Nasdaq’s New World of Orders : Reforms Begun Last Year Have Saved Investors Billions as Dealer Markups Have Narrowed
Reforms adopted a year ago at the Nasdaq Stock Market have helped ordinary investors crack what used to be a members-only club.
Buy and sell orders from plain folks--many of them, to be sure, wielding personal computers and Internet trading accounts--now have the power to directly determine Nasdaq stock prices in ways that only member broker-dealers could in the past.
The new order-handling rules “forced competition upon a reluctant group of market makers, and it’s been a stunning success,” said David K. Whitcomb, a Rutgers University finance professor and sometime Nasdaq critic.
Others are less ebullient about the changes. Nonetheless, the result of the reforms--plus Nasdaq’s move last June, with other U.S. markets, to start quoting share prices in minimum increments of sixteenths of a dollar (6.25 cents) instead of eighths--has been a sharp decline in dealer “spreads,” or stock price markups, and investor savings estimated in the billions of dollars.
The National Assn. of Securities Dealers, Nasdaq’s parent organization, says average spreads between stock “bid” and “asked” prices have shrunk 41% since the implementation of the new order-handling rules. The rules were phased in beginning in January 1997 and extended to all 5,500 Nasdaq stocks by October.
Some experts contend that because of a quirk of measurement, the true drop in spreads might be only about half the stated 41%. But either way it has been a boon for investors.
San Francisco-based discount brokerage giant Charles Schwab Corp. provided dramatic evidence of the impact of shrinking spreads in its first-quarter earnings report: Schwab’s earnings rose just 2% from a year earlier, hurt in part by a 24% decline in trading revenue from the firm’s New York-based Mayer & Schweitzer unit, a major Nasdaq market maker.
“The entire first quarter of 1998 reflected the dramatic changes in Nasdaq trading rules that were phased in during 1997,” Schwab said in a statement.
And so far at least, there is little evidence of the feared downside of shrinking spreads: that dealers’ falling profitability would drive a large number of them out of market-making activities, hurting investors’ ability to buy and sell Nasdaq stocks when they want and in the quantities they want.
Still, except for last October’s brief market turbulence, there hasn’t yet been a stern test of the Nasdaq market’s liquidity under the new trading rules.
The reforms were imposed by the Securities and Exchange Commission after years of criticism of Nasdaq, and after the SEC in 1996 found that Nasdaq market makers had been illegally colluding to maintain wide spreads and keep investors from getting in between those spreads.
Say, for example, that a market maker is quoting a bid (buy) price of $40 and an asked (sell) price of $40.25 for a particular stock, and that an investor places a “limit” order--an order stating a specific price--to buy at $40.06.
Before the reforms, market makers could in effect ignore limit orders that would cut into their spread. Now, under the new order-handling rules, dealers must either promptly meet and execute such “inside” orders or electronically display them to the whole market, so other investors have the chance to trade at the inside price.
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The competition that this move instilled was turbocharged by Nasdaq’s decision to also display any inside orders that enter the market through the fast-growing private electronic communications networks, or ECNs, such as Reuters’ Instinet, Island and Bloomberg Tradebook, through which professional traders and big institutions trade directly with each other rather than with dealers.
Although the principal customers of the ECNs are institutions, Internet brokerages such as E-Trade also use ECNs. That means that limit orders from individual investors trading from their home personal computers can set the tone for prices in the Nasdaq market overall.
As the ECNs’ share of Nasdaq trading volume continues to rise, it’s estimated that customer orders, rather than dealer-generated quotes, now are dictating the prices of Nasdaq stocks at least 20% of the time. And given that dealers have had to shrink their spreads to remain competitive, the real price effect of the ECNs and limit orders is magnified.
Patrick Healy, a former Nasdaq official who now is president of Chevy Chase, Md.-based Issuer Net, which advises companies on where to list their stocks, said that 20% figure represents a big step forward for Nasdaq in its evolution from a purely dealer-driven market to more of an order-driven--or auction--market like the New York Stock Exchange.
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The SEC had hoped that the order-handling reforms would encourage more use of limit orders by individual investors, thereby enhancing competition and narrowing spreads. Has it happened?
Odd as it may seem, Nasdaq says it currently has no mechanism for measuring the flow of limit orders, as distinct from market orders, which do not specify a price.
“My sense is that there has not been a huge growth in limit orders, but the ones that exist are getting represented as quotes, so they have a better chance of being executed,” said Robert L.D. Colby, SEC deputy director of market regulation.
Indeed, at least one big discount brokerage says the major effect of the rule changes has been to give investors greater confidence to trade Nasdaq stocks.
