July 14, 1998

Nasdaq's NODES Could Transform the Market
Part 2

by Louis Corrigan (TMFSeymor@aol.com)

Day-Traders Raise Concerns

Though the details of NODES are considerably more intricate, this is the gist of the system and enough to locate some of the major objections of the ETA, which is led by James Lee, president of Momentum Securities Management Co., and represented by Rick Roberts, a former SEC commissioner. The day-traders' objections to NODES have been most clearly articulated by David Whitcomb, a finance professor at Rutgers University who is also President and CEO of Automated Trading Desk, Inc., a day-trading firm.

For starters, the day-traders have major problems with the Actual Size Rule. In one sense, the reason is obvious. If they can make good money today by quickly trading against market makers' posted bid and ask prices, which can be hit automatically through SOES, then reducing the market makers' minimum exposure basically cuts back on the volume that makes day trading really profitable. On the other hand, Whitcomb and others claim that the Actual Size Rule simply hasn't worked as Nasdaq thought it would.

Nasdaq's original argument was that reducing market maker exposure by cutting the minimum quote size would narrow spreads since the move would foster more market makers in each stock and thus more price competition. Yet, the NASD's own study published last June showed that these benefits weren't realized. The significant reductions in spreads (up to 35% in some cases) seen early last year actually followed from the new Order Handling Rules, which essentially made market makers compete even with investor limit orders.

Comparing stocks in the Actual Size Rule pilot program with a matched group showed that the liquidity actually dried up for stocks in the pilot. The average share size quoted by market makers at the inside price fell 28% while SOES trades as a percent of total trades fell by 10%. Meanwhile, SOES trades for stocks in the control group rose by 8%. So reducing the market makers' minimum quote obligations effectively reduced liquidity in general while also reducing liquidity for those looking to trade through SOES (probably a decent proxy, in this case, for individual investors).

More troubling, research conducted by Whitcomb and Fordham University's Yusif Simaan shows that during last October's market turbulence, the depth of the inside bid on those Actual Size pilot stocks fell even further. The researchers concluded that this phenomenon was "consistent with the hypothesis that market makers will provide reduced liquidity on the side of the market under the most stress if they are free to do so." In other words, it's precisely when the market most needs the market makers' liquidity that they are most reluctant to provide it.

Of course, NODES will bring the ECNs more directly into the mix, which should help boost liquidity while reducing the spread. However, part of the reason this is true offers another argument against the market makers. Simaan and Whitcomb have presented evidence showing that the ECNs are increasingly likely to be alone at the best bid or offer price, with no company from market makers. Even more curious considering the hoopla over the antitrust case is that ECNs are far more likely than market makers to quote stocks at odd-sixteenths (1/16, 3/16, etc.), as has been permitted since June 2, 1997.

In a perfectly competitive system, a stock's inside price would be quoted at odd-sixteenths 50% of the time. Simaan and Whitcomb found that the ECN's did so 49.7% of the time. However, market makers quoted odd-sixteenths only 6.9% of the time overall and only 11.9% of the time when they were alone at the best quote. Moreover, ECNs often quote prices in 32nds or 64ths (part of the inevitable move toward decimalization). However, ECN quotes are currently rounded to the nearest 16th when they appear on Nasdaq's montage. NODES will provide no improvement in this area since it apparently won't be able to carry quotes finer than 16ths. The day-traders rightly argue that this makes no sense. If the NASD really wants a more competitive market with reduced spreads, then creating a decimalized system ought to be a priority.

The Privileges of Market Makers

If NODES is a balancing act between the NASD's need to create a more dynamic and price competitive market and its need to do so in a way that keeps the market makers happy, it's worth looking more closely at some ways the proposal enhances the market maker's power.

For starters, there are the 17-second and 32-second time delays built into the system outlined above. NODES also will create a "phone ahead" button. This will allow a market maker to continue to advertise a quote during a 17-second period when he's supposedly working on a phone order for that quote. Whitcomb charges this is "false advertising" since the quote is visible but not hittable. The NASD plans to watch for abuses of this phone button, but Whitcomb says it amounts to a 17-second window during which market makers can back away from their quote if they'd rather not honor it. He suggests that a market maker's quote, which is a kind of advertisement of services, should be pulled altogether during any period when it's not actionable.

Yet NODES offers other proposals designed to tilt power toward the market makers and away from other traders. For example, let's say a market maker is offering to sell 500 shares at $20. An order for 300 shares executes against part of that offer. At that point, the market maker has five seconds to change the offer price, perhaps raising it to $20 1/8. This may not sound that significant, but in practice, it means the market makers would have even more leeway to back away from less profitable trades. This privilege differs sharply from the NODES rules governing limit orders, which cannot be changed for 10 seconds.

