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Playing by New Rules

Will Nasdaq Changes Mean More Risk?


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.


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.


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.

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