`A Private Market Within A Market'?

During the 1987 stock market crash, the NASDAQ trading system for over-the-counter securities suffered a communications meltdown. Jammed telephone lines made it well-nigh impossible for investors to reach their brokers and for brokers to reach market makers to execute trades. To rectify the problem and to bolster NASDAQ's image as the market of the future, the National Association of Securities Dealers, which operates NASDAQ, introduced SelectNet, a computerized order system that enables brokers and dealers to bypass phone lines to make trades directly.

But while the three-year-old network may have solved one problem, it has created another firestorm for the NASD. Critics, from institutional investors to Capitol Hill, charge that the trading system has evolved into a private market that NASD securities firms can exploit at the expense of investors. "It makes a sham" of the public market, says Peter W. Jenkins, head trader at Scudder, Stevens & Clark Inc.

PLAYING GAMES. The problem, according to the critics, is that prices are often better on SelectNet, which only NASD members can see and use, than on the national NASDAQ system, where bid and asked prices for the public are posted. Market makers normally buy stock from customers at the public bid price and sell at the public asked price, making their profit on the spread. But by using SelectNet, they can do even better. Often trading in sixteenths and thirty-seconds of a dollar, they can usually buy stock from another market maker at a price lower than the public bid. When a transaction is reported to NASDAQ, the price is rounded up to the nearest eighth. "It's obvious all kinds of games are being played with this system," says Harold S. Bradley, head trader for the 20th Century group of funds.

With 12 million shares traded daily on the system, small differences can add up. That's why a powerful coalition of SelectNet opponents is pressing the NASD to open up the network. Sixteen institutional money managers, including Fidelity Management & Research and T. Rowe Price Associates Inc., are challenging the system. Representative John D. Dingell (D-Mich.), chairman of the House Energy & Commerce Committee, also has chimed in. On Nov. 10, the Investment Company Institute, the mutual-fund trade group, took the unusual step of writing to the NASD to "strongly urge" that the private system be made public.

The institutions aren't asking to bypass market makers and execute trades among themselves on SelectNet. They just want to see the prices, which would allow them to negotiate better deals with NASD market makers or on alternative electronic trading systems such as Reuters' Instinet.

The NASD's board is scheduled to discuss the issue at a meeting in January. Despite intense pressure for change, there will probably be substantial internal resistance. Market makers trading for their own account can profit handsomely by exploiting superior prices on SelectNet, which in the first six months of this year handled about 5% of all shares traded on NASDAQ, though that greatly underestimates the volume linked to SelectNet prices.

"NOTHING EVIL." SelectNet is sufficiently lucrative for brokers and dealers that they're even willing to incur the wrath of the New York Stock Exchange to expand the system. Last year, the NASD asked the Securities & Exchange Commission to approve trading of exchange-listed stocks on the system. The Big Board's chilly comment: The SEC should "reconsider" whether SelectNet should be in business at all. Rather than a backup electronic system, it "has evolved into a private market within a market."

The NASD argues that SelectNet is simply a legitimate way for dealers and market makers to find a better price for customers' securities. Richard Ket- chum, NASD executive vice-president, notes that it enables NASD member firms to direct orders to market makers and to negotiate price through counteroffers entered into the system. "There's nothing evil about it," he declares. As some institutions see it, market makers feel they deserve extra profits from SelectNet to compensate them for trading being siphoned away by alternative systems.

All the same, NASD members seem willing to compromise. On Nov. 12, brokers proposed to the NASD board the option of making SelectNet quotes available to institutions after a 60-second delay. But 60 seconds might as well be a year for money managers. "That would be unacceptable," says Craig S. Tyle, ICI's vice-president for securities.

NASD members haven't settled on their next bid. But for some of their largest customers, only one offer will defuse this fight: access to NASDAQ's private trading network.

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