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Is This a Fair Trade? : Market Makers Draw Criticism, Lawsuits for Ignoring Customer Orders

INSIDE NASDAQ: Questions About America's Busiest Stock Market. Second in a series


CHICAGO — One day in late June, options trader Steven I. Malitz was poised to buy 1,200 shares of American Colloid stock at $13 a share--a quarter of a point more than any of the Nasdaq-listed stock's market makers were offering to pay.

Small investors certainly would have done better to sell to Malitz at his price. But they never got the chance. Instead, market makers ignored Malitz's order--"traded through" it, in market parlance--and continued to sell at $12.75, a price better for themselves and worse for their customers.

After three minutes, as a reporter watched, Malitz's order automatically expired--unfilled.

A cornerstone of the nation's securities laws is the "best execution" rule, meant to guarantee that brokerage customers get the best price available when they put in orders to buy or sell stock.

But much of the time on Nasdaq they don't.

"I get traded through all the time," says Malitz, a veteran floor trader at the Chicago Board Options Exchange. Throughout the day, by telephone from his trading post, Malitz buys and sells Nasdaq shares to limit the risks of his dealings in options on Nasdaq stocks.

The National Assn. of Securities Dealers, which owns and operates Nasdaq--the nation's busiest stock market--says the market could not operate without trading through. The NASD insists it carefully balances the interests of both market makers and its customers.

Still, in one 15-minute span on the raucous floor of the Chicago options exchange that day, a reporter witnessed two other apparent instances of Malitz's better-priced offers being traded through by Nasdaq market makers. Longtime investors and securities professionals say that on any given day, thousands of better-priced orders never get executed.

Another Chicago trader, Mark Shaprow, says he quit trading options on Nasdaq stocks out of frustration with getting traded through. Now he deals only in options on IBM, a stock listed on the New York Stock Exchange, where trading through is banned.

"We're professionals and we see it happen," says Shaprow. "Then we think about the people who aren't professionals. They get cheated the same way, and they don't even know it."

Trading through is just one of the ways the vast Nasdaq trading system produces big profits for market makers at the expense of millions of investors, small retail customers and professionals alike.

The practice, long banned on most exchanges, helps maintain Nasdaq's wide "spreads," the gap between the price at which market makers offer to buy from sellers and the price at which they will sell to buyers.

By ignoring better-priced offers from the public that are "inside the spread"--offers either to sell shares for less than the market maker is demanding or buy them for more--the firms protect their own interests while slighting those of their customers.

The Justice Department said this week that its antitrust division has launched an investigation into allegations that market makers, rather than competing, work together to keep spreads wide and increase their profits. The NASD and many large market makers insist the allegations are baseless.

The Securities and Exchange Commission, too, is beginning to apply strong pressure on Nasdaq to address some parts of the problem. But many believe that the proposed reforms, though they have provoked strong complaints from the market makers, fall short.

Richard G. Ketchum, the NASD's chief operating officer, says trading through is justifiable because of the nature of the over-the-counter market.

If it were banned, he says, some market makers who deal in Nasdaq stocks might lose money and decide to leave the business. The NASD says competition between market makers is at the core of Nasdaq's structure, leading to better prices for customers.

There are no signs that the profits of Nasdaq market makers are precarious. Indeed, with Nasdaq's steady growth, the number of firms making markets in its stocks has risen. There are now 510, up 21% from 1990. They include the big, well-known, Wall Street investment houses, such as Merrill Lynch, PaineWebber and Morgan Stanley, as well as lesser-known firms that do little besides make markets in Nasdaq stocks, such as Troster Singer Corp. and Herzog, Heine, Geduld Inc.

The NASD says it has no data on its member firms' profits from market making. But using the NASD's own figures--average daily volume of 299 million shares multiplied by an average spread of 34.3 cents--indicates that the market makers' revenue each day from spreads comes to $102.6 million, or more than $26 billion a year. (They also make additional trading profits, or losses, on the stocks they hold in their own inventory.)

At the heart of trading through is something called a "limit order." On Nasdaq, as on the New York and other stock exchanges, customers can place limit orders to buy or sell stock at a specified price, as opposed to "market orders" to buy or sell at the current market price.

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