Small Order Execution System
The Small Order Execution System (SOES) was an automated trading technology and market infrastructure system designed and operated by The Nasdaq Stock Market, Inc., under the oversight of the National Association of Securities Dealers (NASD) and the U.S. Securities and Exchange Commission (SEC). It provided immediate, automated execution of small orders in Nasdaq securities, primarily for retail investors, by matching incoming agency orders against the best bid or offer displayed in the quotation system. [1]
Background[edit]
The system launched in December 1984 to help order entry firms and market makers execute small retail customer orders efficiently and inexpensively. Initially, the facility was limited to 25 highly active Nasdaq National Market System securities, allowing agency orders of 500 shares or less to be automatically executed against participating market makers at the inside quote without manual negotiation. [2]
Following the October 1987 stock market crash, which exposed severe weaknesses in market access and liquidity provision, regulators mandated participation in the system for all market makers in Nasdaq National Market (NNM) securities. This policy shift guaranteed that small investors would have assured access to market makers during volatile conditions, transforming the facility from a specialized convenience tool into a central mechanism for enforcing firm quote obligations. [3]
Throughout the 1990s, the NASD and SEC implemented numerous rule changes to refine the system and curb professional day traders' use of it. In October 1991, regulators expanded the definition of professional trading accounts to restrict their access and granted market makers a 15-second window to update quotations following an execution. In January 1994, regulators reduced maximum order sizes from 1,000 to 500 shares, lowered exposure limits, and prohibited short sales through the facility. [4]
By the late 1990s, the rise of electronic trading and electronic communication networks (ECNs) prompted Nasdaq to develop more integrated execution platforms. On July 30, 2001, Nasdaq fully implemented the Nasdaq National Market Execution System (NNMS), commonly known as SuperSOES. This successor system permitted orders up to 999,999 shares and allowed proprietary trading, effectively replacing the original facility for NNM securities. The legacy system was subsequently relegated to handling only Nasdaq SmallCap Market securities, generating $26.1 million in revenue in 2001 before being phased out. [5]
Products & Services[edit]
The system functioned as an automatic execution facility that matched small agency orders with the best-priced market maker quotations visible in the quote montage. Member firms accessed it via Nasdaq Workstation II and the Computer-to-Computer Interface, which supported order routing, execution, trade reporting, and automated forwarding to clearing corporations for settlement. [6]
To manage order flow and market maker obligations, the facility utilized a tiered structure that classified securities based on trading characteristics. The tier sizes dictated the maximum order size eligible for automatic execution and the corresponding minimum quotation size required from market makers. [7]
The tier classifications implemented in 1998 included:
- Tier 1: Securities with an average daily non-block volume of at least 3,000 shares, bid prices at or below $100, and at least three market makers (1,000-share maximum order size).
- Tier 2: Securities with an average daily non-block volume of at least 1,000 shares, bid prices at or below $150, and at least two market makers (500-share maximum order size).
- Tier 3: Securities with an average daily non-block volume below 1,000 shares, bid prices up to $250, and at least two market makers (200-share maximum order size).
Risk Management[edit]
The system incorporated specific risk management mechanisms to protect market makers from excessive exposure to automatic executions. Exposure limits controlled the maximum cumulative share volume a market maker was obligated to trade at a given quotation before being allowed to update their price. In 1994, the SEC introduced an automated quotation update feature that allowed market makers to set an exposure limit equal to the maximum order size for a security; once exhausted, the system automatically updated their quotes to prevent consecutive executions at stale prices. [8]
Contoversies[edit]
The facility became the subject of intense regulatory and industry controversy due to its exploitation by professional day traders, widely known as "SOES bandits." Because participation was mandatory for market makers in major securities, these professional traders utilized proprietary software to systematically execute trades against stale or slow-moving quotes before market makers could manually adjust their prices. This activity undermined the system's original intent to serve retail investors and forced regulators to implement a series of restrictive rule changes throughout the 1990s to limit professional access and mitigate market maker liability. [9]
References[edit]
- ↑ SOES Regulatory Framework and Market Structure. Securities and Exchange Commission.
- ↑ Notice to Members: Introduction of the Small Order Execution System. FINRA.
- ↑ Securities Market Operations: The Effects of SOES on the Nasdaq Market. Government Accountability Office.
- ↑ Approval of Rule Changes to Curb SOES Abuse. Federal Register.
- ↑ Nasdaq Corporate Disclosures and SuperSOES Implementation. Nasdaq.
- ↑ Nasdaq Systems Description and Connectivity. FINRA.
- ↑ Periodic Reclassification of NNM Securities into SOES Tier Sizes. Federal Register.
- ↑ Amendments to SOES Exposure Limits and Quote Updates. Securities and Exchange Commission.
- ↑ Investigation into SOES Usage Patterns and Day Trading. Government Accountability Office.