COLUMN ONE : Taking Stock of Nasdaq : A number of the huge marketplace’s controversial practices are hurting the small investor. System officials maintain that it is providing fair, competitive trading to all.

As the morning sun lifts above the hills east of this town near the Hudson River, Harvey Houtkin, principal and chief executive officer of tiny Domestic Securities Inc., sits before a Nasdaq trading terminal, steeling himself to do the unthinkable.

Houtkin taps a few buttons on a keyboard linked to the central computer for over-the-counter stock trading. “What I’m doing now is the most unacceptable thing you can do in the market,” he says.

Indeed, Houtkin--a “market maker” whose business is buying and selling Nasdaq stocks at publicly quoted prices--is about to send traders at vastly larger firms into fits of rage.

Seeking to attract a small portion of the more than 66 billion shares traded annually on Nasdaq, he is about to deliberately narrow the spreads--essentially the market makers’ profit margin--on some of the most widely traded over-the-counter stocks.

The move will save investors money. But it also will cut into the hefty profits of more established Nasdaq dealers.

He punches in the symbol for Intel Corp., the computer chip maker that is Nasdaq’s second-largest company. Houtkin, with 1,000 shares to sell, changes his posted prices. He cuts the “spread”--the gap between the best price at which any dealer will buy the stock and the price at which he will sell it--from a quarter of a point, or 25 cents a share, to a mere eighth of a point, or 12 1/2 cents.

In response, a message flashes on his trading terminal from a much larger market maker, Weeden & Co.: “Pathetic.”

A caller who says he is Peter from Morgan Stanley complains: “You guys break the spread for 1,000 shares?”

Chiron Corp.’s stock has been trading with a 1/2-point spread; Houtkin narrows it to three-eighths. The phones ring again. This time, Keith Balter, head of over-the-counter trading at Weeden, tells Houtkin: “You’re embarrassing and pathetic. . . . You’re breaking the spreads for everybody.”

Small investors may never be aware that they benefited from Houtkin’s initiatives. Yet an ordinary individual investor buying 200 shares of Chiron or Intel at the better price posted by Domestic Securities would have saved $25. With an average of 299 million shares changing hands daily on Nasdaq, narrower spreads on just the biggest Nasdaq stocks would add up to millions in dollars of savings for retail customers every year.

Nasdaq this year surpassed the New York Stock Exchange to have the highest daily trading volume of the nation’s stock markets. But amid the massive trading, such savings--representing millions of dollars in foregone profits for market makers--rarely materialize.

Instead, close examination of Nasdaq’s day-to-day operations shows that the system is biased against the small investor, favoring big institutional traders and market makers over the ordinary investing public.

The Justice Department confirmed this week that it is conducting an antitrust investigation of Nasdaq, looking into allegations of price-fixing and other illegal practices by dealers.

The National Assn. of Securities Dealers, which owns and operates Nasdaq, says it is unaware of any investigation but will cooperate fully. NASD officials insist that their fast-growing electronic market--home to such familiar stocks as Microsoft Corp., MCI Communications Corp. and Apple Computer Inc.--is fair to small and large investors alike.

Nasdaq has made it possible for some of these companies to raise the money they needed to prosper, creating billions of dollars in wealth for the U.S. economy. And as the home to many of the most rapidly growing firms in technology and health care, it has increased tremendously in recent years in its importance to small investors.

“That’s where the growth is,” said Robert W. Erikson, 67. He is an original member of a Michigan investment club, founded in 1955, that now invests almost half its assets in Nasdaq stocks.

But an inquiry by The Times--including three months spent sitting on Nasdaq trading desks and interviews with more than 100 traders, professional investors, customers and Nasdaq officials--found that individual investors are much more likely to get fair treatment for their trades on the venerable New York Stock Exchange than on Nasdaq.

On the NYSE, spreads for most stocks are a mere eighth of a point, while the vast majority of Nasdaq stocks--even the biggest, most actively traded issues--trade at spreads of a quarter-point or more. In part through an automated computer system, big and small orders get executed on a relatively equal footing on the New York exchange; indeed, investors often get prices better than the posted spread. Nasdaq investors, by contrast, get a worse price for their trades than big investors, such as pension and mutual funds or the market makers themselves.

