Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: SUNDAY, November 20, 1994 TAG: 9411220001
SECTION: BUSINESS PAGE: G-1 EDITION: METRO
SOURCE: SCOT J. PALTROW LOS ANGELES TIMES
DATELINE: SUFFERN, N.Y. LENGTH: Long
Houtkin taps a few buttons on a keyboard linked to the central computer for over-the-counter stock trading. ``What I'm doing now is the most unacceptable thing you can do in the market,'' he says.
Indeed, Houtkin - a ``market maker'' whose business is buying and selling Nasdaq stocks at publicly quoted prices - is about to send traders at vastly larger firms into fits of rage.
Seeking to attract a small portion of the more than 66 billion shares traded annually on Nasdaq, he is about to deliberately narrow the spreads - essentially the market makers' profit margin - on some of the most widely traded over-the-counter stocks.
The move will save investors money. But it also will cut into the hefty profits of more-established Nasdaq dealers.
He punches in the symbol for Intel Corp., the computer-chip maker that is Nasdaq's second-largest company. Houtkin, with 1,000 shares to sell, changes his posted prices. He cuts the ``spread,'' - the gap between the best price at which any dealer will buy the stock and the price at which he will sell it - from a quarter of a point, or 25 cents a share, to a mere eighth of a point, or 121/2 cents.
In response, a message flashes on his trading terminal from a much larger market maker, Weeden & Co.:
``Pathetic.''
A caller who says he is ``Peter'' from Morgan Stanley complains:
``You guys break the spread for 1,000 shares?''
Chiron Corp.'s stock has been trading with a 1/2-point spread; Houtkin narrows it to three-eighths. The phones ring again. This time, Keith Balter, head of over-the-counter trading at Weeden, tells Houtkin: ``You're embarrassing and pathetic. ... You're breaking the spreads for everybody.''
Small investors may never be aware that they benefited from Houtkin's initiatives. Yet an ordinary individual investor buying 200 shares of Chiron or Intel at the better price posted by Domestic Securities would have saved $25. With an average of 299 million shares changing hands daily on Nasdaq, narrower spreads on just the biggest Nasdaq stocks would add up to millions in dollars of savings for retail customers every year.
Nasdaq this year surpassed the New York Stock Exchange to have the highest daily trading volume of the nation's stock markets. But amid the massive trading, such savings - representing millions of dollars in forgone profits for market makers - rarely materialize.
Instead, close examination of Nasdaq's day-to-day operations shows the system is biased against the small investor, favoring big institutional traders and market makers over the ordinary investing public.
Last Monday, the Securities and Exchange Commission said it would investigate Nasdaq's trading practices, joining the Justice Department, which last month confirmed it is conducting an antitrust investigation of Nasdaq, looking into allegations of price-fixing and other illegal practices by dealers. Also on Monday, Nasdaq itself said it would name a special panel to review its operations.
Nasdaq has made it possible for companies such as Microsoft Corp., MCI Communications Corp. and Apple Computer Inc. to raise the money they needed to prosper, creating billions of dollars in wealth for the U.S. economy. And as the home to many of the most rapidly growing firms in technology and health care, it has increased tremendously in recent years in its importance to small investors.
``That's where the growth is,'' said Robert W. Erikson, 67. He is an original member of a Michigan investment club, founded in 1955, that now invests almost half its assets in Nasdaq stocks.
But an inquiry by the Los Angeles Times - including three months spent sitting on Nasdaq trading desks and interviews with more than 100 traders, professional investors, customers and Nasdaq officials - found that individual investors are much more likely to get fair treatment for their trades on the venerable New York Stock Exchange than on Nasdaq.
On the NYSE, spreads for most stocks are a mere one-eighth of a point, while the vast majority of Nasdaq stocks - even the biggest, most actively traded issues - trade at spreads of a quarter-point or more. In part through an automated computer system, big and small orders get executed on a relatively equal footing on the New York exchange; indeed, investors often get prices better than the posted spread. Nasdaq investors, by contrast, get a worse price for their trades than big investors, such as pension and mutual funds or the market makers themselves.
And if a customer has put in an order to sell a stock at, say, $20, that order will be filled on the NYSE before any buyer has to pay a higher price. On Nasdaq, there is no such rule. The federal Securities and Exchange Commission has moved in recent months to stop Nasdaq firms from ``trading ahead'' of their customers' orders. But the new rules still will allow thousands of more advantageous offers to sit unfilled each day in Nasdaq's fragmented trading system while market makers sell shares to small investors at higher prices.
Unlike the New York or American stock exchanges, Nasdaq [the name originally stood for National Association of Securities Dealers Automated Quotation system] has no trading floor. It is a nationwide network of 510 market-making firms linked together by a central computer system and telephones.
