Talk About A Glitch In The System

Every investor dreams of beating the market. And a band of nimble traders has figured out how to do just that, extracting as much as $30 million a year in profits--quite legally--from the hides of Wall Street dealers that make markets in over-the-counter stocks. These traders are doing it by ingenious use of NASDAQ's computerized order-taking system designed to aid unsophisticated small investors. The market makers, hoist with their own electronic petard, are outraged.

After the 1987 market crash, the computer network, called the small-order execution system (SOES), was upgraded to bring disaffected small investors back to OTC stocks. Market makers serve as clearinghouses for transactions in OTC stocks, which aren't listed on organized exchanges. Some of these dealers drew fire for ducking phone calls to sell during the 1987 crash. So the National Association of Securities Dealers began requiring that dealers use SOES to automatically execute any small order--1,000 shares or less--at the dealer's quoted price. SOES, as the small-investor component of the NASD Automated Quotation computer network, would ensure that the market never again snubbed the little people.

What the NASD didn't foresee was how dealers could be zapped by savvy types who weren't the little people--full-time traders, whom the dealers deride as "SOES bandits." These traders monitor the news wires for company developments and use the computer system for lightning-fast trades that exploit brief price discrepancies among different dealers. Since the dealers must juggle dozens of stocks, some of them can be too slow at repricing a particular issue when there is news about it. That's the time the traders pounce (chart).

Harvey Houtkin, a former arbitrageur and futures trader, camps out at the offices of Philip A. Dina Securities, a small brokerage in Suffern, N. Y., checking the news, market trends, and price quotes. When Houtkin spots a price that's momentarily out of line, his broker punches in a SOES order. Even at the system's 1,000-share limit, every quarter-point difference brings Houtkin a quick $250 profit, before the broker's commission.

Pocket change? Hardly. By striking as many as 50 quick-hit trades a day--mostly in volatile computer or biotech stocks--the best traders can make $500,000 a year or more. Consider the morning of Aug. 16, when Hewlett-Packard Co. surprised Wall Street with lower-than-expected earnings. Within minutes of that bombshell, sell orders for small Adobe Systems Inc., a key HP supplier, came flooding in from investors working through six firms, including Dina, Seaside Securities Inc. in Aspen, Colo., and All-Tech Investment Group Inc. in Suffern.

Before some of Adobe's market makers could react, Houtkin and other traders sold them 13,000 shares at $57.50 each. The stock had slumped to $55 an hour and a half later. By then, Piper, Jaffray & Hopwood Inc. and two other Adobe market makers had lost more than $30,000. "SOES wasn't meant to be abused by traders machine-gunning the market," says Antonio J. Cecin, Piper's director of equity trading.

TIGHTER REIN. The market-making community, led by Merrill Lynch & Co. and Salomon Brothers Inc., possesses the clout to fix that. This fall, the Securities & Exchange Commission will likely O. K. NASD proposals to bar any investor from entering five or more SOES trades daily and give dealers 15 seconds between orders to update quotes.

The traders contend that they are only using publicly available data--and that the dealers are really the rascals. They say some dealers create artificially high market quotes and don't honor verbal orders as NASD regulations require. Dealers deny that such problems exist. With the SOES system, "market makers don't like the fact that, for the first time, they can no longer weasel out of a trade," says Mark D. Shefts, All-Tech's president and SOES trader Houtkin's brother-in-law.

The proposed rule change may squelch the SOES sharpies, yet it raises a larger question. NASD promotes its computerized dealer system as the marketplace of the future. But critics warn that the dealers' response to the SOES woes shows how entrenched interests can undermine attempts to make the market more efficient if their wallets are at risk. "It troubles me that the very organization that says, `We're all computers,' wants to throw sand in the gears when the computers start to pinch a little," says former SEC Commissioner Charles C. Cox. Well, it shouldn't come as a surprise. After all, SOES pros are teaching Wall Street that electronic trading can sometimes be a jolting experience.

Before it's here, it's on the Bloomberg Terminal.