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SEC Moves to Tighten the Rules

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


On Nasdaq, when it comes to deciding whose trade takes precedence--a customer's or a market maker's--the winner often has been the market maker.

But the Securities and Exchange Commission called earlier this year for eliminating one practice that has allowed brokerages and market-making firms to ignore their own customers' orders. And in recent months the SEC has been moving to do just that, forcing reforms that Nasdaq's operators had long opposed.

The practice is known as "trading ahead." It occurs when a market maker receives a customer limit order and then trades for its own account at a better price without filling the customer's order. While trading through is mainly the result of the fragmented nature of the Nasdaq market, trading ahead is almost always due to willful action by individual market makers.

Also known as "front running," it is considered particularly egregious, because it represents the market makers favoring themselves over their duty to their customers. It allows market makers to make profitable trades based on the knowledge that market prices are likely to move once their customers' orders are executed.

For the Record
Los Angeles Times Wednesday October 26, 1994 Home Edition Business Part D Page 2 Column 3 Financial Desk 6 inches; 188 words Type of Material: Correction
Nasdaq market makers--An article in Friday's editions on Nasdaq trading, the second part of a Times series on the market, incorrectly estimated the annual revenue of firms that make markets in Nasdaq stocks. Those firms earn revenue from the spreads--the gap between the bids and asked prices--on those stocks. The Times estimate of $26 billion was made after the National Assn. of Securities Dealers, which owns Nasdaq, declined to provide figures on market makers' revenue from the spreads. The Times has since learned that the assumptions it used in calculating the revenue, based on the average spreads and the average daily trading volume, were erroneous. In a letter to The Times on Friday, the NASD cited a statistic put out by the Securities Industry Assn. that securities firms' total over-the-counter trading revenues in 1993 amounted to $3 billion, and to $1.6 billion for the first six months of 1994. The association's figures do not include some of the largest Nasdaq market makers, however. Interviews with business school professors who study the financial markets, a securities industry analyst and executives at market making firms suggest that the correct figure is in the range of $3.5 billion to $7 billion a year. The NASD has not responded to numerous requests from The Times for data that would provide a precise figure.

In June, the SEC approved a rule banning trading ahead by big brokerage firms that execute their own customers' orders. But the ban contained a big loophole: It allowed many large market-making firms that execute trades for independent brokerages to go on trading ahead of customer orders. Now, the SEC has proposed banning that, too.

As things stand now at these firms, a customer might put in a limit order to buy shares of a stock at 20 1/4. If the market-making firm that gets the order is offering to buy shares itself for 20 and sell for 20 1/2, the firm commonly will let the order sit unfilled while continuing to buy stock from other customers at 20. The firm gets a better price; other customers get a worse price.

If the firm buys enough shares at 20, the market price of the stock will jump, moving up to 20 1/4 bid, 20 3/4 asked--at which point the market maker will execute the customer's limit order.

But having waited until the market price moved, the market maker is now in a position to make a 1/2-point profit by immediately reselling the stock at the new asked price of 20 3/4. If the market maker had executed the customer's order immediately, it most likely would only have made a 1/4-point profit in reselling the stock.

Like trading through, trading ahead has long been forbidden on the New York Stock Exchange and other exchanges.

Why has the NASD resisted eliminating the practice? Because it says the additional profit market makers earn by trading ahead of customer orders is justifiable compensation for the risks they incur making markets and for providing a liquid market in Nasdaq stocks.

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