And if a customer has put in an order to sell a stock at, say, $20, that order will be filled on the NYSE before any buyer has to pay a higher price. On Nasdaq, there is no such rule. The federal Securities and Exchange Commission has moved in recent months to stop Nasdaq firms from “trading ahead” of their customers’ orders. But the new rules still will allow thousands of more advantageous offers to sit unfilled each day in Nasdaq’s fragmented trading system while market makers sell shares to small investors at higher prices.

Unlike the New York or American stock exchanges, Nasdaq (the name originally stood for National Assn. of Securities Dealers Automated Quotation system) has no trading floor. It is a nationwide network of 510 market-making firms linked together by a central computer system and telephones.

In a massive ad campaign, Nasdaq bills itself as “the stock market for the next 100 years.” Yet traders say that except for a separate computer system owned by the British firm Reuters PLC, much of Nasdaq’s daily volume is traded not through sophisticated electronic networks. Instead, it trades the old-fashioned way--by one dealer talking to another over the phone, much as the over-the-counter market operated in the decades when it served mainly as a means for obscure companies to sell shares to the public.

Among the Nasdaq’s most controversial practices:

* Competition among market makers to offer the best price and the narrowest spreads has all but disappeared on Nasdaq, according to veteran traders, mutual fund managers and others. Under a controversial system in which many market makers pay brokerage firms to send them a steady flow of orders from small investors--regardless of the price the market maker is offering--a financial incentive exists to keep spreads as wide as possible.

The NASD insists that price competition is the heart of its market system--indeed, one of its key advantages over the NYSE’s traditional “auction” system, in which a single “specialist” firm serves as the sole market maker for each stock.

* Nasdaq dealers flout the requirement to execute customer orders at the best available price. Despite new rules, market makers still will be able to ignore better offers for their customers’ stock and thereby maximize their own profits. Dozens of times, a reporter watched as individual customers or traders entered orders at prices inside the prevailing spread, only to see the orders ignored while other trades were executed at less desirable prices.

The NASD insists that it carefully balances the interests of its customers and market makers alike.

* Nasdaq seldom enforces a key securities regulation, the “firm quote” rule, which requires dealers to honor the prices they post on Nasdaq computer terminals. Instead, dealers routinely “back away” from their quotes--that is, they refuse to trade at all at the prices they advertise.

Although 4,748 backing-away complaints have been filed with the NASD through Oct. 4 of this year, the group has taken no public disciplinary action on any of them. (On three, small fines of $500 to $1,500 were imposed but were not publicly disclosed.) Market makers charge that the NASD doesn’t aggressively investigate most of the complaints. The NASD says many of the complaints are frivolous.

* Nasdaq also seldom enforces the requirement that dealers promptly report each trade for display on the public tape. Senior executives of mutual funds and other institutional investors complain that some Nasdaq market makers routinely delay reporting trades--and thereby avoid influencing the market. In doing so, critics say, they prevent investors from accurately assessing the supply, demand and price for a stock.

The NASD says it closely monitors the market, but that deliberate wrongdoing is difficult to prove. The group said it has taken no public action this year against any market maker for failing to accurately report trades.

While these problems are interlinked, veteran traders say the most fundamental problem with Nasdaq trading is the market’s wide spreads. The Justice Department investigation is focusing on an alleged conspiracy by market makers to keep spreads wide.

The NASD has vehemently denied that there is collusion in its marketplace. In an interview, NASD President Joseph Hardiman said that as far as he knew, market makers were completely free to narrow spreads. Hardiman said he had no knowledge of any verbal harassment of market makers who did so.

“I would be very distressed if that practice were to occur in our marketplace,” Hardiman said. “To say that we would react strongly if any evidence of that were presented to us is an understatement.”

Documents obtained by The Times show that formal complaints have been filed with the NASD, which so far has taken no disciplinary action on any of them.

