Pressure on Liquidity May Prompt Changes

Stock market liquidity--the ability of buyers to find sellers, and vice versa, at a particular price--is being as sorely tested now as at any time in years.

Liquidity has held up reasonably well, traders say, but some experts believe the fallout from a week of historic trading volume and violent price gyrations will be changes in the way the markets operate.

Some dealers, for example, may balk at making large trades for their customers unless they are compensated upfront for their risk. Others may stop trading shares of smaller companies, ceding the business to regional firms that know the stocks better.

Liquidity is rarely a problem in such marquee names as IBM, Exxon or Citicorp, because somebody’s nearly always willing to trade, regardless of where the price may be. But even those stocks had trouble trading when the New York Stock Exchange opened Tuesday, the morning after the Dow Jones industrial average had plunged 7.2% (a record 554 points) on the market’s worst day in 10 years.

Citicorp did not open for trading until 10:17 a.m. Tuesday--47 minutes late--and when it finally did open, it carried a huge $1 “spread” between the bid and asked (buy and sell) quotes. Normally, the spread would be 6 cents.

IBM, Exxon and numerous other big-name stocks also opened unusually late Tuesday and with unusually large spreads.

However, the worst liquidity crunch typically comes in smaller stocks traded on the Nasdaq stock Market. When prices are moving rapidly up or down, investors can find it difficult to get in or out when they want to.

The key providers of liquidity in Nasdaq stocks are market makers, dealers who agree to act as buyers or sellers when a trade can’t otherwise be completed.

If you want to sell 1,000 shares of XYZ at the quoted asking price of $20 and there is no buyer waiting in the wings, it’s the market maker’s job to take it off your hands.

It’s a risky job in a volatile market because market makers can lose big if the only “natural” buyer they can find is at a much lower price.

It works just the same in the other direction. On Tuesday, when the markets snapped back frenziedly from an early plunge, a Smith Barney trader lost $64,700 on a single trade, trying to fill a customer’s order by chasing a rapidly rising stock, said Bob Moore, the firm’s head of over-the-counter trading.

Nasdaq Chief Economist Dean Furbush said such market makers held their ground bravely last week. On Monday, he said, Nasdaq’s 20 largest market makers collectively bought $250 million of stock for which it wasn’t clear there would be any buyers the next morning.

“I don’t know if that’s a record, but it was huge,” Furbush said.

He said more quantitative liquidity measures--the average spreads and the average number of shares offered per quoted price--did not change significantly even during Monday’s unprecedented half-hour trading halt, when traders fully expected the market to resume its plunge upon reopening.

“Our market makers were not running scared,” he said.

Nasdaq took a lot of lumps after 1987’s 22% Black Monday crash, when some market makers refused to pick up their phones and get back in the game on Tuesday.

An important difference between then and now is not that the dealers got more courageous, but that they have adopted better strategies for using derivatives--futures and options contracts--to reduce the risk of cataclysmic losses.

Last week took the cake, but volatility has been on the rise all year, increasing the risk for market makers. As a result, some market makers have quietly pulled in their horns.

Giant Merrill Lynch, for example, used to make a market in about 850 over-the-counter stocks, but it pared the list back to 500 in September.

Bear Stearns trimmed its OTC list to 360 from 450 earlier this year, but has actually been adding a few stocks recently, a spokeswoman said.

Smith Barney continues to make a market in about 950 Nasdaq stocks, but that commitment is under scrutiny, Moore said.

Some experts say new rules imposed on Nasdaq this year by the Securities and Exchange Commission have hurt liquidity by shrinking spreads between the bid price at which a dealer will buy a stock and the asked price at which he or she will sell it. Wider spreads protected market makers against sudden price fluctuations.

SEC officials declined to discuss the issue, an agency spokesman said.

Bernard L. Madoff, a former Nasdaq chairman who welcomed the new rules as a benefit for investors, nonetheless believes they have caused some short-term damage to liquidity.

“What happened was the risk-less trade virtually disappeared,” said Madoff, whose Bernard L. Madoff Investment Securities makes a market in the 200 largest Nasdaq stocks.

In an environment with less margin for error, he said, the firms that will continue dealing in smaller, lesser-known stocks are regional firms that know their local companies well and are more apt to anticipate price changes.

“It’s easier to lose money when you’re not paying attention,” and the big national brokerages aren’t equipped to pay attention to thousands of stocks, said Paul Schultz, a visiting finance professor at the University of Chicago who studies the Nasdaq market.

Emanuel E. “Buzzy” Geduld, president of Herzog, Heine, Geduld, one of the largest market makers specializing in Nasdaq stocks, said that as spreads shrink and dealers’ expenses mount, he foresees a profound change in the way Nasdaq business is done.

Geduld expects market makers to begin charging fees for trades, as is done on the New York Stock Exchange. The move would be radical because Nasdaq has always considered its spreads-only way of doing business as one of its unique advantages over the Big Board.

“It’s a psychological mountain to climb, but eventually fees will come,” Geduld said.