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Fun and games on Nasdaq
By Gretchen Morgenson
IN SHARE of U.S. equity-trading volume, over-the-counter trading through Nasdaq is closing in on the once dominant New York Stock Exchange. In 1982 the NYSE traded 63% of the shares changing hand while Nasdaq traded 32%. In 1992 Nasdaq's share had jumped to 47% while the Big Board's had dwindled to 50%. The Big Board's former 2-for-1 lead has turned into a dead heat. The exchange retains a big lead only in dollar volume, a lead it is losing.
Why is Nasdaq outgrowing the New York Stock Exchange? Nasdaq claims its computerized trading system is more efficient and just as fair as the Big Board's auction system with its flesh-and-blood specialists. And Nasdaq claims to be the home for companies of the future, intimating that the Big Board is for the tired old giants. Day after day such Nasdaq stocks as Apple Computer,MCI Communications and Intelcompete in volume with Big Board giants like IBM, Wal-Mart, Merck.
But there's another factor involved that Nasdaq people don't like to talk about. Nasdaq volume is more profitable for the brokers than is stock exchange volume. Because it is more profitable for brokers, they have more incentive to push Nasdaqstocks.
It shows in broker compensation. Most firms pay registered reps 33% of gross commissions on exchange stocks -- but 40% on Nasdaq stocks for which the firm is a marketmaker. Because of this sponsorship, many fastgrowing companies prefer Nasdaq to the Big Board. Those extra percentage points motivate the brokers to work the phones on their behalf.
Fine. That's good for brokers and in many cases companies. What about investors? That's another story. Nasdaq employs a multiple marketmaker system, wherein many dealer make bids and offers on stocks supposedly competing for customer trades. The New York and American stock exchanges use the auction method, where one specialist handles all trades in a given stock, passively matching orders when buyers and sellers are in balance, taking a position himself when they are not.
Unlike the Big Board, Nasdaq (short for its former name, the National Association of Securities Dealers Automated Quotation system) is not a place. No shouting, gesticulating traders throng its floor, because it has no floor. Nasdaq is simply an association of 472 marketmaker firms tied together by telephones and computers.
After careful reporting Forbes is convinced that the auction system produces better prices for all but the biggest investors.
Let's look at some numbers. Given its high degree of automation an ostensibly large number of marketmakers competing for business Nasdaq's bid/asked spreads should have narrowed over the years an investors' costs of trading on Nasdaq should be lower than on the Big Board. This would show up in a narrowing of the difference between bid and asked prices -- the spread.
Have Nasdaq spreads narrowed? Are they lower than comparable Big Board spreads? No on both counts. And there's this very important difference: You can buy and sell in between the spread on a listed stock, but you can't on an o-t-c stock, even one traded every minute or two.
Take a Big Board stock quoted 49 1/2 bid, 49 3/4 asked. If you as an individual place an order to buy in the middle, at 49 5/8, your order goes on the specialist's book. It takes precedence over all similarly priced offers that come in later, and also over trades by the specialist for his own account at that price. There's a good chance you'll get the stock at 49 5/8. All you need is one or more sellers willing to take 49 5/8 for their shares.
Try the same thing on a Nasdaq stock. Unless you are a huge investor or otherwise carry clout, you can't get your order executed at a price between bid and asked. In most cases, you pay the asked price or you don't get the stock.
From May 1989 to May 1993 the trade-weighted average spread on Nasdaq's main listing, called the National Market, increased from 43 cents to 59 cents. During these years, average spreads on the New York and the American exchanges have held steady at 21 cents. No question where investors get the better deal.
Nasdaq makes much of a study by Hans Stoll of Vanderbilt University finding that, in cents per share, there is little difference in trading costs between the exchanges and Nasdaq. Wait a minute. Share prices tend to be much lower over-the-counter than on exchanges. As a percentage of trade value, Stoll found, equity transaction costs are more than twice as high o-t-c as on an exchange.
The folks at Nasdaq say that to look at average spreads is misleading, and that spreads should be compared only in "comparable" stocks -- Apple and IBM, for instance, or U.S. Healthcare and United HealthCare.
Fine. On a recent trading day Apple had a 1/4-point spread, IBM's was 1/8; U.S. Healthcare's spread was 1/2 on Nasdaq, United HealthCare's was 1/8 on the New York.