Meanwhile, NASD officials privately have been pressing market makers to cut spreads. Among the reasons: fear that big companies are becoming reluctant to list their stock on Nasdaq because of concern about excessive spreads--and fear that Congress or the SEC might step in and require sweeping reforms.

Besides the Justice Department antitrust probe--still in its preliminary stages--the big trading firms face more than a dozen major class-action lawsuits accusing them of conspiracy to keep spreads artificially wide. The suits, filed since May, seek millions of dollars in damages. They were prompted by news reports that business professors William G. Christie of Vanderbilt University and Paul H. Schultz of Ohio State University had found strong circumstantial evidence of tacit collusion among market makers to fix the spreads.

The market makers also deny that there is any collusion in Nasdaq.

Yet Balter, the OTC trading chief at Greenwich, Conn.-based Weeden & Co., acknowledged that he verbally pressured Houtkin at Domestic Securities when Houtkin cut the spreads. Indeed, Balter expressed no remorse for berating Houtkin as a reporter listened in.

“A thousand shares is not worth breaking the spread in a stock,” Balter said. “My comment is that for somebody who narrows a spread (without standing ready to buy large quantities of stock), pathetic is a good word.”

(A Morgan Stanley Group Inc. spokeswoman said the firm would not comment on the call placed to Houtkin by its trader.)

Richard G. Ketchum, the NASD’s chief operating officer, confirms that market makers are not allowed to speak “abusively” to each other or to try to threaten or intimidate fellow dealers. The NASD’s rules of fair practice require member firms “to observe high standards of commercial honor and just and equitable principles of trade.” The NASD has the power to censure and fine violators, although it does so rarely.

*

What are spreads?

If you were to look at a computer screen used by Nasdaq traders, you would see each market maker quoting two prices for each stock.

One is the “bid” price, at which the market maker is willing to buy the stock from the public. The other, known as the “asked,” is the higher price at which the market maker is willing to sell. The difference between the two is called the spread. It exists to cover a dealer’s costs of making a market in a stock (including the risk of holding shares that might go down in price) and the dealer’s profit margin.

In promoting itself as superior to the NYSE, the American Stock Exchange and other exchanges, Nasdaq boasts that for each of its stock, multiple dealers vie with each other to make markets.

For such big Nasdaq stocks as Apple Computer, MCI, and Microsoft, there are 50 or more market makers. The NASD contends that Nasdaq’s multiplicity of market makers creates intense competition and results in customers getting better prices.

But the vaunted competition among market makers is more illusory than real.

On Aug. 30, for example, nearly 450,000 shares of Cambridge, Mass.-based Biogen Inc. had traded as of 11:57 a.m. EDT Although there were 38 market makers supposedly competing with each other to trade the stock, 13 were posting the identical bid price, 50 3/4. All of the rest posted less favorable prices--indicating, basically, that they were not willing to trade. And none had stepped forward to beat the 51 1/4 asked price by breaking the 1/2-point spread.

At about the same time, shares in Intel, a Santa Clara-based semiconductor maker, were trading with a 1/4-point spread--and continued to do so throughout the day, though 63 market makers were posting prices for the stock. Intel ended the day with a higher trading volume than all but three stocks on the NYSE.

Experts say the day’s trading pattern was typical. On Nasdaq, the vast majority of stocks have spreads of at least 1/4 of a point; less actively traded stocks can have spreads ranging beyond 2 points--that is, more than $2 per share.

On Wednesday, for example, Oneita Industries Inc., one of the smallest stocks listed on NYSE, had a spread most of the trading day of 1/8, even though only a total of 55,500 of its shares changed hands. In contrast, the spread on Lotus Development--a far larger company that is one of the biggest listed on Nasdaq--varied between 1/4 and 1/2, even though more than 3.2 million shares traded.

“There is no real competition” among market makers on spreads, said Robert M. Gintel, chairman and chief executive of the Gintel Group, a mutual fund manager in Greenwich, Conn. Nasdaq’s claims about the benefits of market maker competition are “fictional,” he said.

Nasdaq officials contend that the spreads are determined purely by competitive market forces. Indeed, the NASD and market theorists say that in a truly competitive market, spreads should be determined by how actively traded a stock is, how many shares are held by outside investors, the volatility of a stock’s price and the number of market makers competing against each other.

