Heard on the Street - SEC Pricing Study Deals A Blow to Nasdaq Market
By GREG IP and MICHAEL SCHROEDER
Staff Reporters of THE WALL STREET JOURNAL
After a year of debate over whether it is cheaper for investors to trade on a central exchange like the Big Board or with multiple dealers like on Nasdaq, the Securities and Exchange Commission has weighed in: The Nasdaq, despite major reforms, is still costlier.
Yet while the long-awaited SEC study isn't kind to the Nasdaq Stock Market, as expected, it also carries some good news for that market and a potential warning for the NYSE. It finds Nasdaq's costs are the same as the NYSE's and its speed generally faster in the very largest stocks, such as WorldCom and AT&T. Those are also the stocks in which screen-based systems known as ECNs, which allow buyers and sellers to bypass dealers, have made the biggest inroads. That suggests the NYSE has fewer advantages over these electronic upstarts than it has over traditional Nasdaq dealers. ECNs, after capturing an estimated third of Nasdaq volume, now are trying to invade the Big Board's turf.
The study, released Monday, finds that for orders of 100 to 499 shares, the spread -- the difference between what a buyer pays and a seller receives for a stock, which is a major trading cost -- was between five and 11 cents a share wider for Nasdaq stocks than NYSE stocks on all but the very largest stocks. Nasdaq's spreads were also wider for 500-share to 4,999-share orders, but not by as much. On the largest stocks there was a slight, but not statistically significant, advantage for Nasdaq.
SEC Chairman Arthur Levitt, while careful to note the limitations of comparing two different markets, said in a speech at Stanford University last night, "For Nasdaq, [the study] confirms a challenge it faces and quantifies what most traders freely acknowledge -- the ability to trade inside the best displayed [price] quotes is substantially limited."
The study also finds that "limit" orders, which must be executed within specified time and price constraints, are filled more often on the NYSE than on the Nasdaq.
Offsetting these negatives for Nasdaq, the study finds that on small orders of 100 to 499 shares, orders get executed by 10 to 19 seconds faster on Nasdaq than on the Big Board; on 500-share to 1,999-share orders there is little difference; and on 2,000-share to 4,999-share orders, the NYSE is usually faster, by 29 to 47 seconds.
The study identified two structural differences between the markets which, though it didn't say so, could explain the discrepancies. First, the NYSE is a central agency-auction market, where more than 80% of the volume in its stocks is executed on the floor, maximizing the chances for a buyer to meet a seller. Nasdaq is decentralized, or "fragmented," with no dealer or ECN accounting for a majority of volume.
Second, dealers fill far more of the orders on Nasdaq (where they are called market makers) than on the NYSE (where they are called specialists). Dealers try to profit at the price at which they trade with customers, and their greater involvement on Nasdaq may translate into higher trading costs for customers.
Since government probes found in 1996 that dealers were systematically charging investors excessively wide spreads, Nasdaq has undergone major reforms forcing dealers to post better prices and making ECNs an integral part of Nasdaq. Since then, it says spreads have fallen 75%. Neither the SEC study nor Mr. Levitt attributed the findings to bad behavior on Nasdaq.
Nonetheless, Nasdaq vigorously challenged the study. (The NYSE praised it.) It played up its performance on the largest stocks, which it says account for more than 40% of its volume, and questioned the study's methodology on the rest.
Indeed, Nasdaq has been arguing with the SEC for months over the study, and the "very large category" was added after it supplied detailed data on its 31 largest stocks. In its report, the SEC, which delayed the release so as to take every Nasdaq objection into account, notes that "Nasdaq management strongly insisted on full representation of the very largest stocks in the sample."
Michael Ferri, vice president of Nasdaq economic research, said of the 200 Nasdaq stocks the SEC originally looked at, barely a third met NYSE listing standards.
Nasdaq President Richard Ketchum said, "Nasdaq companies tend to be younger, less diversified, from quite different industries, and more growth-oriented than NYSE companies ... It is not surprising that their trading characteristics are also different. [But] these differences are in the companies themselves, not differences in the trading venue."
He also noted that contrary to the presumption that fragmentation raises costs, the study finds that costs were lowest in the stocks with the most competition. Nasdaq's 20 largest stocks average about 60 market makers each.
But those stocks' volume and spreads also are dominated by ECNs, so the study could be evidence that as long as investors can see all the orders and trade with them, as they can on ECNs, a market need not be too costly even if it is fragmented.
Nasdaq's proposed "Supermontage" trading platform is meant to both centralize its fragmented nature and give all Nasdaq more of the features of a stock exchange or ECN, addressing some of Mr. Levitt's concerns. Nasdaq has revised the trading system repeatedly to mollify the concerns of critics, including ECNs, which believe they will be disadvantaged. The SEC is scheduled to vote on the controversial proposal Wednesday.
Among the pairs of stocks the SEC said matched closely were Apple Computer (Nasdaq) and Teradyne (NYSE) among the very largest; Outback Steakhouse (Nasdaq) and Harris Corp. (NYSE) among the largest; Ohio Casualty (Nasdaq) and La Z Boy (NYSE) among the middle stocks; and Coinstar (Nasdaq) and United Auto Group (NYSE) among the smallest.
The SEC looked at "effective" spread, which compares the price actually received with the bid and offer posted at the time the order was sent, which takes account of when an investor does better, or worse, than the quoted best bid or offer. That tends to favor venues, such as the NYSE or an ECN, where a buyer or seller can meet directly at, or inside, the quoted spread, rather than giving up some of the spread to a dealer.
The study's origins date back to a speech in late 1999 in which Mr. Levitt asked if fragmentation of trading volume among various venues, so that buyers and sellers couldn't interact, was eroding the fairness and efficiency of the U.S. stock markets. Around the same time, the NYSE, under pressure from the SEC, dropped a barrier to its member firms' trading of NYSE stocks in their own dealing rooms or on ECNs, raising the possibility that over time the NYSE would look like Nasdaq.
Mr. Levitt went on to toy with the idea of a so-called central limit-order book that would mandate that all orders around the country were executed in order of the best price and the first in line. That controversial proposal had supporters among major firms on Wall Street, but was bitterly opposed by the New York Stock Exchange and firms such as Charles Schwab & Co.
Write to Greg Ip at greg.ip@wsj.com and Michael Schroeder at mike.schroeder@wsj.com
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