Even better, why not look at spreads of identical stocks that have moved from the Nasdaq to an auction market? That's what William Christie and Roger Huang, also professors at Vanderbilt, analyzed in 1992. They concluded that sharp reductions in a stock's spread -- more than 50% on average -- resulted when a firm moved from Nasdaq's National Market to an exchange.
Not everyone pays more for using Nasdaq. Institutions and big traders can advertise their wants or offerings on Reuters' Instinet, circumventing spread-hungry dealers. There's also Posit, a five-year-old electronic matching system operated by Investment Technology Group in New York. On Posit, orders on listed and o-t-c stocks pile up all morning; a around 11 a.m. a computer begins sorting through them, matching them up on price, and in some cases size. Posit's volume, though small, is rising fast.
Individual investors are unlikely to use either Posit or Instinet because a substantial deposit or a large minimum asset requirement is needed. Nor does any broker we know of offer to put small customers on Instinet. The best that individuals can do to minimize o-t-c trading costs is to instruct their brokers to execute their Nasdaq trades on the Chicago Stock Exchange. In a relatively new program, specialists in Chicago make markets in 100 o-t-c stocks. By sending your order to Chicago, you have a better chance of paying only a commission -- rather than a spread and a commission.
It's not our fault if Nasdaq trading costs a bit more for individual investors, says Nasdaq. James Spellman, spokesman for the National Association of Securities Dealers and Nasdaq, says spreads have increased in Nasdaq stocks in recent years because a group of nondealer firms is "arbitraging" momentary and minute discrepancies between dealer bids and dealer offers. They do this, according to Spellman, by placing orders electronically on a system called Small Order Execution System, or SOES. Spellman says these dealers, which other marketmakers derisively call "SOES bandits," have forced genuine marketmakers to widen their spreads to cover SOES bandits' costs.
Nice try, but that's only a small part of the answer to why Nasdaq spreads are higher. For starters, these SOES firms aren't taking advantage of Nasdaq price discrepancies, they are trying to catch trading trends. Furthermore, these 18 firms can place only four SOES orders for 1,000 shares per customer per day; their numbers are miniscule compared with regular dealer and customer trading of some 240 million shares on a typical Nasdaq day.
Why hasn't competition narrowed the Nasdaq spreads? Cut through the rhetoric and this is what you discover: Nasdaq is more costly for investors because the dealers work together to keep it that way. As one cynical o-t-c trader points out: "In the over-the-counter market, the competition is between the dealers and the customer."
Note this: Bid and asked prices on Nasdaq stocks rarely vary from dealer to dealer. Most Nasdaq stocks have a dominant dealer, who is, in some ways, comparable to the Big Board specialist. When that "specialist" moves his bid -- in trading lingo this dominant dealer is known as "the name" -- the others almost invariably follow. Some firms have their workstations programmed to ape the bid and offer quoted by the name.
Novice traders learn quickly that if they want to keep their jobs on an o-t-c desk, they will do well not to beat the price of fellow marketmakers. "Breaking the spread," as it is called, just isn't done. On veteran, who tried on occasion to narrow an o-t-c spread, told Forbes: "I used to get phone calls from people; they'd scream, 'Don't break the spread! You're ruining it for everybody else!'"
Another trader who tried something similar said: "My phone lights up like a Christmas tree. 'Whaddya doing in the stock? You're closing the spread. We don't play ball that way. Go back where you belong.'"
One dealer recalls putting up a price on 10,000 shares of Seagate Technology with a 1/8-point spread, instead of the 1/4 point that was typical at the time. When fellow marketmakers' threats didn't scare her into pulling her quote, they stopped trading the stock, one of Nasdaq's most active issues. She says: "This was not a regulatory halt. They [the dealers] simply stopped trading it for 45 minutes; not one trade went by." Finally First Boston filled the order and the stock began trading again, with a 1/4-point spread.
Veterans well know that closing the spread might gain them an order, bu it would in the long run spoil the game. It's no coincidence that as o-t-c spreads have increased, so too has the number of marketmakers. Firms making active markets in o-t-c stocks now number 472, up from 407 ten years ago. During the same period the number of specialist firms on the New York and the American stock exchanges declined.