“The spreads in highly liquid, highly active stocks (on Nasdaq) are very good,” insisted Hardiman, the NASD president.

Yet records of market makers’ daily quotes and the new study by Christie and Schultz suggest the existence of a gap between official explanations and reality.

The professors discovered something odd about Nasdaq trading: Seventy-one out of 100 of the largest Nasdaq stocks almost never were quoted in “odd eighths,” they wrote. That is, the quoted bid or asked prices might be 20 or 20 1/4 or 20 1/2, but almost never 20 1/8 or 20 3/8 or 20 5/8. And as a direct result, the spreads on these stocks almost never were less than a quarter of a point.

Christie and Schultz, whose findings will be published in December in the Journal of Finance and have been cited in many of the class-action lawsuits, searched for market-related reasons why these stocks would not trade in odd eighths when, at the same time, much more thinly traded stocks routinely had odd-eighths quotes.

In the end, they concluded that there must be an unwritten agreement among market makers to keep the spreads in these stocks wide.

“While this paper does not provide conclusive evidence of tacit collusion among market makers, we are unable to offer any other plausible explanation for the lack of odd-eighth quotes,” they stated.

None of big market-making firms contacted by The Times would give an explanation for not quoting major Nasdaq stocks in odd eighths. All declined comment, some citing the pending class-action lawsuits.

Publicly, NASD officials tried hard to discredit the study. Ketchum told The Times in May that the report “is irresponsible--and in fact we believe it is slanderous.”

NASD chief economist Gene L. Finn acknowledged that the NASD has no studies of its own on the subject. But he and Ketchum maintain that market forces explain why quotes for certain stocks “gravitate naturally” toward increments of 1/4 of a point.

Ketchum said spreads on big Nasdaq stocks stay wide because Nasdaq market makers are expected to stand by the prices they quote for large amounts of stock--10,000 shares or more per trade. The dealers, he said, need wide spreads to cover the risks they undertake in filling such big orders.

But Nasdaq rules only require market makers to honor their prices for 1,000 shares. Despite repeated requests, NASD officials did not offer statistical evidence that dealers routinely honor their prices for bigger amounts of stock.

The Times, meanwhile, has learned that at the same time they were deriding the professors’ report, top NASD officials quietly had begun moving to address a problem whose existence they publicly denied.

On May 24--just a day before he publicly blasted the professors’ report as “slanderous”--Ketchum addressed a closed-door meeting of major Nasdaq market makers, sponsored by the Securities Traders Assn., at the headquarters of Bear, Stearns & Co. Inc. in New York.

Ketchum has since confirmed that he told the market makers that the spreads on some stocks were too wide--and asked for voluntary action to narrow them. Otherwise, he said, the NASD might be forced to crack down.

A few days later--on Friday, May 27, and Monday, May 30--the spreads on three of the biggest Nasdaq stocks--Apple Computer, Microsoft and Amgen Inc.--suddenly narrowed to an eighth, and stayed there. In the previous months, they almost always had traded with spreads of at least a quarter.

What happened?

Ketchum and other NASD officials confirm that, in response to his speech, three leading market makers each picked a leading Nasdaq stock and unilaterally cut the spread.

Among them was William R. Rothe, a member of the NASD’s board of governors who is also a managing director in charge of OTC trading at Baltimore-based Alex. Brown & Sons. Rothe cut the spread on Apple Computer that Monday, The Times has learned. All day, whichever way the stock moved, Rothe moved his firm’s bid or asked prices to ensure that the spread stayed an eighth.

Goldman Sachs & co. did the same with Microsoft. And a third market maker did so with Amgen, an NASD source said.

The spreads have stayed at an eighth ever since.

Rothe declined to comment about the narrowing. Goldman Sachs spokesman Edward G. Novotny, in a written statement, denied that the firm’s decision to cut the spread on Microsoft that day had anything to do with Ketchum’s speech. Ketchum, however, said in an interview that he believes the decision stemmed at least partly from his remarks.