In a massive ad campaign, Nasdaq bills itself as ``the stock market for the next 100 years.'' Yet traders say that except for a separate computer system owned by the British firm Reuters PLC, much of Nasdaq's daily volume is not traded through sophisticated electronic networks. Instead, it trades the old-fashioned way - by one dealer talking to another by phone, much as the over-the-counter market operated when it served mainly as a means for obscure companies to sell shares to the public.
Among Nasdaq's most controversial practices:
Competition among market makers to offer the best price and the narrowest spreads has all but disappeared on Nasdaq, according to veteran traders, mutual fund managers and others. Under a controversial system in which many market makers pay brokerage firms to send them a steady flow of orders from small investors - regardless of the price the market maker is offering - a financial incentive exists to keep spreads as wide as possible.
Nasdaq dealers flout the requirement to execute customer orders at the best available price. Despite new rules, market makers still will be able to ignore better offers for their customers' stock and thereby maximize their own profits. Dozens of times, a reporter watched as individual customers or traders entered orders at prices inside the prevailing spread, only to see the orders ignored while other trades were executed at less desirable prices.
The NASD insists that it carefully balances the interests of its customers and market makers alike.
Nasdaq seldom enforces a key securities regulation, the ``firm quote'' rule, which requires dealers to honor the prices they post on Nasdaq computer terminals. Instead, dealers routinely ``back away'' from their quotes - that is, they refuse to trade at all at the prices they advertise.
Although 4,748 backing-away complaints had been filed with the NASD through Oct. 4 of this year, the group has taken no public disciplinary action on any of them. (On three, small fines of $500 to $1,500 were imposed but were not publicly disclosed.) Market makers charge that the NASD doesn't aggressively investigate most of the complaints. The NASD says many of the complaints are frivolous.
Nasdaq also seldom enforces the requirement that dealers promptly report each trade for display on the public tape. Senior executives of mutual funds and other institutional investors complain that some Nasdaq market makers routinely delay reporting trades - and thereby avoid influencing the market. In doing so, critics say, they prevent investors from accurately assessing the supply, demand and price for a stock.
The NASD says it closely monitors the market, but that deliberate wrongdoing is difficult to prove. The group said it has taken no public action this year against any market maker for failing to accurately report trades.
While these problems are interlinked, veteran traders say the most fundamental problem with Nasdaq trading is the market's wide spreads. The Justice Department investigation is focusing on an alleged conspiracy by market makers to keep spreads wide.
The NASD has vehemently denied that there is collusion in its marketplace. In an interview, NASD President Joseph Hardiman said that as far as he knew, market makers were completely free to narrow spreads. Hardiman said he had no knowledge of any verbal harassment of market makers who did so.
Besides the Justice Department antitrust probe, the big trading firms face more than a dozen major class-action lawsuits accusing them of conspiracy to keep spreads artificially wide. The suits seek millions of dollars in damages. They were prompted by news reports that business professors William G. Christie of Vanderbilt University and Paul H. Schultz of Ohio State University had found strong circumstantial evidence of tacit collusion among market makers to fix the spreads.
Nasdaq officials contend that the spreads are determined purely by competitive market forces. Indeed, the NASD and market theorists say that in a truly competitive market, spreads should be determined by how actively traded a stock is, how many shares are held by outside investors, the volatility of a stock's price and the number of market makers competing against each other.
``The spreads in highly liquid, highly active stocks [on Nasdaq] are very good,'' insisted Hardiman, the NASD president.
Yet records of market makers' daily quotes and the new study by professors Christie and Schultz suggest the existence of a gap between official explanations and reality.
The professors discovered something odd about Nasdaq trading: Seventy-one out of 100 of the largest Nasdaq stocks almost never were quoted in ``odd eighths,'' they wrote. That is, the quoted bid or asked prices might be 20 or 201/4 or 201/2, but almost never 201/8 or 203/8 or 205/8. And as a direct result, the spreads on these stocks almost never were less than a quarter of a point.
Christie and Schultz, whose findings will be published in December in the Journal of Finance and who have been cited in many of the class-action lawsuits, searched for market-related reasons why these stocks would not trade in odd eighths when, at the same time, much more thinly traded stocks routinely had odd-eighths quotes.
They concluded there must be an unwritten agreement among market makers to keep the spreads in these stocks wide.``While this paper does not provide conclusive evidence of tacit collusion among market makers, we are unable to offer any other plausible explanation for the lack of odd-eighth quotes,''
Publicly, NASD officials tried hard to discredit the study. Richard G. Ketchum, the NASD's chief operating officer, said the report ``is irresponsible - and in fact we believe it is slanderous.''
by CNB