Revised System for Small-Lot Trades Decried as Unfair : Access: Some smaller traders say the proposed change would favor big-time dealers. Officials say it favors stability.

By SCOT J. PALTROW

Oct. 22, 1994 12 AM PT

TIMES STAFF WRITER

NEW YORK —

On Black Monday in October, 1987, when the Dow Jones industrial average fell a record 508 points, none of America’s major securities exchanges performed worse than Nasdaq.

Rather than making markets as they were supposed to, many Nasdaq dealers simply stopped trading--and stopped answering their phones, according to a presidential task force appointed to look into the crash.

One result: Individual investors who wanted to sell before prices fell further couldn’t.

“For many investors, both large and small, the over-the-counter market broke down,” the task force report said.

In the aftermath of the crash, Nasdaq undertook a big improvement designed specifically for small investors: a major enhancement of its computerized small-order execution system (known as SOES), which completes trades automatically, without the need for a phone call to a market maker.

All market makers were required to participate in SOES. So for orders to trade up to 1,000 shares at market prices, investors essentially were guaranteed the right to buy or sell stock swiftly at the current quoted price.

But SOES may soon be no more.

The National Assn. of Securities Dealers, which operates Nasdaq, has already sharply scaled back the system. In January, it cut the maximum SOES order to 500 shares. And it is awaiting approval from the Securities and Exchange Commission to eliminate SOES altogether--and replace it with a new system favored by Nasdaq’s big market makers.

The NASD contends that the new N-Prove system would benefit small investors, giving them more of a shot at buying or selling stock at better than the quoted prices.

But in letters to the SEC, many investors and professionals have said the benefits would be largely illusory. In the event of another crash, they say, it would be much less likely that small investors’ orders would be executed quickly by N-Prove.

According to SEC sources, SEC Chairman Arthur Levitt Jr. agrees--and is likely to try to force the NASD to make major changes.

As now proposed, critics say the chief effect of N-Prove would be to allow market makers more freedom to duck small customers’ orders--if the market makers do not think they can make a profit on the trades.

And SEC officials who have evaluated the N-Prove plan say it would ensure that market makers--not customers--get first crack at the best orders, officially sanctioning a practice known as “trading ahead” (or “front running”) that the SEC says should be banned.

The Justice Department confirmed this week that it has launched an antitrust investigation of Nasdaq, which since the 1987 crash has grown into the nation’s busiest stock market, an electronic bazaar where, on average, about 299 million shares trade daily. The NASD says allegations that market makers collude to fix prices are baseless, and it insists that the Justice Department will reach the same conclusion.

The threatened demise of SOES reflects conflicts rending the ranks of Nasdaq traders.

When SOES was beefed up after the crash, some small traders used it heavily. Their foes protested that these traders--whom the NASD initially dubbed “SOES bandits”--were picking off market makers who were slow to update their quotes in rapidly changing markets. The dealers were said to be using SOES’ swift, automatic execution to reap quick profits at the expense of unwary market makers. For their part, the SOES traders argued they were staying within the rules, legally exploiting a system the NASD had created.

With the new N-Prove system, these pick-offs would not be possible. But critics, in comments filed with the SEC, contend that the plan would take away protections for small investors at the same time it punishes the SOES activists.

The critics, including Jeffrey P. Ricker, a San Francisco-based consultant to institutional investors, note that N-Prove, unlike SOES, would give market makers an opportunity to reject trades. And it would allow a significant amount of time to elapse before an order is executed, during which the price of a stock could change substantially.

Rather than an order being executed instantaneously, as under SOES, each market maker would have a chance to reject the order, allowing up to 45 seconds to pass before the computer finally selected one against which to execute the order automatically.

If all the market makers said they were in the process of changing their quotes when the order came in, the customer would get the stock at the new price, not at the quote posted when the order was entered.

Michael F. Frey, president of A.J. Michaels & Co., a Hauppauge, N.Y., trading firm that was among the SOES activists, notes that in a rapidly moving market, 45 seconds can be an eternity.

“Count off 15 seconds and see how long that seems to you,” Frey says. His point: 15 seconds is plenty of time for market makers to tap a couple of keys on their computers and change their quotes--and thus enough time to ensure that an order is executed at a worse price.

The NASD claims N-Prove will give small investors a much-improved chance to get prices inside the spread--that is, better than the quoted bid or asked prices.

Customer orders to buy or sell stock at a specified price--so-called limit orders--would go into the N-Prove computer. If an order came into the system to sell at the going market price and there was a limit order already in the system to buy at a price higher than the market makers were offering, the lucky seller would be able to sell at the higher, better price.

However, the customer who put in the limit order wouldn’t necessarily get to buy the stock. That’s because N-Prove would give the market makers first crack at matching the limit-order price. They would have 15 seconds to do so. So the small investor on the other side of the transaction--the one who offered a better price to begin with--might lose out to the market makers.

“In essence, this rule is an incredibly blatant license for front running,” Ricker objected in a letter to the SEC.

In its proposal, the NASD said giving market makers the chance to run ahead of customer limit orders is necessary; otherwise, it said, “market maker profitability will suffer,” potentially drying up liquidity on Nasdaq. The NASD says liquidity--a market’s ability to absorb large trades with minimal impact on prices--is one of Nasdaq’s key virtues.

Another criticism of N-Prove: Only limit orders from small investors would enter the system. So small investors would miss out on better prices being offered by big investors, including mutual funds and other institutions, that execute their trades over other networks.

And some individual investors say it is unfair that short selling would be banned completely on N-Prove, as it has been on SOES since January. Short selling involves selling borrowed stock in expectation that the stock’s price will soon go down. If it does, the investor buys it back at the new, lower price and pockets the difference.

Short selling is freely allowed to larger traders and market makers on Nasdaq--and to all investors on the NYSE.

Why deny short selling to N-Prove users? Richard G. Ketchum, the NASD’s chief operating officer, said there were too many abuses by the activist firms when short selling was allowed on SOES.

But Ronald Sudol, a retired engineer in New Jersey who spends much of his time trading small quantities of Nasdaq stocks, complains that the ban on short selling is unfair. “Market makers can play both sides,” he said. “We’re only allowed one side.”

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.

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.

Revised System for Small-Lot Trades Decried as Unfair : Access: Some smaller traders say the proposed change would favor big-time dealers. Officials say it favors stability.

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