In any event, at an eighth, these stocks now trade with spreads the same as those for comparable stocks on the NYSE. Critics say the ease with which market makers were able to permanently lower them raises questions about whether competitive market forces really determine Nasdaq spreads--and about why the spreads on more big Nasdaq stocks haven’t followed suit.

Schultz, the Ohio State professor, said the fact that three market makers easily were able to narrow the spreads on three of Nasdaq’s biggest stocks supports the theory that there is collusion among market makers to set spreads.

On Microsoft, for example, he noted that 41 market makers on a single day began quoting in odd-eighths, changing a pricing practice that had been in effect for years.

“That, we think, is probably the strongest evidence that the dealers are not acting independently,” Schultz said.

*

From the vantage point of small investors, spreads can be the difference between winning and losing on an investment.

For a stock quoted 8 bid-8 3/4 asked, investors buying on the asked price would have to wait for the stock’s bid price to go up nearly 10% (not counting commissions) before they could break even on their investments.

Even so, the quoted spreads don’t tell the whole story. Professionals often trade “inside the spread,” paying far less to buy and sell Nasdaq shares.

“Institutions love to trade Nasdaq because they get treated very nicely and can trade inside the spread,” said Andrew Schwarz, an options trader and specialist on the American Stock Exchange. “But if your Aunt Betty wants to buy 500 shares of a Nasdaq stock, good luck getting a price inside the market.”

Many individual investors say they have no idea they routinely pay more for Nasdaq stocks than the professionals.

Consider the recent experience of Beverly Wayte of Pasadena, an avid investor who teaches adult English classes.

Through her broker Charles Schwab & Co., Wayte on Aug. 17 bought 200 shares of Eltron International, a Chatsworth company that makes bar code printers.

Her order was executed at 11:24 a.m. EDT, and she got the stock at its quoted ask price, 12 3/8. But records obtained from the NASD show that within minutes of her trade--while the stock’s quoted price remained unchanged--other investors were able to buy it for less. A case in point: In another trade that took place within just seconds of Wayte’s, a bigger investor bought 1,000 shares of Eltron and paid only 12.

Schwab, the nation’s leading discount brokerage firm, would seem to have little incentive to get customers like Wayte a price inside the spread. Schwab owns one of the biggest Nasdaq market makers, Mayer & Schweitzer Inc., which executes most of the Nasdaq trades for Schwab’s customers. So Schwab profits from the wide spreads, as do large Wall Street brokerage firms like Merrill Lynch & Co. Inc. and PaineWebber Inc., which are Nasdaq market makers themselves.

Schwab spokesman Hugo Quackenbush said most retail customers are not concerned about getting a price inside the spread, but rather about getting their orders filled quickly at the price quoted to them over the phone.

Quackenbush defended the firm’s handling of Wayte’s and similar trades. “We’re not embarrassed about it,” he said. “We go to great efforts to guarantee that customers get the best nationwide inside bid or offer, as appropriate.”

And he acknowledged that Schwab has a profit incentive to charge the full spread. “Sure we make more money,” he said, adding: “We play by the rules of the Nasdaq market.”

Hardiman, the NASD president, said he is not troubled by small investors getting worse prices on Nasdaq. “The retail investor clearly doesn’t have the negotiating clout that an institutional investor has,” he said. “That’s true in any business.”

And, he said, the spreads should not be significant to small investors. “Individuals should not trade a lot of stocks in the Nasdaq market,” he said. “These are growth stocks. They should be investors, not speculators.”

Yet Wayte, who buys a few hundred shares of Nasdaq stocks from time to time, said she was surprised to learn from a reporter that others trading at the same time get better prices.

“I’m disappointed and frustrated,” she said. “And I’d like to know what the SEC thinks about this.”

A number of companies whose stocks traded on Nasdaq have taken investors’ concerns so seriously that they have pulled their shares off Nasdaq and listed them elsewhere.

Until August, the NAIC Growth Fund, a closed-end mutual fund, was listed on Nasdaq. But swamped with complaints from fund investors about the wide spreads market makers were quoting on the shares, it moved to the Chicago Stock Exchange.

