who does ECN trade with? Brokers? Market Makers?

Answer 1

First, have a look at Market Microstructure in Practice (Laruelle et L) to have generic explanations about all this. In short:

• Equity markets are fragmented: it means to buy or sell shares, you connect (via a broker) to a server on which you send a message with a side (buy or sell), a max/min price and a quantity.
• these servers are technically matching engine: they check if they have a resting compatible message (selling/buying message with a lower/higher price than yours), they generate a transaction. NASDAQ, Nyse, BATS, etc (ie market operators) are running such servers. In the US, depending on the regulatory status they choose, they will be called an Exchange, an ATS, or an ECN. In Europe they will be called Regulated Markets or MTF.
• In the US the regulation demand the server you are connect to to check if there is a better price elsewhere (this is called the trade through rule) and have to route your message there in such a case. The market operator has to check the NBBO (national best bid and offer) to know if there is a better quote, compatible with your message, elsewhere. In Europe brokers are in charge of this re-routing task via their best execution policy.

In such a landscape, from the viewpoint of a market operator, the more resting orders you have, the largest market share you will have (ie the more transactions you will generate), because you take fees on trades you generate. That is why you make agreements with market makers so that they will post resting orders. Agreements can mean: pay less fees, have optional orders or special priority schemes (for instance about parity on the Nyse).

Note it means the broker does not choose that much with whom you trade. He can have agreements with other brokers to match your message inside the NBBO, but cannot worsen your price.

Answer 2

The status if a "market maker" is usually tied with an exchange. Like there are market makers on NASDAQ, NYSE, etc. As such they receive certain privileges from the exchanges for taking certain obligations to keep quotes on stocks on those exchanges.

So for the first two questions - they quote on the trading venues, their trades are reported on the venues and SIP, and there is no particular way to differentiate their activity from the rest of the market activity.

This is completely independent from the way a broker's routing is set up.

For the last question ECN doesn't trade by itself, it provides a place where participants' orders are matched.