SEC Ends Nasdaq Dealer Trading Privileges

The Securities and Exchange Commission on Wednesday took another dramatic step toward reforming the Nasdaq Stock Market, adopting rules that will give individual investors better prices and abolishing special privileges long enjoyed by dealers and institutional investors.

SEC Chairman Arthur Levitt, whose agency also recently settled major civil charges against the Nasdaq market, called the rules “among the most significant ever to be considered by the commission.”

Traders said the rules will fundamentally change Nasdaq trading, creating far more competition on price and possibly encouraging more small investors to invest directly in Nasdaq stocks.

But some also contend the rules will increase traders’ costs and risks and may even drive some marginal brokerages out of business.

By a 4-0 vote, the SEC adopted two basic changes. One is aimed at ending dealers’ and institutional investors’ privileged access to the best prices on stocks. The prices in question are those quoted on private electronic trading networks, such as Reuters’ Instinet, which are currently unavailable to individual investors.

Instinet, which by some estimates handles 50% of the trading in Nasdaq’s 100 biggest stocks, often displays more advantageous prices than those available to individual investors. Often, in fact, dealers offer each other even better prices via the closed networks than they offer their customers. The new rule requires dealers to make those prices available to all of their customers.

The other reform greatly improves the chance that customer limit orders--orders to buy or sell at a price the customer specifies in advance--will be filled if they are at prices better than those offered by dealers. The rule states that the limit orders must be publicly displayed, meaning investors will have better information about the genuine supply of or demand for a stock.

The limit order rule may go far to resolve what has been one of the major complaints about Nasdaq: that customer limit orders were seldom filled unless they happened to match the dealers’ prices.

Dealers, also known as market makers, are the Wall Street firms that stand ready to buy or sell Nasdaq stocks at publicly quoted prices. In practice, they quote two prices for Nasdaq stocks: the “bid” price at which they offer to buy, and a higher “asked” price at which they offer to sell.

A dealer, for example, might quote XYZ Corp. stock at 20 bid, 20 1/4 asked.

The 1/4, or 25-cent, gap between them is known as the spread and represents dealers’ profit margins. Both the Justice Department’s antitrust division and the SEC have accused dealers of colluding to keep these spreads artificially wide, which enhances dealers’ profits.

Under the new limit order rule, dealers will have to display to all investors any such bid and asked prices that are better than the dealers’ own; such information was unavailable previously, meaning customers were forced to pay whatever prices dealers quoted them. Now, market experts say, dealers will have to fill customer orders at the best price.

Longtime Nasdaq critics responded to the SEC’s action with jubilation. Harold Bradley, head of trading for the Twentieth Century group of mutual funds, called the SEC’s action “courageous” and said that as a result, “dealers will truly have to become price-competitive if they want to survive.”

Nasdaq’s parent, the National Assn. of Securities Dealers, has long fought any changes that would reduce the privileges of the big stock brokerages that are its most influential members.

But the organization has recently undertaken major internal changes in response to federal investigations, and on Wednesday it publicly embraced the new rules. Nasdaq’s own new president, Alfred R. Berkeley III, promised to enthusiastically implement the changes.

“We think this is a major step forward to leveling the playing field” between brokers and their customers, he said.

The rule changes follow a massive SEC enforcement action on Aug. 8 against the NASD and Nasdaq. The SEC charged the NASD with ignoring rampant violations of trading rules on Nasdaq and extracted a settlement requiring the organization to spend $100 million on enforcement over five years and to take detailed steps to ensure fairer trading.

The SEC said the rules adopted Wednesday will go into effect in phases beginning in about 120 days. All are expected to be in effect within a year. The SEC first proposed versions for public comment last year.

However, the agency at least temporarily dropped one controversial proposal that would have required dealers to allow market order customers to trade at a better price if one emerged before their orders were filled. But the dealers would also be bound to fill the order at no worse than the initially quoted market price.

Market orders are those that can be filled at whatever price is prevailing on the market at the time the order is placed.

Dealer firms protested that the “price improvement” rule would leave them with too much risk from an adverse market move.

Levitt said the other rules adopted Wednesday would probably eliminate much of the problem the price improvement rule was meant to eliminate. But the SEC commissioners made clear that they may still adopt it after assessing how well the other rules work.

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What the Changes Would Mean for Investors

Situation now:

Nasdaq dealers quote two prices for each stock--a price at which they offer to buy a stock from investors and a higher price at which they offer to sell. Currently, individual investors can almost never get prices better than those offered by dealers.

Under the new rules:

Customers would have a much greater chance of getting better prices. They would also have far more chance to trade directly with one another, reducing the middleman role of thedealers. Dealers would be required to publicly display better-priced customer limit orders, which are orders to buy or sell at a price specified in advance. The orders therefore would have a much greater chance of being filled.

Situation now:

There is a two-tier trading system in which individual investors pay the prices quoted by dealers, but the dealers themselves and institutional investors have access to much better prices quoted on private electronic trading systems.

Under the new rules:

The playing field would be leveled. All investors would have access to information about the better prices quoted on private trading systems such as Reuters’ Instinet.