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Fun and Games Continue On Nasdaq Despite Government’s Probe

News

After almost two years of investigating allegations of collusion on the Nasdaq stock exchange, the Justice Department on July 17th confirmed some of the allegations but came short of filing criminal charges against any of the participants. Moreover, Forbes magazine (July 29, 1996) has its lead story on "games" played.

Analysis

I would like to use these stories to look at some of the differences between auction markets, like the New York Stock Exchange (NYSE), and the Nasdaq market.

Auction vs. Dealer Markets

Basic Structure

The National Association of Securities Dealers Automated Quote (NASDAQ), pronounced "naz-daq," use a multiple marketmaker system, where many dealers make bids and offers on stocks. On the other hand, the New York Stock Exchange, also referred to as Big Board, as well as the American Stock Exchange employ the auction method, wherein one specialist handles all trades in a given stock.

 The specialist passively matches orders of buyers and sellers wishing to trade at a specific price. Moreover, she is obligated to step in to buy and sell out of her capital anytime there is an imbalance between buy and sell orders. The market crash of October 19, 1987 was a good illustration of how important this function was. The Nasdaq dealers could just walk away from a rapidly falling market without having to buy for their account in an attempt to at least stabilize such a situation and limit the downward spiral. Furthermore, she, unlike her counterparts on the Nasdaq market, is not allowed to execute her trade, i.e., buy or sell out of her capital, before the public’s.

 Nasdaq officials have traditionally argued that their marketmaker trading environment is better for investors as it provides competition fostered by having a number of marketmakers competing for business. The evidence, however, is overwhelmingly in favor of the auction type markets, as I hope to demonstrate below.

Who Are These Maketmakers?

Marketmaker firms include such industry giants as Merrill Lynch & Co., Travelers Group's Smith Barney Inc., Dean Witter, Discover & Co., Salomon Brothers Inc., Goldman, Sachs & Co. and Morgan Stanley Group Inc. There were 542 firms in May, up almost 30% from five years ago.

Collusion

Forbes magazine (August 16, 1993) provides some examples of how collusion on maintaining the spreads work. A dealer who tries to narrow, or "break the spread" as it is called, would get phone calls from people screaming ‘Don’t break the spread! You’re ruining it for everybody else!’ or ‘Whaddya doing in the stock? You’re closing the spread. We don’t play ball that way. Go back where you belong.’ Occasionally, the magazine added, other marketmakers would completely stop trading in that particular stock until wider spreads are reestablished.

Size Comparisons

According to Forbes magazine (July 29, 196), the market value of all Nasdaq stocks at midyear 1996 was a bit under $1.5 trillion, compared with $6.6 trillion on the NYSE. The volume on the Nasdaq last year was in excess of 100 billion shares, compared with 87 billion on the Big Board. Whereas trading volume on the Big Board has little more than doubled since 1990, Nasdaq's has tripled.

P/E Ratios

The average price/earnings (P/E) ratio of a Nasdaq stock stood at 44 last month, up from 35 just six months ago. The average ratio on the NYSE was 20 and 21 on the American Stock Exchange, according to Forbes magazine.

Spreads and Transactions Costs

When investors buy or sell stocks they incur transaction costs. There are three sources of costs: (1) commission that brokers make; (2) the spread, or the difference between the price at which dealers offer to buy, or bid, and the price they’re willing to buy a stock for, or ask; and (3) market impact, or moving the market price in an unfavorable direction associated with an order to buy or sell a large number of shares of a given stock. The issue at hand deals with the bid-ask spread.

In a well functioning financial market, the size of a stock’s spread is directly influenced by the stock’s liquidity. Holding stocks in inventory that are not liquid, or don’t trade frequently, represents an additional source of risk that must be absorbed by the marketmaker. Thus, the spread of such a stock, other things being equal, should have a higher spread to compensate the marketmaker. However, the debate centers on excessive compensation. The marketmaker’s compensation ends up being paid by the small investor.

Quoting two studies, Forbes magazine confirms that the size of spread on Nasdaq is larger than the NYSE. Quoting Abel/Noser, average Nasdaq spreads are roughly double those on the NYSE--38 cents versus 19. This was also confirmed by a March 1996 working paper on trading costs and exchange listings by Paul Schultz, a professor at Ohio State University, and Mir Zaman, a professor at the University of Northern Iowa. The academics found that on small trades, effective spreads usually increase by more than 100% when a stock moves from a listed market to Nasdaq.

Spreads and Order of Execution

The wider spreads and the ability of the Nasdaq marketmakers to trade before the public have important transactions cost implications for investors. Here is an example drawn from the magazine.

