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Nasdaq: Not just for members anymore

Reforms adopted a year ago at the Nasdaq Stock Market have helped ordinary investors crack what used to be a members-only club.

Buy and sell orders from plain folks _ many of them wielding personal computers and Internet trading accounts _ now have the power to directly determine Nasdaq stock prices in ways that only member broker-dealers could in the past.

The new order-handling rules "forced competition upon a reluctant group of market makers, and it's been a stunning success," said David K. Whitcomb, a Rutgers University finance professor and sometime Nasdaq critic.

Others are less ebullient about the changes. Nonetheless, the result of the reforms _ plus Nasdaq's move in June, with other major U.S. markets, to start quoting share prices in minimum increments of sixteenths of a dollar instead of eighths _ has been a sharp decline in dealer "spreads," or stock price markups, and savings estimated in the billions of dollars for investors.

The National Association of Securities Dealers, Nasdaq's parent organization, says average spreads between stock "bid" and "asked' prices have shrunk 41 percent since the implementation of the new order-handling rules. The rules were phased in beginning in January 1997 and were extended to all 5,500 Nasdaq stocks by October.

Some experts contend that because of a quirk of measurement, the true drop in spreads might be only about half the stated 41 percent. But either way it has been a boon for investors.

And so far at least, there is little evidence of the feared downside of shrinking spreads: that dealers' falling profitability would drive a large number of them out of market-making activities, hurting investors' ability to buy and sell Nasdaq stocks when they want and in the quantities they want.

Still, except for October's brief market turbulence, there hasn't yet been a stern test of the Nasdaq market's liquidity under the new trading rules.

The reforms were imposed by the Securities and Exchange Commission after years of criticism of Nasdaq, and after the SEC in 1996 found that Nasdaq market makers had been illegally colluding to maintain wide spreads and keep investors from getting in between those spreads.

Say, for example, that a market maker is quoting a bid (buy) price of $40 and an asked (sell) price of $40.25 for a particular stock, and that an investor places a "limit" order _ an order stating a specific price _ to buy at $40.06.

Before the reforms, market makers could in effect ignore limit orders that would cut into their spread. Now, under the new order-handling rules, dealers must either promptly meet and execute such "inside" orders or electronically display them to the whole market, so other investors have the chance to trade at the inside price.

The competition that this move instilled was turbocharged by Nasdaq's decision also to display any inside orders that enter the market through the fast-growing private electronic communications networks, or ECNs, such as Reuters' Instinet, Island and Bloomberg Tradebook, through which professional traders and big institutions trade directly with each other rather than with dealers.

Although the principal customers of the ECNs are institutions, Internet brokerages such as E-Trade also use ECNs. That means that limit orders from individual investors trading from their home personal computers can set the tone for prices in the Nasdaq market overall.

As the ECNs' share of Nasdaq trading volume continues to increase, it's estimated that customer orders, rather than dealer-generated quotes, are dictating the prices of Nasdaq stocks at least 20 percent of the time. And given that dealers have had to shrink their spreads to remain competitive, the real price effect of the ECNs and limit orders is magnified.

Patrick Healy, a former Nasdaq official who is president of Chevy Chase, Md.-based Issuer Net, which advises companies on where to list their stocks, said that 20 percent figure represents a big step forward for Nasdaq in its evolution from a purely dealer-driven market to more of an order-driven _ or auction _ market like the New York Stock Exchange.

One of the big remaining questions about the order-handling rules is how they might affect Nasdaq stocks' liquidity in a sustained market downturn.

Unlike at the NYSE, which requires that its "specialist" traders _ in exchange for their monopoly in handling trades for a particular stock _ also act as buyers of last resort, Nasdaq market makers are free to simply post uncompetitive quotes when they don't want to trade.

Dealers have long argued that their price spreads have been necessary to earn adequate returns so that they have the capital needed to support the market when there are few investor buyers.

Thus, the fear with the new Nasdaq trading rules was that dealers' shrinking profits from narrowed price spreads would cause some of them to stop handling smaller stocks, for which the relative lack of trading interest increases the chance that a market maker will get stuck holding a stock that nobody wants to buy.

Overall, it's hard to make a case that the new rules have yet enhanced or have reduced liquidity significantly, analysts say.

Market makers got high marks for performance during last October's mini-crash, when the Nasdaq composite index fell 7 percent in one day and volume surged to a record 1.3-billion shares the next day.

Spreads in the market did not widen sharply, and there were few reports of dealers refusing to trade, both Nasdaq officials and critics said. "None of the horror stories have come to pass," said John Tognino, president of the Security Traders Association, a trade group.

Still, he added, "the fact is, we don't know what the level of liquidity will be in a real down market in the face of all these innovations and the profit-margin squeeze" on dealers.

Healy noted that Merrill Lynch & Co., Bear Stearns Cos. and other Wall Street giants have trimmed the number of Nasdaq stocks in which they make markets. "When Merrill and Bear are not in the game, you have to look who's taking their place," he said. "Obviously, the guys taking their place don't have as much capital."

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