The fund is run by the National Assn. of Investors Corp., a Royal Oak, Mich., not-for-profit group that promotes responsible investing by individuals and helps set up investment clubs, including many for senior citizens. The closed-end fund (a mutual fund whose shares trade like a stock) was set up as an investment vehicle for NAIC members.

While the stock was listed on Nasdaq, the spread was 1 1/2--or sometimes more, according to NAIC Chairman Thomas E. O’Hara. Market makers “were making as much as $2 on a $10 stock,” he said. “We thought that was a little ridiculous. Our members blamed us for that.”

Since switching on the Chicago exchange, the spread on NAIC Growth Fund shares has narrowed to 1/4, according to Lawrence Augustyn, the specialist who handles the shares.

On Feb. 2, O’Hara wrote to Hardiman seeking an explanation for the wide spreads. NASD spokesman James Spellman said the NASD had no record of receiving the letter. He declined comment on the NAIC fund’s move to the Chicago exchange.

Other companies have cited spreads as a reason for bolting from Nasdaq. David C. Carney, chief financial officer of CoreStates Financial Corp., said the Philadelphia-based bank holding company switched to the NYSE last year, in part for its narrower spreads.

Though insisting that spreads on most Nasdaq stocks are acceptable, Hardiman conceded: “It’s one reason we lose companies to the exchanges.”

*

Although Nasdaq says competition among market makers is its greatest advantage over the NYSE, longtime traders say they no longer need to compete to get business.

The reason, they say, is a practice known in the industry as “payment for order flow.” Mushrooming since 1987, it means market makers no longer need to compete on price to be guaranteed a steady flow of customer trades: They get it anyway.

Market-making firms pay brokerage firms to send them their customer orders for execution. Instead of shopping around a customer’s order to find a market maker willing to offer the best price, the brokerage gives all or most of its orders to one willing to pay for them. The market makers typically pay several cents per share for each buy or sell order.

The biggest brokerage firms have become major market makers themselves. Firms such as Merrill Lynch, the nation’s largest brokerage, execute a great proportion of their customers’ trades--assuring them a flow of internal orders.

Payment for order flow exists for stocks listed on the NYSE and other exchanges as well. And controversy about the practice is not new; it has prompted class-action lawsuits (which are pending) and condemnation from many investor groups.

But what has drawn scant public scrutiny is its profound impact on Nasdaq trading, where it serves as a strong incentive for market makers to keep spreads wide.

The reason: Their contracts require market makers to give the best quoted bid or asked price for a stock at the time an order comes in, regardless of that market maker’s own price. So if a small market maker, such as Domestic Securities’ Houtkin, breaks rank and cuts the spread, other, bigger market makers suddenly have to meet his price.

In other words, a market maker who cuts the spread does not just narrow his own profit margin, but that of fellow market makers as well.

Critics such as Houtkin call the system “bribery for order flow.” A Harvard Law Review article published in May said brokerage firms that accept payment for order flow “are engaging in a practice . . . that may induce them to place their own interests ahead of their customers’ interests.”

On Nasdaq, payment for order flow “has eliminated competition based on price,” said Benjamin L. Lubin, a former member of the NASD’s board of governors, its top policy-making body.

“If I have captive order flow coming in, I do not have an incentive to tighten my (spreads),” added another member of the NASD board of governors who declined to be named. “I don’t have to attract business by having a superior bid or offer, (because) it’s coming to me no matter what.”

Many market makers and brokerage firms contend that payment for order flow is necessary if very large numbers of small orders are to be handled efficiently. The volume of small orders on Nasdaq has grown so explosively during the last decade, they say, that they could not shop each one around to multiple market makers seeking the best price.

The SEC, after spending several years agonizing over the issue, has decided not to ban payment for order flow. Instead, the agency is adopting a rule that would require brokerages to make detailed disclosure of such payments to customers.

There are other reasons why market makers get upset when Houtkin and others cut the spreads.

Not only does it cost them money under payment-for-order-flow arrangements, but it also riles up their big institutional customers, such as pension and mutual funds.

