Is This a Fair Trade? : Market Makers Draw Criticism, Lawsuits for Ignoring Customer Orders

One day in late June, options trader Steven I. Malitz was poised to buy 1,200 shares of American Colloid stock at $13 a share--a quarter of a point more than any of the Nasdaq-listed stock’s market makers were offering to pay.

Small investors certainly would have done better to sell to Malitz at his price. But they never got the chance. Instead, market makers ignored Malitz’s order--”traded through” it, in market parlance--and continued to sell at $12.75, a price better for themselves and worse for their customers.

After three minutes, as a reporter watched, Malitz’s order automatically expired--unfilled.

A cornerstone of the nation’s securities laws is the “best execution” rule, meant to guarantee that brokerage customers get the best price available when they put in orders to buy or sell stock.

But much of the time on Nasdaq they don’t.

“I get traded through all the time,” says Malitz, a veteran floor trader at the Chicago Board Options Exchange. Throughout the day, by telephone from his trading post, Malitz buys and sells Nasdaq shares to limit the risks of his dealings in options on Nasdaq stocks.

The National Assn. of Securities Dealers, which owns and operates Nasdaq--the nation’s busiest stock market--says the market could not operate without trading through. The NASD insists it carefully balances the interests of both market makers and its customers.

Still, in one 15-minute span on the raucous floor of the Chicago options exchange that day, a reporter witnessed two other apparent instances of Malitz’s better-priced offers being traded through by Nasdaq market makers. Longtime investors and securities professionals say that on any given day, thousands of better-priced orders never get executed.

Another Chicago trader, Mark Shaprow, says he quit trading options on Nasdaq stocks out of frustration with getting traded through. Now he deals only in options on IBM, a stock listed on the New York Stock Exchange, where trading through is banned.

“We’re professionals and we see it happen,” says Shaprow. “Then we think about the people who aren’t professionals. They get cheated the same way, and they don’t even know it.”

Trading through is just one of the ways the vast Nasdaq trading system produces big profits for market makers at the expense of millions of investors, small retail customers and professionals alike.

The practice, long banned on most exchanges, helps maintain Nasdaq’s wide “spreads,” the gap between the price at which market makers offer to buy from sellers and the price at which they will sell to buyers.

By ignoring better-priced offers from the public that are “inside the spread”--offers either to sell shares for less than the market maker is demanding or buy them for more--the firms protect their own interests while slighting those of their customers.

The Justice Department said this week that its antitrust division has launched an investigation into allegations that market makers, rather than competing, work together to keep spreads wide and increase their profits. The NASD and many large market makers insist the allegations are baseless.

The Securities and Exchange Commission, too, is beginning to apply strong pressure on Nasdaq to address some parts of the problem. But many believe that the proposed reforms, though they have provoked strong complaints from the market makers, fall short.

Richard G. Ketchum, the NASD’s chief operating officer, says trading through is justifiable because of the nature of the over-the-counter market.

If it were banned, he says, some market makers who deal in Nasdaq stocks might lose money and decide to leave the business. The NASD says competition between market makers is at the core of Nasdaq’s structure, leading to better prices for customers.

There are no signs that the profits of Nasdaq market makers are precarious. Indeed, with Nasdaq’s steady growth, the number of firms making markets in its stocks has risen. There are now 510, up 21% from 1990. They include the big, well-known, Wall Street investment houses, such as Merrill Lynch, PaineWebber and Morgan Stanley, as well as lesser-known firms that do little besides make markets in Nasdaq stocks, such as Troster Singer Corp. and Herzog, Heine, Geduld Inc.

The NASD says it has no data on its member firms’ profits from market making. But using the NASD’s own figures--average daily volume of 299 million shares multiplied by an average spread of 34.3 cents--indicates that the market makers’ revenue each day from spreads comes to $102.6 million, or more than $26 billion a year. (They also make additional trading profits, or losses, on the stocks they hold in their own inventory.)

At the heart of trading through is something called a “limit order.” On Nasdaq, as on the New York and other stock exchanges, customers can place limit orders to buy or sell stock at a specified price, as opposed to “market orders” to buy or sell at the current market price.

But the way limit orders are handled is dramatically different on the NYSE or American Stock Exchange than on Nasdaq.

On Nasdaq, market makers may continue to trade at their quoted bid and asked prices while limit orders sit unfilled. Despite a recent rule change, small investors who put in limit orders are most affected: Their limit orders often have to wait until the market price happens to hit the price they specified.

This occurs in part because Nasdaq has set up no centralized mechanism for handling limit orders.

Not only are there multiple market makers for each stock, but on Nasdaq, limit orders may go into one of many different computer trading systems without appearing on the others. Some of the systems are owned by the NASD, while others are operated by independent companies such as Reuters or Los Angeles-based Jefferies & Co. Still others are in-house systems for giant brokerage firms such as Merrill and PaineWebber that execute most of their customers’ Nasdaq stock orders themselves.

So orders sitting in one computer system are likely never to be seen by market participants not using that system. And even those who use a particular system might not see an order; the typical trader at a market-making firm may be responsible for watching 40 or 50 stocks at a time.

As a result, unlike on the NYSE, there is no true “price discovery” on Nasdaq: The quoted market prices do not reflect the prices at which all market participants at any given moment are willing to buy or sell.

