Leveling Nasdaq's Playing Field

New SEC rules would broaden investors' access to prices

On Aug. 8, the National Association of Securities Dealers was censured for failing to halt widespread price-fixing on its NASDAQ stock market. Now, the Securities & Exchange Commission is set to drop a second shoe.

On Aug. 28, the SEC is expected to approve trading rules that could go a long way toward putting small investors on a par with the pros. The two key changes: All investors will have access to the best quoted prices, which are now available only to institutional traders and broker-dealers, and brokers won't be able to ignore offers from investors to trade at prices that undercut the prices quoted by dealers. In any one trade, a small investor might come out only a few dollars ahead. But cumulatively, the difference amounts to hundreds of millions of dollars a year.

CONTROVERSY. Proposed 11 months ago, the changes have stirred a huge controversy. Angry market makers have complained to Congress that their views haven't been adequately aired. They've gotten the ear of Rep. Thomas J. Bliley Jr. (R-Va.), chairman of the House Commerce Committee, which oversees the SEC. The agency is concerned that Congress could delay or block the rules.

At the center of the dispute is profits. Offering better prices to small investors will slice into the earnings of broker-dealers. Many dealers think the rules will put firms out of business and hurt liquidity in the markets. "More study is needed. NASDAQ is the engine of growth for small companies," says E.E. Geduld, president of market-maker Herzog Heine Geduld.

Advocates counter that the rules will only improve NASDAQ and other markets. A level playing field for small investors will attract more participants and increase the buying and selling of stocks. "Some market makers will drop out," says Bernard L. Madoff, principal of Bernard L. Madoff Investment Securities. "The ones who stay are the most competitive. The market will be more competitive than ever," he says.

The SEC is convinced that the rules are needed to clean up the market. In its investigation of NASDAQ trading practices, the SEC found ample evidence that dealer firms trading in the same stock sometimes conspire to set an artificially wide "spread"--the difference between the bid and ask prices. Generally, investors must sell at the quoted bid price and buy at the ask price. Dealers profit by buying for less than the advertised bid price and selling for more than the ask price. They keep the difference--usually at least 12 1/2 cents a share.

With new electronic markets such as Instinet Corp., owned by Reuters Holdings PLC, the ability of brokers to strike favorable deals at prices better than the spread has become more prevalent. These electronic systems are a quick and anonymous way for big traders to buy and sell blocks of stock at prices better than the quoted NASDAQ spread. But only the biggest players--broker-dealers and mutual-fund traders--have access to these systems. NASDAQ dealers are the biggest users.

The SEC wants investors to be aware of better prices--without putting the innovative systems out of business. Industry insiders think the SEC will require bid-ask quotes from Instinet to be displayed side by side with NASDAQ prices on national quote systems. They expect the SEC to allow traders to remain anonymous on Instinet.

IGNORED. The SEC plans to help small investors in another way. Investors too often come up short when submitting an order to buy or sell at a specific price inside the dealers' quoted range. These "limit orders" are often ignored because more competitive offers narrow dealers' spreads.

To correct the problem, a second rule will require dealers to broadcast customer limit orders to the market when they are offering a better price than the one being quoted in the market. The industry won't contest the rule, but it is fighting the SEC on the size of the orders. The SEC is proposing that the rule cover trades of up to 10,000 shares. The dealers want the upper limit to be smaller, perhaps as low as 1,000, to protect their business. The SEC hasn't made a final decision.

Whatever the SEC staff recommends, the commissioners are expected to approve at their next open meeting. Compliance is expected to be phased in over the next several months. That is, if Congress doesn't step in. Under a small-business bill signed last spring, Congress can delay for 60 legislative days new federal regulations for further study or even overturn the rules. But with so much attention focused on NASDAQ problems, Congress will hopefully side with the investor on this one, and not the securities industry.

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