Investment officers at these institutions have computer terminals on which they can see the current best bid and asked prices for Nasdaq stocks. If Houtkin cuts the spread on a stock, his new, better price will flash on their screens. And that leads institutions to demand better deals too.

In a notarized affidavit, Domestic Securities trader James Mercer stated that on July 15, a trader at San Francisco-based market maker Hambrecht & Quist Inc. called Domestic to complain that Houtkin had cut the spread on the stock of Xilinx Corp., a San Jose software company.

“This is bull----,” the caller allegedly raged. “I have institutional customers who come to me and I have to match your price. It’s bull----, you guys going down an eighth for a thousand shares.”

Asked about the allegation, Hambrecht & Quist general counsel Steven Machtinger said: “In our opinion, the Nasdaq stock market is very competitive. Beyond that we have no comment.”

NASD officials have tried to cast doubt on Houtkin’s motivation, pointing out that he has a record of minor disciplinary violations. Houtkin has been censured and fined twice, paying an undisclosed amount under $3,000 in total--once in 1991 for failing to keep accurate records and once in 1985 for allegedly abusing a Nasdaq computer system for handling small orders.

Linda Lerner, general counsel of Domestic Securities, says Houtkin has been singled out for disciplinary action because he is a maverick, an assertion the NASD denies.

Other market makers have a new strategy for dealing with Houtkin, Lerner contends.

When Domestic Securities cuts the spread on a stock, a big market maker will hit the firm with a huge order to buy or sell 50,000 or 100,000 shares. Domestic Securities must fill only 1,000 shares at its posted price, but then either must immediately change its price or accept the full order--which Domestic Securities, a small firm, says it cannot afford to do.

“They just blow us out of the way so that the spread can go right back to where it was before,” Lerner said.

Individual investors are frustrated too.

“You pay on the way in and on the way out,” said John D. Miskie, 59, a Redding, Pa., chemist forced into retirement by a stroke. Miskie says he invests some of his limited savings in Nasdaq and NYSE stocks to have “something to hand over to my grandchildren.”

Says Miskie: I understand that market makers have to make money to stay in business. But that’s their problem. These (spreads) seem tough to justify.”

About This Series

The electronic Nasdaq market has grown into the nation’s busiest marketplace for buying and selling stocks, with higher trading volume than the better-known New York Stock Exchange. Nasdaq is where investors trade shares of Intel, Microsoft, Apple Computer and other leading firms, along with the stocks of hundreds of smaller companies.

Critics are questioning the fundamental fairness of Nasdaq’s trading system, and the Justice Department has launched an antitrust investigation of possible price-fixing and other illegal activities.

Other stories in this series will appear in the Business Section, focusing on:

* The problem of ensuring that Nasdaq customers get the best price available when they put in orders to buy or sell stock.

* What has happened to the reforms Nasdaq put in place after the October, 1987, stock market crash?

* How the failure of market makers to honor the prices they advertise on Nasdaq’s computer systems hurts small investors.

* Some Nasdaq market makers delay hours before reporting big trades, withholding from investors the most basic information about supply, demand and stock prices.

* Improving the Nasdaq system and protecting small investors.

Comparing Stock Markets

NASDAQ NYSE Average Daily 299.1 295.3 Trading Volume million shares million shares JAN.-JUNE Number of Listed 4,849 2,499 Companies Market Value of $738.4 billion $4,375.8 billion Listed Stock AS OF JUNE, 1994 Growth in Composite Price Index 88% 36% EARLY 1991-MID-1994 Trading System Negotiated Auction market, market; multiple single “market “specialist” for makers” for each stock, in each stock in principle stocks principle bought and sold negotiate with at best price each other and through investors on competitive price. bidding.

Speaking the Language

A glossary of common terms used on Nasdaq:

* Market makers: Firms that put up their own capital to “make a market” in particular Nasdaq stocks, acting as dealers by continuously posting prices for the stocks on Nasdaq’s computer and standing ready to buy or sell. Unlike the New York Stock Exchange, where a single “specialist” is the sole market maker for each stock, each Nasdaq stock has multiple market makers. There may be 60 or more market makers for very big Nasdaq stocks, such as MCI, Apple Computer, or Microsoft, or fewer than five for small, very thinly traded stocks. Market makers include many big, well-known Wall Street investment houses, such as Merrill Lynch and Morgan Stanley, as well as lesser-known firms that do little else besides making markets in Nasdaq stocks.