“My frank opinion after 37 years in this business is that I’d rather trade on the New York Stock Exchange, for one basic reason: You really do have ‘price discovery,’ ” says Benjamin L. Lubin, a former member of the NASD’s board of governors and president of Securities Industry Management Corp., a Connecticut consulting firm.

Indeed, the way trading works on the NYSE is a sharp contrast to the fragmented Nasdaq system.

On the NYSE, in most cases, customers trade with other customers. A “specialist” on the floor is the exchange’s only market maker for each stock. All customer limit orders are recorded in one centralized list, the specialist’s “book.” Mostly, the specialist matches up customer orders (for a commission) and generally buys and sells stock for his own account only when there is a shortage of public buyers or sellers.

There is no trading through on NYSE or the Amex; their rules require that if an investor is offering a better price than the market maker, that order must be filled before the specialist is allowed to trade for his own account at the same or a worse price.

Assume, for example, that the specialist in Exxon stock is offering to buy shares at $60 and sell at $60.125. If an investor comes along who is willing to sell the stock at $60, the investor’s order will be filled before the specialist is allowed to sell anyone stock at $60.125. The specialist’s only revenue from the transaction is his commission.

Ketchum, the NASD’s chief operating officer, says having no central limit-order book is basic to the way Nasdaq operates. “Market makers handle their own limit orders and provide the quality of execution they want to,” he says.

Without the freedom to trade through, he says, market makers would leave the business, drying up liquidity and harming the Nasdaq market: “The net result is you’re going to eliminate market making as you know it.”

The extent of trading through on Nasdaq has so irked Malitz and a group of fellow options traders in Chicago that several filed a federal class-action lawsuit in May.

Their suit accuses major Nasdaq market makers of deliberately trading through better offers, conspiring to fix prices, colluding to maintain--even widen--spreads and restraining competition by punishing fellow market makers who break the spreads. The Justice Department investigation covers many of the same alleged abuses.

The market makers deny the allegations. NASD officials say they are unaware of the options traders’ complaints and have no comment on this and other class-action lawsuits.

The SEC, meanwhile, says it is concerned about trading through on Nasdaq. “I don’t think we’re resigned to any pricing inefficiency,” says Brandon Becker, director of the SEC’s division of market regulation. But Becker says the agency has no immediate plans to crack down on the practice.

Yet options traders are not the only people complaining.

In a letter last month to the SEC, Jeffrey P. Ricker--a San Francisco-based consultant to institutional investors and an individual investor himself--recounted what happened last year when he put in a limit order to sell shares of a Nasdaq stock.

“While I was unsuccessfully trying to sell 1,500 shares of MTC Electronics at $19 a share, other hapless investors were buying at 19 1/4,” he wrote. “They were cheated, and I was cheated.”

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Series Reprints: A compilation of this six-part series on Nasdaq will be available from Times on Demand upon completion of the series’ publication next week. Price is $7.95, plus $2.50 for mail delivery. To order, call 808-8463 from the 213, 714, 818 or 909 area codes, then press *8630. Follow the voice instructions and select option 3. Allow two weeks for delivery.

Nasdaq’s Dramatic Growth

Nasdaq emerged this year as the nation’s busiest stock market, with a larger daily volume of shares traded than the New York Stock Exchange. The number of companies listed on Nasdaq has shot up, as has the number of dealers making markets in Nasdaq stocks. SHARE VOLUME (In billions): ‘94*: 49.4 DOLLAR VOLUME (In billions): ‘94*: $979.6 COMPANIES LISTED (In thousands): ‘94*: 4.849 DEALERS ‘94*: 510 Source: National Assn. of Securities Dealers

NASD Chief Expresses Support

Joseph R. Hardiman, president of the National Assn. of Securities Dealers, sent a memo Thursday to Nasdaq market makers expressing confidence that the Justice Department will conclude that allegations of price fixing and other misconduct in the market are baseless.

“As you well know, the Nasdaq stock market is stringently overseen by both the (Securities and Exchange Commission) and the NASD, and neither we nor the SEC have ever found anti-competitive practices to exist in our market,” Hardiman wrote.

The Justice Department said this week that its antitrust division is investigating Nasdaq trading practices.

A Glossary of Market Terms

* 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 higher, asked price.

* Limit order: An order to buy or sell a stock at a specified price.

* Market order: An order to buy or sell a stock at the current market price.

* 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.

* Trading ahead: Also known as front-running, the practice of a market maker buying or selling for the firm’s profit ahead of an order from the firm’s own customer.

* Trading through: Practice of market makers continuing to trade with the investing public at their quoted bid or asked prices, ignoring offers that are better for customers. The customer who puts in the better-priced order often does not get it filled. Other investors never know about these pending orders and thereby miss out on opportunities to buy stock at less than the quoted asking price or to sell at more than the quoted bid price.

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, MCI, Apple Computer and other leading firms, along with those 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:

* THURSDAY: Close examination of Nasdaq shows the market is biased against small investors.

* TODAY: Investors often cannot get the best available price for Nasdaq trades, because dealers ignore their orders.

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

* SUNDAY: Dealers in Nasdaq stocks often refuse to make trades at their posted prices, leaving small investors in the lurch.

* MONDAY: Some Nasdaq market makers wait hours before reporting big trades, withholding basic information from investors.

* TUESDAY: How can the Nasdaq system be improved?