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SEC to Force Nasdaq to Aid Small Traders : Securities: Decision reverses policy. Commissioners cite concern that trading systems unfairly favor dealers.

TIMES STAFF WRITER

In a major policy reversal, the Securities and Exchange Commission said Wednesday that it will force the Nasdaq stock market to make its trading systems give more priority to small-investor orders.

The SEC commissioners said their decision was based on concerns that both Nasdaq’s current system and a planned new one for handling such orders give unfair advantages to dealers of Nasdaq stocks over small investors.

The SEC action means that starting March 27, certain orders from small investors--for up to 1,000 shares--must be executed automatically at posted market prices. Nasdaq had been seeking an extension of rules that reduced the availability of such small-investor advantages.

The decision centers on a computer system, the small order execution system, or SOES, that was designed to give swift, automatic execution of small orders from individual investors.

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The SEC has decided to reject Nasdaq’s request to extend temporary rules that had put tight limits on the use of SOES, to the benefit of dealers. The year-old rules were due to expire Wednesday.

Nasdaq had sought to extend the rules until the beginning of May, when it hoped the SEC would have approved a replacement system, called N-Prove, that is heavily favored by big dealers in over-the-counter stocks.

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But the SEC said Wednesday that it will extend the temporary rules for only two months, until March 27, the amount of time the National Assn. of Securities Dealers--Nasdaq’s parent organization--had indicated was necessary to allow an orderly transition of SOES back to the way it was before, when it favored small investors more.

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“The commission does not believe that further extension of these restrictions without changes to benefit public investors would be appropriate,” the SEC said.

The commissioners said the NASD had provided no firm evidence that the original SOES rules harmed the market.

The commissioners also said they had major concerns about the fairness of N-Prove and indicated that they will not approve it unless the NASD proposes major changes. In a letter to the SEC, the Justice Department’s antitrust division had already criticized N-Prove, concluding that key aspects of it would unfairly disadvantage small investors.

The decision marks a major reversal by the SEC, which in recent years has mostly rubber-stamped proposals from the NASD. The decision comes amid two major federal investigations of alleged illegal trading activities on Nasdaq, and follows an investigative series in The Times in October disclosing that Nasdaq trading systems were heavily biased against small investors.

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In a separate development, at least a dozen Wall Street firms have received SEC subpoenas in recent weeks that contain wide-ranging requests for documents related to Nasdaq trading activities. The subpoenas, first reported by Bloomberg Business News, are in addition to similar demands for documents sent out in November by the Justice Department.

NASD spokesman James Spellman declined to comment on the latest SEC decision. NASD Chief Operating Officer Richard G. Ketchum also did not directly comment on it but said the NASD still hopes the SEC will approve N-Prove.

SEC spokesman Michael Jones said the commissioners were concerned that both the current SOES system with the temporary restrictions and the N-Prove system give dealers too much chance to illegally back away from honoring their posted prices for stocks. “The commission wants to ensure that investors receive the quotes that appear on the (Nasdaq computer) screen,” Jones said.

Dealers, or market makers, are firms that stand ready to buy or sell specific Nasdaq stocks at publicly quoted prices.

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SOES has been controversial for some time. It had been substantially beefed up in the aftermath of the October, 1987, stock market crash. A presidential commission found that during the crash, many Nasdaq dealers simply stopped answering their phones, and small investors in particular had no way to trade as the market plunged.

To remedy that, the SOES system guaranteed automatic execution by computer for orders up to 1,000 shares at market prices.

But beginning several years ago, Nasdaq dealers started complaining loudly that the SOES system was costing them money. They claimed that a small group of maverick dealers was using the system heavily, waiting for periods when prices were changing rapidly and then hitting mainstream dealers with numerous computerized SOES orders before they had time to change their quoted prices.

The SOES activists, in turn, said they were doing nothing illegal and that they resorted to SOES because mainstream market makers often refused to trade with them, in violation of NASD and SEC rules.

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In January, 1994, Nasdaq, with SEC approval, put in place temporary restrictions--the ones the SEC has now decided to let lapse--designed to protect the dealers from the barrage of SOES orders. The restrictions limited SOES orders to 500 shares instead of 1,000. And once a dealer had executed SOES orders totaling 1,000 shares, the dealer was allowed to be exempt from additional SOES orders for that stock for five minutes.

The temporary rules also allowed dealers to automatically change their prices the instant they were hit with one SOES order. As of March 27, all that will be reversed.

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However, the SEC agreed with an NASD request to let lapse immediately a restriction that had banned short selling on SOES. Short selling is a strategy involving selling borrowed stock to profit from a decline in prices.

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While the temporary SOES rules were in effect, the NASD proposed N-Prove as a permanent replacement for SOES. N-Prove is a computer system that is meant to execute small orders rapidly, while allowing dealers some opportunity to refuse ones they don’t want. The NASD contended that N-Prove had many advantages for small investors, but critics argued that the system gave dealers too much opportunity to refuse small investors’ orders.


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