Who are these "names," or "axes," as marketmakers are sometimes called? Nasdaq dealer firms include big retail outfits like Merrill Lynch and Shearson, trading firms like Salomon Brothers and Goldman, Sachs and strictly o-t-c trading houses like Herzog, Heine, Geduld; Sherwood Securities; Troster Singer and Charles Schwab's subsidiary Mayer & Schweitzer.
No one firm makes markets in all 5,000 Nasdaq stocks. A big stock like Apple Computer may have 60 marketmakers, a small stock only 2. Merrill Lynch makes markets in 1,050 U.S. stocks. Publicly traded Sherwood makes markets in at least 2,600 securities.
Sherwood is definitely one of the big "names" in o-t-c trading. It employs roughly 100 traders and salespeople; as it has no retail customer base, its profits come largely from proprietary trading. Last year Sherwood had revenues of $ 45 million, double what it generated in 1991. Pretax income was $ 11.4 million. Sherwood's operating profit margin of 25% of revenues is extraordinary. Powerhouse Merrill Lynch's pretax margin, for example, is 12%, Morgan Stanley's 11%.
These margins make the business of trading Nasdaq irresistible. Merrill Lynch is widely rumored to have earned $ 300 million trading Nasdaq stocks last year, 14% of its principal trading revenues. Mayer & Schweitzer, the New Jersey-based o-t-c trading arm acquired by Charles Schwab Corp. in July 1991, had revenues of about $ 120 million last year.
Dealers argue that 25% margins like Sherwood's are just deserts for the risks they take carrying positions in stocks so that they can make good markets for their firms' customers. Risks? Rarely does a firm hold long or short positions in stocks from day to day. After the 1987 stock market crash, most firms instituted policies requiring traders to go home "flat," with no position, thereby minimizing their potential for losses in a volatile market. Gone are the days of firms maintaining inventories of stocks from which they could execute customer orders. Much smarter simply t take the spread on each trade -- virtually riskless eighths and quarters. Those pennies add up. The NASD says o-t-c marketmakers grossed $ 2.76 billion in 1992, up 50% from 1988.
In the auction markets of the New York and American stock exchanges, the specialist is -- at least in theory -- obligated to make a fair and orderly market in a company's shares. This means the specialist must put his capital at risk in any stock that suddenly moves fast in one direction. He must buy when the stock is dropping precipitously and sell when it is rising precipitously and pray he can liquidate at a profit before the day ends.
The Nasdaq marketmaker is under no such obligation. Who can forget how so many marketmakers' phones went unanswered in the crash of Oct. 19, 1987?
Essentially, Nasdaq runs a two-price system. There are two different kinds of markets. There is the market for outside investors, the bids and askeds found on your broker's quote machine. Intel recently had a outside quote of 57 1/2 to 58, a half-point spread, meaning that an investor wishing to sell would get $ 57.50 a share minus commission; an investor wishing to buy would pay $ 58 a share plus commission. A stockbroker who happened to represent both the buyer and the seller would earn two regular commissions plus the 50-cents-a-share spread on the trade.
Then there is the market for insiders, SelectNet. Here the spread is razor-thin, but it's for dealers only. At the inside price marketmakers buy or sell shares for their own accounts or for their biggest customers. That market on Intel might be 57 5/8 bid, 57 7/8 asked.
It's very simple: A smallish investor pays a spread of 50 cents a share, a dealer, 25 cents. So, if a Schwab customer places an order to buy 500 shares of Intel and Mayer & Schweitzer doesn't have the stock on hand and doesn't want to go short the stock, M&S could buy the shares at 57 7/8 from another dealer and sell them to the customer at 58 -- plus a commission of $ 164. Schwab, so innovative in other ways, has shown no willingness to narrow the spreads in the over-the-counter game.
The brokers have some interesting ways of dividing the spoils. Newly popular is the marketmaker tactic of paying retail firms for the privilege of executing their over-the-counter customer orders -- paying for order flow.
The practice began only a few years ago. A big dealer, like Herzog, Heine, for instance, which makes markets in 4,200 Nasdaq stocks, puts out the word that it will pay 2 cents or 3 cents a share for another firm's orders. In return, Herzog promises to execute the trades at the best bid or offer on the Nasdaq system.
To be sure, the broker who sells some of his order flow is giving up a juicy spread. But then no one broker can make markets in every stock. You sell an order in a stock where you don't make a market, and the fellow who buys your order is supposed to return the favor by sending you an order in a stock in which he doesn't make a market.
