Merrill Expected to Buy Herzog, Boosting Role as Nasdaq Market Middleman

Merrill Lynch is apparently hot to get back into the business of being a major market middleman for Nasdaq shares--which could add more liquidity to the market, but also would allow Merrill to profit by “internalizing” investors’ orders.

The rumor on Wall Street Monday was that Merrill was preparing to pay up to $1 billion for privately held Herzog Heine Geduld Inc., the No. 3 “market maker,” or middleman, in Nasdaq shares.

Buying Herzog would vault Merrill from sixth in a business it shunned three years ago in the wake of major brokerages’ settlement with the federal government in a case alleging massive market-maker price collusion.

A market maker facilitates other investors’ trades by standing ready to purchase or sell shares, profiting on the gap between the “bid” and “asked” prices of a stock.

Since the settlement with the government, the spread between bid and asked prices for Nasdaq stocks has narrowed, cutting dealers’ profits while benefiting investors. But in the meantime, technology has cut trade-processing costs, making the business more attractive to Merrill, analysts say.

Indeed, Merrill last week said it would increase the number of companies’ shares in which it makes a market to 2,000 from 550.

“It’s a buy-versus-build decision,” said Amy Butte, a Bear Stearns Cos. analyst. “It gets them to their goal of trading 2,000 stocks--actually over 6,000 with Herzog--much faster than it would have if they had to build it themselves, which would have taken until the first quarter of 2001.”

Spokesmen for Merrill and Jersey City, N.J.-based Herzog declined to comment on the agreement, which was previously reported by Dow Jones Newswires.

The potential for more competition in the market shook the biggest Nasdaq market middleman, Knight Trading, on Monday. Knight’s shares (ticker symbol: NITE) plunged $4.56 to $30.94. They have fallen from a 52-week high of $64.81. Merrill shares (MER) slipped 50 cents to $107.50.

A Merrill-Herzog alliance would be a blow to Knight in part because it would allow Merrill to keep in house--for its own profit--trades it now sends to Knight.

Discount brokerage giant Charles Schwab & Co. similarly operates a major market-making unit, allowing so-called internalization of customers’ trades.

Merrill may not be the only major brokerage targeting the business of market making for expansion. Citigroup’s Salomon Smith Barney rebuffed overtures from Herzog a few months ago and decided to build its own automated market-making system, sources said.