While such a 10-second rule won't matter directly to the average individual investor, it will still matter, the day-traders argue. That's because such restrictions on limit orders could cause active day-traders to reduce their order size or raise their prices in order to compensate for the added risk. That would likely increase price spreads in NODES since it would actually discourage active price competition. What Whitcomb and other day-traders fear is that the 10-second hold on limit orders could be spread to the ECNs. If that happened, it might all but reverse the gains resulting from the spread-reducing Order Handling Rules.

Perhaps the easiest way to think about these issues is to assume, as the NASD does, that the "SOES bandits" do indeed take advantage of market makers' minimum quote obligations under the current system. If that's a problem, then why is it any better for NODES to establish a system whereby market makers could readily take advantage of (that is, trade against) limit orders? The day-traders argue that NODES would allow market makers to become "NODES bandits."

Where is the individual investor in all of this?

Nasdaq is trying to sell the Limit Order File as an innovative way of allowing actual orders to drive trading. The proposal reads, "For retail investors, the Limit Order File should promote greater confidence in Nasdaq's market structure because it offers another vehicle for transparency and more efficient execution of limit orders. In addition, the File should work toward reducing the perception among some retail investors that the playing field is tilted in favor of broker-dealers and large investors."

Yet, this File is voluntary rather than mandatory, meaning that market orders don't necessarily need to interact with these limit orders except for those at the Top of File (best bid, best ask). In most auction markets, such as the New York Stock Exchange, limit orders are matched with other limit orders first, if possible. The exchange specialist isn't supposed to see a buy order at $20 and a sell order at $20 and decide to fill the buy order herself. Limit orders have priority at the market center. That's why about 90% of NYSE trades involve direct transactions between investors, with the specialists only taking one side of the trade about 10% of the time.

With Nasdaq, though, there is no market center and thus no across-the-board mandate to assure that outside orders from individuals or institutions have priority over orders from market participants such as the market makers or ECNs. As Whitcomb has put it, "In Nasdaq, a market maker can 'trade ahead' of all limit orders except those coming to his firm. If there are 30 market makers and 4 ECNs quoting a stock, any given market maker does not need to cede priority to limit orders coming to 33 out of 34 places." By employing a voluntary limit order book, NODES apparently won't change this.

NODES Begs a Major Question

Despite some shortcomings, NODES is hardly a disaster.

For one thing, individual investors should remember that there are reasons to be skeptical of the day-traders. Robert Woods, a finance professor at the University of Memphis, has argued that the so-called "SOES bandits" have actually cost individual investors hundreds of millions (if not billions) of dollars over the last decade. He bases that figure on a study he conducted with Emory University professor George Benston on trades and quote changes on the NYSE and Nasdaq between January 1987 and March 1997. Woods has argued that when day-traders sense a large order hitting the market, they push a stock up to ride buying pressure or down to benefit from selling pressure. That raises the trading costs above what normal supply and demand would have done. So day-traders pocket money that might have ended up in a mutual fund's account, and thus potentially the accounts of many individual investors.

Moreover, even the visionary Junius W. Peake, a University of Northern Colorado finance professor and longtime critic of Nasdaq, thinks NODES is a positive development for individual investors. Indeed, one can even see NODES and Nasdaq's recent decision to merge with the American Stock Exchange as steps straight out of Peake's playbook for the near future: market consolidation designed to maximize order flow, improve price discovery, and reduce costs associated with market intermediaries. Longer term, Peake expects the Internet will serve as the central trading backbone and orders will be executed at cost, with intermediaries (such as market making firms) collecting their revenue from valued-added services such as research.

Still, as an astute Forbes article recently suggested, Nasdaq's move from a dealer market to something approaching an order-driven auction market has been forced upon it by the collusion scandal, the drop-off in market makers' trading profits resulting from the advent of the Order Handling Rules, and the fierce new competition from more technologically advanced ECNs. So much of what's good about NODES is the product of Nasdaq adjusting to outside pressure. Much of what remains bad about the proposal involves sly attempts to outflank those pressures.

Ultimately, SEC chairperson Arthur Levitt and the other commissioners must determine how much the plan needs to be revised. But NODES ultimately begs a more important question: Does Nasdaq really need market makers at all?

It's simply no longer clear why market makers as currently conceived should be allowed so many special privileges when they have fewer and fewer responsibilities. Yes, they may provide essential liquidity for some thinly traded issues, albeit at often ridiculous spreads. But it's worth asking if something significant would really be sacrificed if the current system were more thoroughly revamped so that all market participants had truly equal access to a dynamically updated central order book. Indeed, the complex and in some ways unsatisfactory compromise that is the current NODES proposal suggests that this should be -- and eventually will be -- an open question.