Paying for order flow is not generally disclosed on customer statements but the subject came up this spring at Massachusetts Congressman Edward Markey's hearings on the future of the U.S. stock market. Representatives from the New York and the American stock exchanges spoke out against payment for order flow.
At the hearings NASD Chief Executive Joseph Hardiman testified: "The NASD believes payment for order flow practices do not interfere with customers' receiving the best qualitative execution nor with brokers' meeting their duties to fulfill fiduciary responsibilities to customers."
Maybe so, but here's an example of how paying for order flow cements relationships among dealers to the detriment of investors. Recently, money manager had been amassing a position in a thinly traded o-t-c utility stock, El Paso Electric, $ 8.44 preferred, which traded at bid 70, asked 75. He knew there were 2,000 shares for sale at 73, a price he was happy to pay. So he called the three brokerage firms who carried his clients' accounts and told them the stock was available and to buy the shares at 73. One firm refused to buy it, reporting to the customer, "nothing done," thereby forfeiting a commission.
Why did it risk disappointing a good customer and why did it throw away a commission? Explains the broker watching all this: "The marketmaker told me, 'I have to go to my friendly dealer,' in other words, the one who pays me for business." The "friendly" dealer was obviously the one offering to pay for order flow. He was not the guy offering the El Paso shares at 73 between big and asked.
Payment for order flow is only one of the practices common to the clubby world of Nasdaq trading. Trading ahead of customers is another one. Most investors are probably unaware that Nasdaq marketmakers can and will trade ahead of customers' orders all day long, even if the shares trade through a client's limit price. This explains why you might get a "nothing done" on an order to buy 1,000 shares of Video Lottery Technologies at 12, even though many shares traded there while your order sat. At the same time that dealer firms are executing customer trades, they are also trading in these and other shares to make money for themselves.
Trading ahead of customer orders can have the effect of driving the price of a stock up when you want to buy and down when you want to sell. On the New York and the American exchanges, this is illegal. Specialists on the exchanges can and do make money taking positions in their stocks, but they are forbidden to trade ahead of customer orders for their own accounts.
When asked about this practice, Hardiman says the NASD is considerin a rule making trading ahead "inconsistent with just and equitable principles of trade." Nevertheless, Hardiman does not believe trading ahead of customers is prevalent. Says he: "We asked member firms and they said 'No, we don't do it.'"
That's not the story we heard from many of the traders we talked to. Even if the NASD were to institute a long overdue rule against trading ahead, traders say it would be almost impossible to enforce. Regulators would have to comb through order flow minute by minute every day in order to identify firms trading ahead. The marketmaker is the only one who knows exactly when an order comes in over the phone -- the very person who has the most to gain by trading ahead.
Heavy dealer trading helps explain why some Nasdaq stocks show daily volume at times that is way out of proportion with their float. For example, on July 6, following a holiday and not a heavy volume day, Dell Computer traded 4%, Seagate Technology 2% and Microsoft 1% of its available shares. Rarely does a Big Board stock experience that level of activity. Neither was there any dramatic news on these Nasdaq stocks make them trade wildly that day. Clearly, 4% of Dell's shares had not changed hands at the end of the day. Much of the trading would have been by dealers darting in and out, sometimes to grab a trend, sometimes to accentuate a trend, always to capture those spreads.
Much more than on the Big Board, trading on Nasdaq is between dealers for their own accounts and for their own reasons. Nasdaq says it doesn't know how much of its trading volume is customer business and how much is traders' transactions. A knowledgeable source estimates that 38% of Nasdaq's volume is customer business, compared with 90% on the NYSE.
This trading among dealers leads to some sharp practices. Let's say, for example, the "ball" on the stock -- that is, the dominant dealer -- who also underwrote a secondary offering in the shares recently, has a huge order to sell. Other traders on The Street would get nervous and dump if they saw the underwriting firm come into the market with that sell. "So," says one trader, "you send a stooge down to bid higher for the stock." Other marketmakers raise their bids in tandem, buyers are enticed in, the stock gets sold without alarming Wall Street, and the firm doing the shilling gets 1/8 or 1/4 over any cost incurred during the exercise.
Shills, beards, fronts. They cause extraordinary volatility, adding to investors' already high transaction costs. Nasdaq does not deny the volatility of its shares, saying that it's in the nature of small growth stocks to trade more violently. But this excuse contradicts its own claim to be home to some large, fastgrowing companies. Is Apple a small stock? Intel? Dell Computer? MCI Communications?