* Bid: The posted price at which a market maker is willing to buy a stock.

* Asked: The posted price at which a market maker is willing to sell a stock.

* Spread: The gap between the bid and asked prices. This is essentially the market maker’s profit margin for acting as a dealer in the stock. Market makers buy from investors at the bid, and sell at the highter, asked price.

* Backing Away: The illegal refusal by a market maker to honor the prices it posts in the Nasdaq computer system for buying or selling a stock. This is analagous to a store that refuses to honor its advertised prices. The SEC requires market makers to buy or sell, from anyone who wants to trade, usually at least 1,000 shares of stock at the bid or asked prices it posts. When a stock’s price is moving up or down, market makers may be afraid that they will suffer losses if they honor their quoted prices. So they refuse or ignore an offered trade. They might falsely claim that someone else was “ahead”--i.e., that the market maker just sold the required amount of stock to another customer or market maker at that price. For individual investors, backing away means they end up having to pay more to buy a stock, or get less for selling it. It also delays execution of customer orders, which can cost customers money if the stock price is quickly changing.

* Trading through: Market makers continue to trade with the investing public at their quoted bid or asked prices, ignoring offers that are better for customers. The customer who put in the better priced order often doesn’t get it filled. Other investors never know about these pending orders, and miss out on an opportunity to buy stock at less than the quoted ask price or sell at more than the quoted bid price. Trading through benefits the market makers because they get to charge the full spread. Critics say this is a fundamental flaw of the Nasdaq market, since it prevents some investors from knowing what other investors are willing to pay for a stock at a given time.

* Trading ahead: Also known as front-running, this refers to a market maker buying or selling for the firm’s profit ahead of an order from the firm’s own customer. When a customer places an order that is likely to move the market--on Nasdaq even relatively small orders can have a big affect on a stock’s price--the firm might buy or sell ahead of that order, profiting later from the price move from the customer’s order. This can also result in the customer getting a worse price, if his brokerage firm trades ahead of his order and snaps up all the stock at the best available prices. This has long been illegal on NYSE, and many other exchanges. Since June, a limited ban on this has been in effect on Nasdaq.

Impact of Nasdaq “Spreads”

Stock transaction on the Nasdaq routinely cost small investors more than big, institutional investors. Consider these parallel transactions in the shares of a hypothetical firm, XYZ Co.:

SMALL INVESTOR

Jane Smith buys 300 shares of XYZ stock. Almost certainly, her order will be executed at the asked price, $10.50 per share. So she pays $3,150.

Two weeks later, XYZ stock’s price hasn’t changed, so a disappointed Smith decides to sell. As a small investor, she almost certainly will get the bid price, $10.00 per share. So she gets back $3,000.

Her net loss on a stock that hasn’t budged--$150, or 4.8%--is the direct result of the 1/2-point spread, the 50 cents-per-share difference between the bid and asked prices.

If you add in the commissions she’ll pay her discount brokerage--$76.79 on the purchase plus $75.80 on the sale--Smith’s total loss climbs to $302.59, or 9.6% of her investment. The stock price would have to rise 10% just to break even.

BIG INVESTOR

Major Pension Fund buys 4,000 shares of XYZ stock. As a big, institutional investor, Major can get a price “inside” the spread, buying at less than the asked price--in this case, $10.25 per share. It pays $41,000.

Two weeks later, Major again goes inside the spread, selling at $10.125 per share. The pension fund gets back $40,500.

The fund’s net loss of $500 amounts to just 1.2% of its investment. The effective spread on its transaction was just 1/8 point.

As a big investor, Major is able to negotiate much smaller commissions as a percentage of its investment. So between the narrower spread and the lower commissions, XYZ shares would have to rise far less for the pension fund to break even.