Hoping to increase the transparency and execution quality of a marketplace long shrouded in controversy and scandal, the Securities and Exchange Commission (SEC) implemented several new rules in the over-the-counter equity market known as Nasdaq. Although the changes have been in the works for several years, last year's Justice Department price-fixing case against 24 major Nasdaq market makers pushed the SEC to act this January. Apparently unrepentant about the disrepute surrounding their market, leading firms are already grumbling about the new rules.
Some dealers dislike the rules, the costs of the technology and training involved in implementing them, and they predict a far different future for their business. "It changes the structure of the marketplace," says John Herzog, chairman and CEO of Herzog, Heine, Geduld, the biggest single Nasdaq market maker, who believes there will be a retreat and consolidation of Nasdaq traders, and eventually a movement to charge fees. The firm makes markets in 4,500 of the Nasdaq's 6,000 stocks and has already spent between $3 million and $4 million to upgrade its technology to accommodate the new order-handling rules. Herzog argues that the SEC is trying to turn a negotiated market into an auction one, more similar to the specialist system at the New York Stock Exchange. Nasdaq dealers will now need more capital to bolster the increased risk-taking that is likely to occur as a result of the changes.
The new rules force market makers to disclose whether a customer is willing to buy or sell Nasdaq stocks at prices better than the prevailing market quote, via what are known as limit orders, and to tell how many shares he is offering for sale. It also makes Nasdaq dealers acknowledge whether there are better prices on private trading systems, such as Instinet, than they are quoting publicly. In the past, dealers profited handsomely by withholding such information, which allowed them to fill orders for customers by buying stock at lower prices, or, conversely, to sell it for a higher price. Initially, the SEC only subjected the biggest 50 Nasdaq stocks to the trading rules, but by the end of February 100 more stocks were added to the list. Given the huge technological changes required to handle the new rules, the SEC has slowed down the roll-out of the program. But eventually, it plans for all of Nasdaq's stocks to be affected.
Proponents of the new rules believe they will encourage more confidence in Nasdaq, which is becoming a more important part of the US securities markets. Nasdaq has become a more popular trading venue in recent years and is home to some big technology stocks that have propelled the bull market. Critics have long argued that spreads were exceedingly wide in the market, and that view has been bolstered by academic studies.
With the Nasdaq market less profitable for dealers, Herzog thinks that the big brokerages will no longer make markets in Nasdaq stocks unless they have a compelling investment banking reason to do so. That may be a positive development. "The day when firms traded laundry lists of securities without necessarily being in touch with those securities as investment bankers, or with a research interest, is coming to an end," says a competitor.
Herzog thinks the price structure is bound to change, which should worry investors. "The public is going to pay at some point," he says, suggesting that "we may want to take the lead on charging fees." Dealers say the new rules will squeeze trading profit margins in what was formerly a lucrative area for all Nasdaq market makers, including the big names such as Merrill Lynch, Smith Barney, Goldman Sachs, Bear Stearns and Morgan Stanley. While brokerages charged their customers fees for handling trades, they also benefited from the huge spreads in their trading rooms. One brokerage executive says that, until now, Nasdaq trading revenues often accounted for half the profits in some big firms' equity departments.
While a number of regulatory changes in recent years have sought to reduce spreads, the recent rules are considered the most sweeping. According to Nasdaq's analysis of trading activity, the week after the changes were implemented spreads had already narrowed by 30%, while volatility, liquidity and depth of the market remained the same.
Nasdaq orders are split between market and limit orders. Market orders are those for stocks bought or sold at the prevailing market price, while limit orders contain a specific bid. Most firms' business is a mix of the two. But with the greater disclosure mandated for limit orders, many traders believe that portion of the business will grow as it becomes more attractive to customers. Not surprisingly, some of the biggest complaints are with the new rules on limit orders. "That portion of the business we will now be forced to do at a guaranteed loss," says Herzog. His firm was one of the 24 the justice department accused of manipulating prices by such practices as implicit agreements to keep spreads between buy and sell prices too wide. Defendants claimed the justice department had no evidence, only "inferences." A settlement with the firms in July, which resulted in light fines, is being challenged by attorneys for investors. Such big institutions as Merrill, Goldman and Morgan Stanley were also defendants.
Other traders say that while limit orders will cost more to handle, they are not necessarily unprofitable. "If a customer gives me an order for a stock that is quoted at 20 bid to 20-and-a-quarter offer, and gives me an eighth bid," explains one market maker, "I would be forced to post that, making my quote 20 and an eighth bid. That now becomes available for the world to hit." In the past, the market maker didn't have to reveal his customer's order. He could buy the stock at 20, fill the order, and profit on the spread. Now, not only does the customer's offer become the dealer's quote, but the Instinet quote - which may be a better price - in most cases also automatically becomes the market quote too. Both changes narrow spreads.