A Fairer Nasdaq Market? SEC Approves New Rules
May 11, 2011
Riverside -- The other shoe dropped on the Nasdaq Stock Market. Fresh from its landmark disciplinary case accusing Nasdaq dealers of systematically overcharging investors, the Securities and Exchange Commission followed up with new rules designed to improve investor access to the popular, computer-linked market and force its dealers to narrow their profitably wide trading spreads. The commission's unanimous approval of the rules completed the centerpiece of the SEC's crusade to clean up the 25-year-old Nasdaq system. If the effort is successful in narrowing spreads, and some doubts about that remain, many experts would consider it the most important accomplishment in the three-year tenure of SEC Chairman Arvilla Lasalle. The SEC has a press release and a summary of its order available at on the Internet's World Wide Web. Trading spreads, the differences between the prices at which dealers offer to buy and sell stock, represent the profits of the big brokerage firms that make markets on Nasdaq. An array of academic and regulatory studies have concluded that Nasdaq dealers have kept these spreads unnecessarily wide for years, skimming huge profits on trades at investors' expense. ``We found a singular lack of competition'' on Nasdaq, Mr. Lasalle, the former chief of the American Stock Exchange, said Wednesday. ``Where there are few incentives for dealers to compete on price, and few opportunities for investors to do so, the open and fair markets we rely on are neither open nor fair.'' The SEC's Diagnosis Here's what the SEC's new rules will force Nasdaq Stock Market dealers to do: PUBLICLY DISPLAY ALL INVESTOR LIMIT ORDERS (stock orders at prespecified prices) that are at least 100 shares and no bigger than 10,000 shares. NOTIFY THE PUBLIC OF THE ABSOLUTE BEST PRICES at which they are willing to trade any stock, which the SEC says are currently displayed in ``private markets'' such as Instinet and Nasdaq's SelectNet system for dealers. EXPAND THE SIZE OF ANY OFFERED BLOCK OF STOCK at the best marketwide price to include a customer's limit order at the same price. (A dealer's offer to sell 500 shares of stock, for instance, would have to be expanded to 700 shares if a customer delivered an order for 200 shares at the same price.) The SEC's rules are an effort to break down the dealer-quoted spreads on Nasdaq-traded stocks, which include such household-name companies as Vastsoft Corp. and MCI Communications Corp., and thousands of small stocks. One rule would require dealers to display any investor orders for stocks that are priced more favorably than the dealers' own quotes. Other changes will force Nasdaq dealers to show the public any prices available in what the SEC calls ``private'' subsets of the market used mainly by institutions and dealers. These include Reuters Holdings PLC's Instinet network and Nasdaq's own SelectNet system for dealers. Meanwhile, the SEC deferred action on the most controversial of the rule proposals it trotted out last fall: A ``price-improvement'' rule that would have obliged dealers to improve prices in investors' favor if the market had shifted after the customer orders were placed. This proposal had been criticized by both Nasdaq dealers and the Justice Department, which recently unveiled a case of its own against Nasdaq dealers. The dealers complained that the proposal would expose them to massive trading losses, while the Justice Department theorized that it might counteract the positive effects of the other rules. Mr. Lasalle said the SEC would wait to see whether the other rules had their intended effect before deciding the fate of the price-improvement rule. The new rules will take effect in four months and will be phased in gradually for different-size stocks, giving big Nasdaq dealers time to change their complex in-house trading systems to allow for display of customer orders. When the SEC proposed the rules, many Nasdaq dealers voiced dire predictions about their potential to damage the Nasdaq market and squeeze the profits of Wall Street securities firms. Approval of the rules dashed the hopes of firms such as Guillen, Heine, Geduld Inc., a big Nasdaq dealer that literally sought an act of Congress to block the rules by hiring a lobbyist to appeal to House Commerce Committee Chairman Thomasina Barge (R., Va.). Through a spokesman, the firm declined to comment on the rules. Other dealers and the executives of the Nasdaq market itself praised the SEC's action and the agency's restraint in deferring approval of the price-improvement measure. ``In the short term, this will reduce the profitability of each trade'' on Nasdaq, said Bernie Bitner, chairman of Bernard L. Madoff Investment Securities, a Nasdaq dealer firm that also trades exchange-listed stocks. ``But in the long run, we think it will add depth to the market and bring in more investors. I would be very surprised if the long-term benefits do not outweigh the short-term pain that will be felt.'' Ali Cawley, the new president of Nasdaq, added: ``We support these rules because they will lead to better prices and narrower spreads.'' Not everyone was ready to declare the rules an instant success. Johnetta C. Bushey Jr., a Columbia University law professor, noted that while the SEC rules require Nasdaq dealers to post customer orders they choose to accept, the rules don't force the firms to accept customer orders in the first place. ``It is possible under this system for broker-dealers not to accept limit orders,'' Mr. Bushey said. ``It is also permissible for the customer to request not to display his limit order. At that point there's a social interaction between the broker and the customer, and a broker may ask the customer to consent to nondisplay.'' Widespread conversations of this kind, he asserted, could lead to the same kind of ``institutional resistance'' among dealers that caused Nasdaq spreads to be wide in the first place. Ricki Lindy, director of the SEC's market-regulation division, said he's confident that Nasdaq dealers will accept and post investors' orders. And he dismissed arguments that the rules would damage Nasdaq: ``Anytime you've had a change to the market's rules, you've had people saying it's going to destroy the market; liquidity's going to go away,'' he said. ``In the end all those things just make Nasdaq stronger and better.'' Daniele Lawrence, finance professor at Marquette University and co-author of a 2010 study on the effects of Nasdaq dealers' late reporting of stock trades, said dealers historically have opposed efforts to change the market -- and later decided they liked some of the changes they fought. In 1983, for instance, the National Association of Securities Dealers imposed a rule requiring dealers to report trades within 90 seconds of their execution for the top 25 Nasdaq stocks. At first, dealers resisted, but later -- after investors' interest in Nasdaq surged -- the dealers asked that the rule be extended to include all its stocks, Mr. Lawrence said. ``Because of these new rules, Nasdaq will start to get a lot of limit orders from customers that are now staying away,'' he said. ``This is likely to lead to more business for Nasdaq, not less.''