The volatility numbers tell the story. Compare the average trade-to-trade percentage price changes on all Nasdaq National Market, Amex an NYSE stocks. Forbes looked at these changes during the month of April and found the average trade-to-trade percentage price changes on the New York and the Amex were 0.5% and 1.1%, respectively. On Nasdaq the average change was almost 2%. In short, Nasdaq stocks were four times as volatile as NYSE issues, almost twice as volatile as Amex issues.
Examining price changes as they are related to trade size -- 500 or fewer shares, 501 to 1,000, 1,001 to 9,999 etc. -- is illuminating. This helps identify how deep a market is and tells you which investors end up paying the most through increased volatility.
Strangely enough, the smallest trades -- 500 or fewer shares -- produced the biggest percentage price change in Nasdaq stocks: a 2.2% difference. One would expect that small trades would not move the market nearly as much as big trades. Indeed, on the New York and the Amex, small trades produced the smallest price change.
As trade size increases, disruption to the market in Nasdaq shares
decreases; at 10,000 shares or more, the average Nasdaq stock changes
price by 1.7%. This is probably because institutional investors wisely
place limit orders on their trades and demand that their brokers "work
them" to get the best price. Another explanation: Marketmakers trading
among themselves give themselves the best prices. Small investors, once
again, get iced.
However unsafe it may be for the individual investor, Nasdaq has plenty
of corporate fans. Douglas Maine, chief financial officer for MCI
Communications, explains why his $ 16 billion (market cap) company
stays on Nasdaq rather than move to the NYSE: "The cost of listing is
substantially lower; we don't have trading halts or delayed openings like
they do on the New York, and we have 50 marketmakers in our stock,
which provides us greater liquidity than we would get on the New York."
And, Maine points out, MCI traded more shares than any other stock in
America from 1988 to 1990. Nasdaq returns the compliment by featuring
MCI in its ad campaign that promotes Nasdaq as "the stock market for
the next 100 years."
MCI has considerable company. Huge and successful outfits like
Microsoft, Sun Microsystems, Tele-Communications, Inc. all stay on
Nasdaq, and for roughly similar reasons. But investors should remember
that, while all Nasdaq stocks are equal, a few are much more equal than
the majority. While markets may be liquid and spreads reasonably
narrow in the top 100 Nasdaq stocks, they are not in the other 4,900
Nasdaq stocks.
Listen to Robert Uricho, chairman of Sunair Electronics, a military
equipment manufacturer, who late last year moved from Nasdaq to the
American Stock Exchange. "Last September we put out the notification
of a $ 4.2 million government order, and they [marketmakers] ran the
stock from $ 1.50 to $ 6 and back to $ 2 in the span of 30 days. I thought
it was pretty bad." Sunair's marketmakers included Troster Singer,
Mayer & Schweitzer and Herzog, Heine. On the Amex Sunair recently
traded at 2 3/4.
When companies do abandon Nasdaq, they not infrequently are bullied
by their former marketmakers. Lawrence Breneman is president of
Maryland's Washington Savings Bank, and previously headed another
company, Washington Homes. At various times he moved both from
Nasdaq, one eventually to the New York, one to the Amex. He says:
"Our marketmakers were very unhappy; they were losing their ability to
gouge. But we told 'em to go to hell and did it anyway."
Note this: Salomon, Merrill, Bear, Stearns, Morgan Stanley, Charles
Schwab, Dean Witter, even Sherwood, are listed stocks. None trades
o-t-c. The folks who know the markets best seem to prefer the
exchanges.
There's a simple cure for what ails the small o-t-c stock investor: Make
Nasdaq more like the Toronto Stock Exchange. Since 1991, that
exchange has become a hybrid of auction and electronic markets. Each
stock has a specialist obligated to make a market in the security, but the
entire specialist's order book is also available to customers on computer
screens. Buyers and sellers meet and have their orders matched. Says
James Gallagher, executive vice president of the Toronto Stock
Exchange: "We believe sunshine is not only the best disinfectant, it's also
the best advertising for our market."
No one questions that Nasdaq is a vital and lively market, but if you are
an individual investor, those spreads and price manipulations will eat you
alive. The odds are firmly stacked against you.
[end of article]
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