"Let's say you want to sell 500 shares of Big Board-listed Micron Technology at 23 1/8 a share. The current market is 23 1/8 bid, 23 1/4 asked. If you put your order in with a 23 1/4 limit and are patient, the specialist in Micron will very likely find a customer who is willing to pay 23 1/4 for your shares. In any case, the specialist could not sell shares ahead of you at that price. But if Micron were traded over-the-counter, your limit order would very likely not get executed unless the market started to move up. As long as the market is 23 1/8 bid, 23 1/4 asked, over-the-counter, your order would generate a "nothing done," and marketmakers could trade ahead of you."

The magazine provides the following evidence in support of the above illustration. The number of investor orders that are passively matched or "crossed" by the specialist on average on NYSE and AMEX stocks 91.4% and 89% of trades, respectively. Only 1.7% of the investors on Nasdaq market are crossed, adds the magazine. This implies that in 98.3% of Nasdaq trades, a marketmaker inserts himself between buyer and seller not to provide liquidity but to bite off 1/8 of a point or more. The magazine points out that such fractions can very quickly mount up when dealing with 2 billion shares a week.

Spreads and Volatility

The average volatility today in NYSE and AMEX stocks--as measured by intraday price movements off the stocks' daily lows--is 2.09% and 2.87%, respectively. On Nasdaq this volatility is more than double the Big Board's--4.9% (Forbes magazine).

What happens to a stock's volatility when it moves from Nasdaq to the NYSE? Of the 68 companies that made this move from January 1995 to May 1996, 93% saw a decline in intraday volatility in their stocks--from 3.4% on Nasdaq to 2.2% on the NYSE, according to the magazine. The reverse was also true. When companies trading on AMEX begin trading on Nasdaq, it’s highly likely that their volatility would increase.(Companies are prohibited from leaving the NYSE unless their stockholders vote to do so, so this comparison can't be made.) Between January 1995 and May 1996, 19 companies moved their stocks from the AMEX to Nasdaq; 95% experienced a wider intraday price range.

Source of Original Complaint

In an academic paper in 1994, Professor William Christy of Vanderbilt University and Paul Schultz of Ohio State University reported that Nasdaq dealers systematically avoided quoting stocks with spreads narrower than 1/4, even though spreads of 1/8, or 12.5 cents were typical on the New York Stock Exchange. They said "tacit collusion" appeared to be the only possible explanation.

The Government’s Settlement

Ruling

Atty. General Janet Reno said that the Justice Department’s investigation, which produced tape-recorded evidence, uncovered "numerous instances" of rival firm dealers' agreeing to help each other benefit financially by raising or lowering quoted prices. Janet Reno contended that the settlement required the firms to take steps that would end the fixing of spreads, even though the accord involves no direct financial penalties.

The settlement did not require the dealers to admit wrongdoing and, in statements, they strongly denied engaging in any collusion with rival firms. They said they had simply settled on what they contended were mild terms to avoid a threatened lawsuit by the Justice Department.

Justice Department Antitrust Chief Anne K. Bingaman was quoted by the Los Angeles Times (July 18) as saying that "even though the government believed it had strong evidence that dealers had manipulated spreads, it decided early on not to file criminal charges. She said it made the decision because the conspiracy had been in effect for so long--perhaps 30 years--that it had simply become a way of life on Wall Street."

Chief Bingaman added that once the government decided to file only civil charges, the law did not allow it to seek fines, damages or restitution. In civil antitrust cases, the Justice Department can only get court orders stopping the alleged illegal practices and requiring remedial steps.

Under the settlement, the firms will be required to randomly tape about 3.5% of traders' conversations and listen to the tapes, which would amount to some 40,000 hours of tape each year. Justice will be allowed to make surprise visits, listen to the tapes at any time and order taping of traders against whom complaints had been made. The Justice Department is also setting up a telephone hotline for complaints against traders.

The firms, on their part, agreed to be banned from colluding on spreads and from taking any steps to punish dealers that lower spreads. The firms will also be required to file detailed reports with Justice and to take steps to ensure that traders comply with the ban.

Implications Of Ruling

However, this does not necessarily mean that the firms are completely off the hook. They still face possible stiff financial penalties from a private antitrust lawsuit pending in federal court in New York. The law allows such private suits to seek treble damages, which investor lawyers contend could total in the hundreds of millions of dollars, noted the Los Angeles Times.

Chief Bingaman, as quoted by the Los Angeles Times, noted that the average spread on Nasdaq stocks had narrowed about 27% in an apparent response to the case’s publicity and the investigation.

