Nasdaq Looks to Protect Investors
From Dealers' Pre-Opening Trades
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
The Nasdaq Stock Market is considering new rules on how dealers trade before the
market's regular opening, responding to concerns that such trading may sometimes hurt
investors.
The rules under consideration would require Nasdaq dealers to give customers the benefit
of any prices that the dealers obtain by trading before the regular 9:30 a.m. EDT opening.
Currently, that obligation doesn't ordinarily exist.
The proposed rules, outlined in a memo from Nasdaq to its Quality of Markets Committee,
appear to reflect a concern that dealers, by trading before the opening, may be taking
advantage of their knowledge of investors' trading intentions, sometimes at investors'
expense. For example, a dealer with many buy orders of a stock might snap up shares
before the opening, then sell them at a higher price to investors at the opening.
"Nasdaq staff have recently become aware of certain practices in the pre-market that it
believes adversely impact public customers," says the memo to the committee, which is
Nasdaq's top advisory committee on market-structure issues and is made up of brokerage
and institutional traders.
Some brokerage firms are using information about orders their customers want executed at
the 9:30 opening to trade before the opening, then fill those "queued customer orders at the
open, at prices significantly above the firm's pre-market purchase cost," the memo states.
The memo, dated March 20, followed a page-one article in The Wall Street Journal several
weeks earlier about Knight/Trimark Group Inc., Nasdaq's biggest dealer, or market maker.
The firm, based in Jersey City, N.J., executes hundreds of thousands of orders a day sent
to it by online and discount brokers. The article described, among other things, how Knight
uses knowledge of its customers' order flow, including pre-opening orders, to aid its
proprietary trading. But it also noted that Knight's brokerage customers praise the firm's
service, speed and willingness to use its capital to quickly give investors the best price on a
stock anywhere.
Richard Ketchum, who is president of the National Association of Securities Dealers, which
runs Nasdaq, said Tuesday: "We are seriously looking at the trading rules governing the
opening. But I can't comment on anything in particular because there isn't a hard proposal at
this moment."
The memo made no mention of any particular firm. But people familiar with the committee's
deliberations said the issue arose because of the attention focused on Knight, though other
dealers often engage in similar activity.
Kenneth Pasternak, Knight's chief executive officer, said he was unaware of the proposals,
but bristled at the suggestion that his firm's activity comes at investors' expense. "We don't
make any money off the pre-opening," he said, and in fact the firm, though highly profitable
overall, regularly loses money at the opening by guaranteeing the opening price to all eligible
orders. "We're trying to add value, not detract value." It's the customer, not Knight, that has
the edge, he says. "The customer chooses when we trade, at what price we trade, at what
[share amount] and at what time."
The memo describes a hypothetical situation in which a market maker -- a dealer who
quotes bid and offer prices at which he will trade with investors -- has received 500,000
more shares of buy than sell orders to be executed at the opening. Using this information,
the market maker buys shares before the opening, placing bids at successively higher
prices, sometimes at or above another market maker's offer price (an anomaly known as
"locking" or "crossing" the market). "At times the member will lock/cross the market without
trading, which raises concerns of manipulation," the memo says.
It buys 500,000 shares at an average price of $21.50, then sells those shares to customers
at an opening price of $23.0625 apiece, profiting from the difference. "Nasdaq believes
such activity is not in the best interests of public investors or the quality of the Nasdaq
market," the memo says.
The memo makes two proposals. The first is to require that a market maker that holds both
a customer's limit order (an order that can be executed only within specified price limits)
and a same-priced in-house order for itself, fill the customer's order first. That obligation,
known as the Manning rule, already exists after 9:30 a.m., but the memo proposes it begin
at 8:30 a.m. The second proposal is that market makers give customers' market orders
(which are to be executed at the best available price) the benefit of any prices it obtains
trading before the opening.
Mr. Pasternak says his firm already applies the Manning rule to all its customers' orders, but
those orders generally aren't eligible for execution before the opening. If they were, Knight
would extend Manning protection to them as well, he says. He added that a market maker
is taking on risk when trading before the opening, since the price can move against it, and
customers can cancel their orders before 9:30.
"I'm in favor of adding best-execution practices" to whatever rules the industry agrees on,
he says. He has also said his traders must trade at the quotes they show before the opening,
even when Nasdaq rules don't require it.
The proposals face many practical obstacles, persons familiar with them acknowledge, such
as how to divvy up a dealer's pre-opening in-house trades among an unrelated set of
customer orders, and what to do if the dealer's pre-opening price is worse than the opening
price.
"Two totally different market dynamics" are at play before and after the opening, notes one
person. Indeed, preopening trading is part of how Nasdaq's competing market makers and
trading systems known as ECNs determine the right opening level for a stock. Nasdaq's
plate is also full overhauling its routing and executing systems and preparing for decimal
prices. But the memo notes that the Securities and Exchange Commission is placing greater
scrutiny on Nasdaq's opening, where volumes are rising.
Nasdaq's opening has long been criticized as sometimes being chaotic, but market
participants differ on how to change it.
One approach is to publicly display all market makers' limit orders. Because they show
how many shares investors intend to buy or sell at given levels, limit-order files can provide
market makers and stock-exchange specialists with valuable information on market trends.
Thursday, the SEC is scheduled to host an industry round table on the subject.
Mr. Pasternak says he supports the idea. "There is no justification for the age-old practice
of market professionals walling off access to important market information," he told a
subcommittee of the Senate banking committee last week. "It is neither fair to individual
investors, nor healthy for the marketplace." Mr. Pasternak says limit-order information is
not "central" to the firm's trading, and he would be happy to provide his firm's limit-order
and opening-order information to a third-party information vendor.
Write to Greg Ip at gregory.ip@wsj.com |
