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April 30, 1998

Traders' Fears Over a 'Compulsory' NASD CLOB: Do the Primary Market-Making Rules Foreshadow NASD

By Jeffrey L. Winograd

The order-delivery and execution system recently proposed by the National Association of Securities Dealers is still mired in controversy over its consolidated limit-order book.

Traders fear that the NASD-sponsored book - designed to give them a new option for executing their customers' limit orders - may compete directly with market makers for customer order flow.

Now another equally controversial fear has flared over whether the limit-order book will effectively evolve into a mandatory utility traders must use to remain profitable.

That view became increasingly evident when the NASD recently filed its proposed set of standards with the Securities and Exchange Commission for broker dealers that want to become primary market makers in Nasdaq stocks.

Reemerged

Primary market-making standards were essentially abandoned in the wake of the order handling rules, but have now reemerged as an important carrot to drum up market-maker support for the limit-order book.

Fulfilling the new primary market-making standards allows a market maker to sponsor institutional access to the book. That alone may force scores of market makers to become book users.

"There's not much wiggle room, is there?" one trader asked rhetorically. "A market maker that values his institutional business could be compelled to use the NASD's limit-order book."

What's more, traders say, investors may view the book as the best place to execute their orders. The SEC published the NASD's primary market-making rule proposals in April. The NASD has stressed the marketing value that primary market-making compliance gives trading firms, as well as the more tangible benefits, including exemption from the short-sale rule.

"The exemption frees a market maker to aggressively unwind a position, or otherwise to aggressively sell," one expert explained. "The SEC's intent is to encourage deeper and better-priced markets"

At the same time, the NASD recently suggested that it would engage in profit-sharing arrangements with market makers using the limit-order book, provided they adhere to the new primary market-making rules.

Reincarnated

The new standards have the support of the NASD's Quality of Markets Committee. Under the reincarnated primary market-making rules, a market maker's performance will initially be measured against two standards: how often the market maker buys at the bid when the market is moving down, and how frequently he sells when the market is moving up.

For example, if NASD computers show the market maker is always buying in a down market, the market maker bats a 1.000 average, according to an analogy provided by an NASD official. Always selling when the market is heading up will also produce a 1.000 average. A market maker with an average of at least .670 will be viewed by the NASD as worthy of a primary market-making designation.

However, measuring a market maker's performance in connection with the standards is complex. The NASD's computers will evaluate the proportion of a market maker's trades in a particular stock, and the proportion of the market maker's share volume in that stock. The most valuable traders will produce a high number of trades and a large volume.

The NASD said it would like to implement the new standards on a pilot basis as early as possible. The first month of operation would be used to begin calculating whether market makers are meeting the new criteria.

Market makers would receive their initial ratings and then have the second month to more fully adjust. The third month would produce an actual effect for market makers.