“The biggest complaint we had [before the rule changes] was people would put in limit orders and they’d never get filled,” said John Tovar, vice president for brokerage services at La Jolla-based Jack White & Co. “A lot of people who were used to the way an exchange works--where you see your order posted when you put it in--wouldn’t even trade over-the-counter securities.”
But since the changes were instituted, he said, Jack White has seen an “overwhelming” amount of new interest in Nasdaq-listed securities.
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One of the big remaining questions about the order-handling rules is how they might affect Nasdaq stocks’ liquidity in a sustained market downturn.
Unlike at the NYSE, which requires that its “specialist” traders--in exchange for their monopoly in handling trades for a particular stock--also act as buyers of last resort, Nasdaq market makers are free to simply post uncompetitive quotes when they don’t want to trade.
Dealers have long argued that their price spreads have been necessary to earn adequate returns so that they have the capital needed to support the market when there are few investor buyers.
Thus, the fear with the new Nasdaq trading rules was that dealers’ shrinking profits from narrowed price spreads would cause some of them to stop handling smaller stocks, for which the relative lack of trading interest increases the chance that a market maker will get stuck holding a stock that nobody wants to buy.
Certainly, some dealers have cut back the number of Nasdaq stocks they handle. Yet Nasdaq says the number of market makers per stock increased 6.3% between January 1997 and last January--from an average of 9.8 dealers per stock to 10.4 per stock. The increase shows that the firms reducing their market-making activity were more than offset by others coming in, Nasdaq says.
On the other hand, Nasdaq’s studies show that the average number of shares offered at the inside price--another measure of liquidity--declined 3%, to 2,082 shares from 2,155 shares in the same survey period.
Overall, then, it’s hard to make a case that the new rules have yet enhanced or have reduced liquidity significantly, analysts say.
Market makers got high marks for performance during last October’s mini-crash, when the Nasdaq composite index fell 7% in one day and volume surged to a record of 1.3 billion shares the next day.
Spreads in the market did not widen sharply, and there were few reports of dealers refusing to trade, both Nasdaq officials and critics said. “None of the horror stories have come to pass,” said John Tognino, president of the Security Traders Assn., a trade group.
Still, he added, “the fact is, we don’t know what the level of liquidity will be in a real down market in the face of all these innovations and the profit-margin squeeze” on dealers.
Healy noted that Merrill Lynch & Co., Bear Stearns Cos. and other Wall Street giants have trimmed back on the number of Nasdaq stocks in which they make markets. “When Merrill and Bear are not in the game, you have to look who’s taking their place,” he said. “Obviously, the guys taking their place don’t have as much capital.”
And although the order-handling rules have substantially narrowed price spreads, there is evidence that market makers still are not ravenously competitive.
A study co-written by Whitcomb of Rutgers and financed by the Electronic Traders Assn.--the industry group for independent day traders--showed that, in the wake of the shift to quoting stocks in sixteenths last summer, Nasdaq’s 10 largest market makers posted prices in even sixteenths (two-sixteenths, four-sixteenths, and so on) 93% of the time, which the ETA said represented anti-competitive behavior.
In a truly competitive environment, the authors reasoned, market makers would quote prices in odd sixteenths just as often as even.
Nasdaq, however, said the study also provided evidence of how much more competition exists in the market since the new trading rules took effect.
But some critics argue that the Nasdaq market’s broker-dealers simply aren’t moving fast enough in the direction of a customer-driven market.
Thomas S. Mulligan can be reached by e-mail at thomas.mulligan@latimes.com
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What’s the Spread?
Dealers in Nasdaq stocks quote two prices: a bid, which is the price at which they’ll buy a stock, and an asked, which is the price at which they’ll sell. The spread, or difference between those prices, now tends to be very narrow for major Nasdaq stocks, though it’s wider for less actively traded issues. The spread percentage shown here is the loss an investor would realize from buying and then immediately selling the stock at the prevailing bid/asked prices. Prices as of Monday’s close for a sampling of large and small Nasdaq issues:
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Current Current Price Spread Stock bid asked spread pctg. Farmer Bros. $194.0000 $203.0000 $9.0000 4.43% Biomatrix 30.0000 30.7500 0.7500 2.44 Quiksilver 17.8750 18.1250 0.2500 1.38 Koo Koo Roo 2.6250 2.6563 0.0313 1.18 K-Tel Intl. 34.6250 34.6875 0.0625 0.18 WorldCom 43.3125 43.3750 0.0625 0.14 Dell Computer 74.3125 74.3750 0.0625 0.08 Intel 80.0000 80.0625 0.0625 0.08 Microsoft 90.3125 90.3750 0.0625 0.07 Yahoo 112.0000 112.1250 0.0625 0.06
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Source: Reuters
