Dow Jones Newswires-Web Stk Volatility Scares Market Makers
NEW YORK -- Certain that the recent frenzied buying in Internet stocks will come to an ugly end, some Nasdaq market makers are running for cover.
As volatility and extreme valuations magnify the risks of owning Web shares, a number of market makers - the broker/dealers that match buy and sell orders on the Nasdaq stock exchange - have started to reduce their dealings with many of these high-profile, controversial names.
That's because market makers often use their own money to take the other side of a trade when brokerage firms come to them to buy or sell shares. And they want to make sure they won't be left holding the bag if the bottom drops out of the market for Web stocks.
"This type of speculation is unprecedented," said Bernard Madoff, chairman of Madoff Securities. "The risk/ reward ratio ... is totally out of whack for the market makers ... Everyone lived through '87 and people are concerned this could be worse."
Brokers say the market makers' actions have had little impact on them so far since there are so many of them.
But some fear the market makers' retreat is in fact exacerbating the very volatility that is scaring them off since it is their job to stabilize jumpy markets. And with fewer market makers to take trades, they could be contributing to the sharp gains in many stocks right now and won't be there to steady the market when a selloff comes.
The market makers' decision to reduce their involvement with Internet shares has little precedent on Wall Street. While market makers have taken similar steps when confronted with speculative bubbles in the past, Madoff said he's never "seen it at this level... with so many firms."
Yet their actions are part of a broader trend as the securities industry tries to protect itself from the sector's volatility by raising margin maintenance requirements on Web stock investments and restricting trading in new offerings.
Some market makers, like Fleet Financial Group Inc.'s (FLT) USCC Trading, have simply stopped making a market in certain Web names altogether. Fleet would not disclose which stocks it has stopped handling.
But Madoff noted that about 16 market makers dropped Amazon.com Inc. (AMZN) after CIBC Oppenheimer lifted its pre-split price target on the stock to $400 a share in mid-December, pushing the shares up 20% in one day and adding fuel to an already-heated controversy over how much the company should be worth. There are now about 40 market makers in Amazon's stock.
Other market makers have scaled back their "liquidity guarantees" - the number of shares they guarantee they will buy or sell, using their own money if necessary - on trades in Internet stocks.
Knight/Trimark Group Inc.'s (NITE) Knight Securities has lowered its guarantees to 500 to 1,000 shares per trade - from the 1,000 to 2,000 shares it normally guarantees - on anywhere from five to 20 Internet stocks almost every day since the start of December. "After that, we will go to actual available liquidity," said Ken Pasternak, president and chief executive of Knight Securities.
Madoff, too, has cut its liquidity guarantees to 500 shares on Amazon and Yahoo! Inc. (YHOO), and to 2,000 shares on America Online Inc. (AOL), Netscape Communications Corp. (NSCP), Egghead.com Inc. (EGGS) and Infoseek Corp. (SEEK). Madoff typically guarantees liquidity of 5,000 shares.
And USCC Trading has stopped guaranteeing liquidity altogether in recent months on some of the volatile Internet stocks it still handles. The firm, which generally guarantees liquidity of up to 2,000 shares, is deciding on a case-by-case basis whether to take orders for Web shares.
Many market makers have also been pricing themselves out of the market for Web stocks by widening their spreads - dropping the prices they will pay to buy a stock, and raising the prices they will accept to sell a stock.
This makes it less attractive for smaller traders - including the day traders and momentum players who have fueled much of the sector's gains - to work with them, said Robert Herwick, president of Herwick Capital Management.
And Herzog Heine Geduld Inc. has stopped guaranteeing "automatic electronic execution" of Internet stock trades over the past few months. President and Chief Executive Emanuel "Buzzy" Geduld said the firm does not let its computers automatically match buy and sell orders for Internet stocks, and is instead executing trades in these stocks manually.
By taking positions in stocks and attempting to maximize the spreads between the prices at which they buy and sell shares, market makers try to assure profits for themselves as they perform a task that is critical for Nasdaq to function.
But when it comes to the volatile Internet stocks, the risk involved is "magnified to the nth degree," said Jae Kim, an analyst at Paul Kagan Associates.
Herwick explained that market makers find it difficult to manage risk with Internet shares since heavy retail interest causes stocks to move unpredictably - and quite sharply - on fairly insignificant news. This leaves many market makers feeling that they have little "control or understanding of what's going on," he said.
"We get hordes of customers searching for liquidity all at one point... like when CNBC mentions a stock ... or when some company says it's going to sell what it already sells on the Internet," Pasternak said.
Sometimes, Herwick added, market makers don't even know why a stock is moving since messages posted on online bulletin boards and chat rooms can affect Web share prices. "They feel they're getting blind-sighted," Herwick said.
In this manic environment, market makers can't perform their job, which is to maintain "orderly markets." As Pasternak said: "That becomes almost a joke when thousands of people are getting into a stock at once... If a stock is not at equilibrium, you don't have an orderly market."
At the same time, Herwick noted, the market makers are also on the defensive against the day traders and momentum players who are trying to take advantage of the volatility in the Web stocks - often at the market makers' expense.
Rules instituted after the 1987 crash require market makers to take the types of small orders that typically come from day traders. "For the market makers, it's like walking down the street with money hanging out of your pockets and trying to keep people from grabbing it," Herwick said.
Of course, as long as the Web stocks continue to go up, the market makers can make money. But, Kim noted, "Internet stocks will turn around on a dime." And when waves of selling hit, there is often no one to take the other side of a trade - other than the market makers themselves.
So they are determined not to become the "market of last resort," as Madoff put it, when the mania finally dries up and panic hits. "The market makers are not going to put themselves in harm's way," he said.
Several brokers that actively deal with trading in Internet stocks, including several online brokers, said the market makers' actions have had little effect on them so far.
Ameritrade Holdings Corp. (AMTD) has not noticed the trend. And E*Trade Group Inc. (EGRP) said it's not a problem for the firm since it deals with 15 to 20 different market makers and can shift orders among them.
But by reducing their involvement with Web stocks, market makers could exacerbate the lack of liquidity in many of the smaller issues, some believe.
Blake Darcy, chief executive of Donaldson, Lufkin & Jenrette's (DLJ) DLJ Direct, added that the market makers' reluctance to accept large orders for Internet stocks also compounds the volatility since they aren't there to take the other side of the trades in these shares.
The market makers' actions comes as the securities industry moves to protect itself from the sharp, unpredictable moves of Web stocks. In recent months, a number of major brokerage firms - including some leading online brokers like Ameritrade and DLJ Direct - have raised the amount of equity that must be maintained in margin accounts that invest in Web shares.
In addition, given the frenzied buying that has propelled many Internet IPOs to incredible heights in the aftermarket, Charles Schwab & Co. (SCH) has stopped letting customers trade new offerings online on their first day of trading.
Meanwhile, the National Association of Securities Dealers recently formed a committee to come up with recommendations on how to deal with the extreme volatility in Web stocks in general and the manic behavior of Web IPOs in particular.
But in the end, Wall Street cannot control the actions of retail investors determined to own Internet stocks at any cost. So for the time being, many market makers are moving closer to the sidelines to wait out the mania. |
