December 11, 2000                            [WSJ.com]

SEC Study May Hurt Nasdaq Image;
NYSE Customers Get Better Prices

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL

The Nasdaq Stock Market, which has labored for four years to improve how its dealers treat investors, may be about to suffer a public-relations setback.

In a study to be released in coming weeks, the Securities and Exchange Commission is expected to say that investors still get worse prices when they trade on Nasdaq than on the competing New York Stock Exchange, according to people who have seen preliminary parts of the study.

The study isn't all bad for Nasdaq. It doesn't accuse Nasdaq dealers of improper behavior. Rather, its findings suggest that the disparity is due to differences between a "dealer" stock market such as Nasdaq, and an "auction market" such as the NYSE that seeks to eliminate the middleman.

Still, if the final version of the new SEC study reflects its preliminary findings, it will be a blow to the image of Nasdaq, which just Friday named Hardwick Simmons, the former chief executive officer of Prudential Securities, to succeed its current CEO, Frank Zarb, in February. (See article.) Nasdaq has been steadily improving its public image as memories of its dealers' price-fixing scandal of the mid-1990s fade.

The study, which SEC researchers have been working on since the spring, compares the spread  between bid and ask prices on similar stocks (e.g., similar market values and volatility) in the two markets, and the frequency with which investors receive prices that are better than the best bid or offer. On both counts, the Nasdaq falls short of the Big Board, these people say. The study also looks at the U.S. options market, but its findings there aren't expected to be as clear-cut.

Nasdaq likely won't take the slap sitting down. Its own economists have been arguing with their SEC counterparts for several weeks over the study's methodology and preliminary findings. Nasdaq stocks -- predominantly those of technology companies -- tend to be more volatile and newer than those on the NYSE, notes one Nasdaq sympathizer, adding, "Don't compare Microsoft to a utility."

Whether Nasdaq succeeds in swaying the study's outcome remains to be seen. A spokesman for the National Association of Securities Dealers, which operates Nasdaq, "We haven't seen the study." An SEC spokesman declined to comment.

While other studies have found similar things, this carries the SEC's imprimatur. Furthermore, SEC economists think their privileged access to the markets' most detailed price-quotation and order information gives them much greater ability to make apples-to-apples comparisons.

Industry executives expect the final version of the study in coming weeks. SEC officials expect to be met with a barrage of rebuttals by Nasdaq.

Nasdaq may, of course, cling to the good news in the study, which is that on some categories of trades involving the market's most heavily traded stocks such as Cisco Systems, its bid-ask spreads aren't that different from the NYSE's.

 Overall, "it's not saying Nasdaq is doing something wrong," says one person familiar with most of the study. "It's a difference in auction model vs. a fragmented dealer market."

That is a crucial difference from the scandal that led to the SEC imposing new "order handling rules" on Nasdaq in 1996. Government investigations had discovered widespread abuse by dealers, also known as market makers, that had the effect of keeping bid-ask spreads artificially wide.

The behavior raised investors' costs by forcing them to sell to market makers at artificially low prices and buy from them at artificially high prices, which enhanced market makers' profits. The new rules required market makers to better display customers' orders and their own best-priced quotes. Spreads on Nasdaq fell about 30% as a result.

The latest study stems from concerns SEC Chairman Arthur Levitt began raising last fall about the cost to investors of the fragmentation of stock trading among multiple venues. The SEC in particular wants to know the implications if the market for NYSE-listed stocks comes to resemble Nasdaq. Last fall, the NYSE scrapped restrictions on its members filling orders as market makers instead of sending the orders to a stock exchange.

Though the study doesn't draw sweeping conclusions about which market is better, its findings are expected to indicate that Nasdaq's structure is responsible for customers' higher costs. On Nasdaq, most customers trade with a market maker, rather than another customer, as occurs on the NYSE's agency-auction market. That means a Nasdaq stock investor is less likely to do better than the quoted bid or ask (i.e., receive "price improvement"), because the market maker captures that spread as profit. On the NYSE, buyer and seller are typically matched at either the bid, the ask or in between. That means either the buyer, the seller or both do better than the quoted spread. Although a market maker also can improve the customer's price, and Nasdaq orders can be matched directly on screen-based systems, the study is expected to find that price improvement still happens more often on the NYSE.

Nasdaq also may suffer from the fact that brokers usually route Nasdaq orders not based on who quotes the best price but on financial incentives. Either the broker owns the market maker or receives a payment from the market maker to whom it sends orders.

This means market makers may have less incentive to quote tighter spreads in order to attract orders. Mr. Levitt earlier this year said one of the study's early findings was that on Nasdaq, "nearly 85% of customer market orders were routed to market centers that were not quoting the best price in the market." Market orders are executed at the best prevailing price.

NYSE specialists, who execute orders on the NYSE floor either against other orders or against their own inventory as needed, don't pay for order flow, although specialists on regional exchanges and nonmember dealers such as Bernard L. Madoff Investment Securities do.

In its review of the listed-stock-options market, the study is expected to find that spreads have widened somewhat since late last year. But they remain narrower than when the four established options exchanges were forced to compete beginning in 1999 with each other and the all-electronic International Securities Exchange for orders in the same, multiple-listed options.

While options markets and their member market makers also began paying for order flow in this period, it isn't clear yet whether the widening in spreads was due to that or to a rebound from unsustainably narrow levels seen during the first days of fierce competition. The study is expected to find that spreads have bounced around as the market rapidly evolves and it may be too early to make firm observations.

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