Playing by New Rules

NEW YORK —  The clouds may be clearing, but the rough weather in the Nasdaq Stock Market this spring has some people wondering whether new Securities and Exchange Commission trading rules--meant to give small investors a better break on prices--are actually making the market riskier for them.

Those who suspect so point to the fact that the Nasdaq composite index hit its all-time peak on Jan. 22, just two days after the new rules started being phased in.

The index subsequently plunged 13.5% to a recent low of 1,201.00 points on April 2. Even with the rebound of the last two weeks, the index is still off 3.5% from its high, and the volatility of the last few months has been gut-wrenching.

Supporters of the new trading rules say there is no evidence that the changes have anything to do with the volatility, much less the price declines. Nasdaq, they note, went through far wilder price swings last July, when the composite index took an even worse pounding.

Besides, these supporters say, the rule changes have done exactly what they were intended to do: introduce more price competition in the Nasdaq market, thus narrowing the spread between the price at which a dealer will sell you a Nasdaq stock and the price at which he or she will buy it from you. That spread provides the dealer’s profit.

Under the SEC’s new rules, investors can enter so-called limit orders for Nasdaq stocks and have those prices displayed to the entire market. In other words, if a dealer quotes a stock at $10 bid (buy) and $10.50 asked (sell), an investor can offer to buy at $10.25, and the dealer must either sell to the investor at that price or show that better price to all other investors.

Before the rule changes, dealers weren’t required to display investors’ limit orders to the rest of the market--thus preserving dealers’ control over bid and asked spreads.

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In fact, the new rules are a response to alleged price collusion among major dealers, including such giants as Merrill Lynch & Co., Goldman, Sachs & Co. and PaineWebber Group. The Justice Department recently settled an antitrust suit against those three and 21 other firms that allegedly rigged stock prices, forcing customers to overpay for Nasdaq stocks.

While pushing hard for the Nasdaq rule changes, the SEC was afraid that dealers would be swamped by technical problems involved in implementing the changes for all 6,000 Nasdaq stocks, so the agency is phasing in the changes 50 stocks at a time. Among the first 50 stocks phased in were Nasdaq’s 10 volume leaders, including Microsoft, Intel and Cisco Systems. Currently, 300 stocks are being traded under the new rules.

When the rules were being debated, some market makers--dealers who specialize in specific stocks--groused that tightening the spreads would cut their profits to the point that market-making would no longer be worth the risk in many thinly traded stocks.

Firms would stop making markets in those stocks or abandon the business entirely, they warned, reducing liquidity and actually hampering the public’s ability to get a good price, or any price.

Given the deep price declines and wild volatility in many Nasdaq issues since January, the suspicion is that the dealers weren’t bluffing.

Nasdaq, however, says its data does not indicate that dealers have dropped away or that the rule changes have contributed to greater volatility.

Since the new rules took effect Jan. 20, the average number of market makers per stock has actually increased slightly, to 21.0 from 19.9--at least for the first 150 stocks to come under the rules, according to Nasdaq statistics.

“We’ve seen some of the weaker sisters drop stocks,” said Holly Stark, head trader for the firm of Dalton, Greiner, Hartman & Maher. But in general, she said, the rules are “great” because they make for better prices.

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Indeed, Nasdaq has reported a 32% drop in quoted spreads for the first 150 stocks to be phased in. The average spread on these stocks shrank from 37 cents before the rule changes to 25 cents afterward, according to Nasdaq.

Yet some Nasdaq critics still accuse market makers of “backing away”--refusing to execute trades at their quoted prices. Although many Nasdaq trades are executed by simply matching investors who want to buy with those who want to sell, dealer market makers also are expected to buy stock with their own capital when there isn’t a “natural” buyer in line.

In a rapidly falling market, a long-standing criticism of the Nasdaq market is that dealers effectively run away, either drastically lowering their bid prices for stocks or making themselves unavailable to sellers.

Nasdaq critic Linda Lerner, general counsel for All-Tech Investment Group, a day-trading firm in Montvale, N.J., said her traders see backing away on a daily basis.

“The market makers are just not cooperating,” she said.

Nasdaq rules generally forbid market makers from outright backing away and punish the behavior with a 20-day suspension from market-making activity in the stock involved.

But some experts say dealers are only being rational when they try to avoid trades that threaten to wipe out their capital.

“Market makers are not lemmings, thank God,” said Junius W. Peake, a finance professor at the University of Northern Colorado in Greeley and a former vice chairman of the National Assn. of Securities Dealers, Nasdaq’s parent organization.

“If the choice is death or dishonor, they’re going to take dishonor, thank you very much,” Peake said.

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Could such de facto backing away have been worse this spring because dealers were reacting to thinning profits on Nasdaq stocks, as spreads begin to narrow?

Probably not, some say. During the phase-in of the new rules, the Nasdaq market is under special scrutiny from the SEC, and some observers believe that tends to minimize abuses.

“A lot of market makers are on their best behavior now,” said Paul Schultz, a professor at Ohio State University who, along with other researchers, is studying the introduction of the new trading rules.

The problem is that it’s very difficult to quantify why illiquid stocks do what they do, experts note.

In any case, the debate over the net effect of the rule changes isn’t going to die down any time soon.

One issue of particular interest to certain controversial traders is the number of shares that market makers are required to buy or sell at their quoted prices--the “minimum block” rule.

Professional day traders, who operate electronically through Nasdaq’s Small Order Execution System (SOES), trade in 1,000-share blocks and may rack up scores of such trades daily to capture relatively modest profits.

Market makers who are on the hook for those mandated 1,000-share minimum blocks spurn these traders as “SOES bandits” and consider them parasites or worse.

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Now the SOES traders are angered by a proposed SEC rule--the subject of a three-month test involving 50 Nasdaq stocks--that would reduce the minimum block size from 1,000 shares to 100 shares.

The traders say the change would hamper their ability to make money because the profit potential per trade--already small--would be reduced by a factor of 10. They also insist that by reducing the block size, the Nasdaq market will only get thinner and more volatile in down periods.

Dealers, however, say they would most likely keep their minimum-block sizes high, even well above 1,000 shares, to accommodate customers, and would use the 100-share minimum sparingly.

Early indications from the test group of stocks are inconclusive. The average trade size dropped by 1.8% to 1,471 shares from 1,498 during the first 31 trading days of the test, but that number was too small to be considered significant.

Not content to let Nasdaq’s analysis be the final word, the Electronic Traders Assn., an industry trade group for day traders, has commissioned its own study by DRI-McGraw Hill of how well SOES orders are being executed under the new rules.

Jim Lee, president of Momentum Securities in Houston and founder of the association, said that although the study is not complete, he has observed a pronounced decline in the number of SOES orders that get executed in a timely fashion and at the price the trader expected.

“We see time delays of 30, 40, 50 seconds” before trades are executed, Lee said, adding that in many cases that means traders obtain worse prices than were available with quicker execution.

His organization will ask the SEC to not permit reducing the minimum block size.