Consider the following illustration: if a stock is quoted by dealers offering to buy it for $10 and sell it for $10.25, another dealer would now be able to offer to buy the stock for $20.125, thus pushing up the best bid and narrowing the spread.

Analysts quoted by the WSJ (July 18, 1996) said that the key to whether investors get improved prices lies in how rigorously the Justice Department enforces the terms of the settlement. If the settlement forces marketmakers to quote prices in one-eighth of a point rather than the current practice of one-quarter, then ‘it will have a huge effect,’ Paul Schultz, co-author of the influential study noted above, told the WSJ. He added that narrower spreads allow mutual-fund managers to get better prices, too. Although large institutional buyers such as mutual funds already get prices inside the spread through negotiations with marketmakers on separate trading systems, ‘studies ... . show that trades of all sizes get better execution when dealers use all prices,’ says Prof. Schultz.

Morris Mendelson, Professor Emeritus of Finance at the University of Pennsylvania's Wharton School, was quoted by the WSJ as saying that : ‘They got off pretty easily this time" but didn't think "they will if they continue to avoid odd eighths." Professor Mendelson added that although the ruling would not have a sizable impact on any individual investor, its effect could "be fairly significant for small investors."

What Does the Volume On Nasdaq Really Measure

In fact, much of the volume that looks so impressive on Nasdaq is not investor meeting investor but marketmaker meeting investor or marketmaker meeting marketmaker, notes Forbes magazine. Moving a share from one investor to another may involve more than one trade: seller to marketmaker; marketmaker to buyer. John Gould and Allan Kleidon in the Stanford Journal of Law, Business & Finance in 1994 analyzed this method of counting volume and concluded that roughly 41% of Nasdaq volume is investor-generated. The rest--59%--is marketmakers trading among themselves, known as "the churn," the magazine points out.

The magazine adds that dealer-to-dealer trading also provides splendid opportunities for creating "attention-getting volume" that will show up on computers and attract momentum investors. Nasdaq admits to as much in the marketing materials it uses to recruit companies. "Nasdaq's increased demand creates a higher price" for your stock, notes the magazine.

Gretchen Morgenson of Forbes magazine (August 16, 1993) points out another possible explanation for the high volume on Nasdaq. She points out that brokers make a higher commission on Nasdaq trades than other markets. Thus, they have an incentive to direct their clients’ stock accounts towards Nasdaq stocks.

Why Don’t Companies Move to the Big Board?

Although the vast majority of the companies on Nasdaq do not qualify to be listed on the Big Board because they have small capitalization, the largest, say, 20 companies definitely qualify. So what is stopping them?

Listing Costs

The chief financial officer of MCI was quoted by Forbes magazine (August, 16, 1993) as saying that ‘The cost of listing on Nasdaq is substantially lower; we don’t have trading halts or delayed openings like they do on the New York.

Free Advertising

The magazine goes on to note that MCI, as well as the other large companies, get a free ride from Nasdaq’s advertising as "the stock market for the next 100 years."

Higher Broker Commission on Nasdaq

As noted above, with brokers’ higher incentives to peddle Nasdaq stock, small emerging companies might initially prefer Nasdaq as the brokers incentive creates much needed liquidity at the early stages of going public.

Easier to Sell "Insider Stock"

See section below.

Other Games Played

The magazine points out some of the games played "under the cover of this dealer-to-dealer trading" For example, insiders can unload restricted stocks under conditions set up by the SEC. Rules say that, per quarter, insiders cannot sell more than 1% of the shares outstanding or more than the average weekly reported volume in the stock for the previous four weeks. Thus, the larger the volume in the stock, the more insider stocks can be sold. If volume were counted as it is on other exchanges, executives of Nasdaq companies could sell less than half the insider stock they can sell today. This is a powerful incentive for stocks to remain on Nasdaq even though they might quality for listing on the Big Board.

New Source of Competition

Some analysts quoted by the Journal noted that small individual investors were still at a disadvantage compared to institutional investors. They noted that the majority of institutional and other big deals are done on private or separate systems, such as Instinet or Selectnet, where trades are executed at negotiated prices -- usually at better prices than on the public Nasdaq system.

Yet others, also quoted by the Journal, pointed out the significant role that Nasdaq's long-awaited small-order handling system, which is being reviewed by the Securities and Exchange Commission, will have when it is finally in place. The new system, known as NAqcess, will allow investors to place "limit orders" to buy or sell a Nasdaq stock at a certain price on NAqcess and get matched up with other orders. No marketmakers would be allowed to execute trades at better prices, even for their biggest customers, before that limit order is filled. 

By Alex Tajirian